Dealing with macro’s dirty little secret

The Fed has long favored a sustained burst of inflation above its long-term target of 2%.  That they have failed to deliver is about luck and minor policy errors, not preferences.

The understated preference for higher inflaton is one of the reasons they have tended to be “surprisingly” dovish over the past decade.  More recently, however, they have become more forthright on the point.  I think this reflects two things. First, they see the urgency of preventing a further decline of inflation expectations in the real economy, and of pushing such expectations higher, to the extent they can.  Second, the leadership is probably now more confident in the intuition it has held for years, and wants to keep itself focused while bringing along some of the laggards.

The leadership’s decision to be more explicit has probably contributed to the recent widening of inflation compensation in the bond market.  However, I would guess that the low-hanging fruit there has already been picked.  At the Covid-crisis tights, breakevens were out of line with even depressed inflation expectations and with the inflation convexity implied by the design of indexed bonds when inflation is low.  Most of the recent widening can be described, then, as simply risk and illiquidity on.  The Fed has obviously contributed to that, but not necessarily through the inflation communication channel.

From here, the question of whether the Fed can credibly commit to delivering on its inflation preference assumes more importance, not just for breakevens but for the markets more generally.  The point of this report is to urge its readers to update their thinking on this issue.

For many years, fans of the efficacy of monetary policy have been pushing easy solutions, such as the use of the balance sheet or maybe “coordination” between central banks and their treasuries in the form of helicopter money.  Market participants just love that term, coordination.

The fibs told around this stuff have probably been helpful to the extent they have encouraged easier financial conditions. But on the specific question of when inflation might move higher, believing in that nonsense would have made investors very early.

But there is a form of coordination that is more slowly acting and whose acceptance has been slower to develop. I refer here to central banks, including the Fed, successfully calling on governments to deliver fiscal expansion, without any funny money aspect.  You may be surprised to read – and may disagree even after you have read – that there is actually a fairly broad consensus that sustained fiscal expansion can raise r*.  Moreover, r* shows up in the logic for Ponzi public finance, just as it does in the secular stagnation thesis.  This may seem obvious, but I have not seen it explicitly emphasized.

Raising r* would immediately ease the constraint imposed by the zero lower bound on rates and thus allow monetary policy to gain traction in supporting aggregate demand and thus real economic growth.  That would be worthwhile in its own right, obviously.  But a knock-on effect of the higher demand growth would be to make it easier for the Fed to hit its higher inflation objective, which is the subject of this report.

Of course, things could work out even without this additional fiscal support. It is possible that this recovery eventually, not soon, evolves into an expansion that eventually tightens up resource use and allows higher inflation.  Importantly, this good-luck scenario does not actually rely on the existence of a Phillips Curve, implying that the resource use overshoot precedes the inflation.  This story could work out in the so-called new classical setting just as easily.

But in terms of the backstop required to make the inflation commitment credible, the most obvious candidate is fiscal expansion.  For those interested in the long-term outlook for breakevens and inflation itself, I think relying on that backstop is a bet worth making. More to the point, it is the bet you are making.