“With regard to interest rates we continue to expect it will be appropriate to maintain the current 0 to 1⁄4 percent target range for the federal funds rate until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time ...” (Fed statement preceding the press conference after the April 27–28 FOMC meeting, https://www.federalreserve.gov/newsevents/pressreleases/monetary20210428a.htm. Bold font is mine.)
The inflation debate rages on. Let’s do that part first.
Some say inflation has arrived. They are partially right. Some say the Fed is going to regret their sustained $120 billion a month quantitative easing policy coupled with an administered short-term interest rate of 0.0% to 0.25%. Maybe yes and maybe no; we do not know the future; the Fed is certainly facilitating the Treasury’s deficit-financing impact on financial markets. Some say the Fed is correct, and the inflation scare is transitory. They may be right; it depends on many factors, including the size and length of the COVID economic shock. Some admit they don’t know. We agree, and we believe that “I don’t know” reflects the single best opinion anyone can offer. Last, we are now hearing some say that the Fed’s use of PCE or core PCE is a flawed choice. Really? That is a way to attack the Fed without offering an alternative. See the latest Dallas Fed releases on trimmed Mean PCE here: https://www.dallasfed.org/research/pce.aspx. Note the related articles linked on the page. See also https://www.mql5.com/en/economic-calendar/united-states/dallas-fed-trimmed-mean-pce-inflation-rate. These resources will tell you that we are a long way from inflation that’s likely to be sustained above 2%.
Let’s finish the inflation debate with two points and get to the size of the shock and the employment part of the two-part prescription quoted above. But before we do, we want to add two points. The first is about what we do NOT see. We haven’t been reading about bank failures during the COVID period. The Fed has accomplished the avoidance of a financial meltdown. The Archegos hedge fund debacle is not a meltdown. And note how the American banking participants have had little damage.
The second point is about the difference between Wall Street and Main Street. Most of the players in the American economy are on Main street. That is the where the real economy is recovering, and that is what the Fed has on its radar screen. Wall Street is important for capital raising and asset pricing. But it is the real economy that the Fed is rightly concerned about.
The opinions matter. And they reflect “expectations,” which are nearly impossible to measure with accuracy. We attempt to do just that with surveys, and we try to do it with certain pricing comparison (TIPS vs. nominal Treasury notes of the same maturity). But those are very poor ways to estimate inflation expectations. In a robust recovery from a very deep shock there are going to be strong price changes, since supply and demand are so imbalanced at the starting point. The rental car at $1000 a week instead of $400 is an example. The COVID shock plunged the rental car companies into bankruptcy, and the old inventory was reduced and facilities closed. Now it takes time to get the system back into balance. We could list a thousand examples.
So is the elevated price of rental cars today sustained inflation or a transitory shock?
But price changes, regardless of duration, do influence attitudes. A recent email from Abnormal Returns summed it up well: “The Fed has committed to printing $120 billion every month and over $2.9 trillion in the next two years. Add in $1.9 trillion of fiscal stimulus and a $2 trillion infrastructure program, and it’s no surprise that 87% of Americans are worried about inflation.” (https://us5.campaign-archive.com/?u=f8843b0fc6f0ed7d35e67dcf5&id=95c84572f9)
Let’s get to the COVID shock, the employment situation, and a view of Fed policy. We asked our friend Charles Plosser, former Philly Fed president and FOMC member, whose term included the years of the Great Financial Crisis, for his perspective.
Charlie wrote:
“Let me first address the number of deaths and the effects. Analytically, you might want to think about this as a one-time shock to labor supply. You speak of excess deaths, but I don’t know much about how those are calculated so I’m just going to assume all are excess deaths to the tune of 500,000. In 2018, the US experienced about 2.8 million deaths. About 650,000 from heart disease and 550,000 from cancer, respiratory disease and strokes account for another 300,000. Putting aside the emotional and personal tragedy of the 500,000 Covid losses, from a labor supply perspective this is not particularly significant. The total labor force is something like 160 million. Since many of the deaths occurred among those 65 and older, the total impact on labor supply is pretty de minimis, perhaps less than 0.25%. Assuming vaccinations bring this way down in the future, this is not an issue of significant economic impact for the economy as a whole and certainly not for monetary policy going forward. Monetary policy is not an effective tool to deal with preventing such supply shocks, especially one-time shocks. Even if you believed this would occur every year, which seems a very, very remote possibility, it would still not be a significant issue for monetary policy. (Ask yourself how monetary policy should change if we suddenly ended all deaths from heart disease. The answer is, of course, it depends on how this impacts the real economy and growth rates over the longer term, but those effects would probably be swamped by other things.) So my view is that monetary policy is not a preventative tool for such real supply shocks. Appropriate fiscal policy may be called for in response to such shocks, but it can't really prevent them. Even then, policies that pay the unemployed more than they can earn by going back to work and then asking the Fed to keep rates low hoping to put people back to work seems to be somewhat counterproductive. It certainly works in the direction of slowing the recovery in the labor market. We may have chosen to do it anyway, but you can’t deny the direction of the effect.”
Charlie closed with this cautionary challenge and transparent communication of the results: “Of course, there are many other issues involved and I don’t mean to minimize the difficult choices we faced. Nor do I want to minimize the value of the lost lives. The most significant real economic consequences of the pandemic stem from the across-the-board shutdowns of the economy we used to reduce the spread and deaths. This cost many their livelihoods, mental health and general welfare even if they did not die. The important analysis that should be done is whether or not there is a better way given all the uncertainty we faced in real time.”
We had further conversation with our friend Charles Plosser about the issue, and we agree that the Fed’s communication is unclear. Maybe part of that problem is that the Fed doesn’t have the model to give it clarity. After all, COVID is a once-in-a-hundred-years shock.
The one thing that was clear is the inflation measure the Fed would use: the PCE year-over-year rate of change above 2%. Fed Vice-Chair Richard Clarida made that very clear in a Bloomberg interview I watched. Note the reference at the start of this commentary about the Dallas Fed’s trimmed mean PCE. Also note that Chairman Powell has referred to trimmed mean PCE several times. I have the release of that information emailed to me each month, just as I do the Cleveland Fed’s trimmed mean CPI. Readers may go to these two Federal Reserve Bank’s websites and sign up for a free emails of the releases. Following these is instructive, in my opinion.
We see the employment situation as follows. The US in February of 2020 had 153 million non-farm payroll jobs. The COVID shock wiped out over 22 million of those in one fell swoop. Then we started a recovery from the shock. Now we are back up to 143 million employed. Before COVID, the US economy was on a trajectory to take us to 155 million non-farm jobs by now. That is where we thought we would be. So I get a 12 million shortfall. Some of those labor force participants are now dead from COVID. Others have long haul sickness. Others are scared to return to jobs where they might not feel safe. Others have recovered from COVID and are letting their unemployment benefits run until September. And still others have decided not to return to their former jobs. (Nurses leaving from COVID burnout or retiring early are a good example.)
This multiply determined mix is the labor shock. So the Fed watches it closely and wants to see total employment back up to the mid-150s in millions of non-farm payroll jobs. That is what we think it takes for the Fed to meet the employment portion of their target or goals. We guess (I repeat, this is a guess) that it will take us two or three years to get to that level. And that assumes we don’t get a COVID surge again.
Now let me get to the assumption that there will be no additional COVID surge. I worry about that one. Too many politicians are making beating this pandemic harder. And two many false narratives are keeping folks from vaccines and simple forms of mitigation. Masks are off in many places. More spread is likely to happen. Vaccines are a partial defense, but not taking a vaccine is no defense. And new variants mean a person can be reinfected if they had COVID before and can possibly get reinfected even if they were immunized. Vaccines and COVID antibodies developed through infection are a partial defense.
But about 70 million Americans are acting as if COVID is over, so they are avoiding vaccination. They are inviting sickness on themselves and those around them. And they are enabling COVID to spread to others.
Governments that discourage mitigation and discourage or prohibit vaccine passports are enabling more spread of the virus. Those same governments are hurting their economic recoveries because they are taking choices way from their citizens in order to pander to political constituencies and influence their behavior. Examples: Would you attend a school that requires a vaccine for matriculation or one that has no rules? Would you prefer a cruise where everyone is vaccinated or a cruise where there are no rules? The list of these choices is long.
So here’s our summary.
Is this inflation spike transitory, or is it on a sustained trajectory? Is it a monetary-induced inflation or a shock response? How do we know? And when will the answers become clear?
The answer, for now, is that we don’t know when, and we don’t have the metrics to prescribe shock response policymaking. The Fed doesn’t have those metrics either.
Portfolios in Cumberland are positioned to try to walk this fine line of uncertainty. That means barbells on the bond side. And it means diverse deployment in preferred sectors of the US market on the stock side. It means being active as a manager of assets.
We are in a remarkable period. Conventional techniques don’t work in the face of shock responses. An investor who is too doctrinaire or otherwise uncritically dependent upon conventional approaches can get into trouble.
We want to offer three links in closing.
The first is an excellent paper by Michael Bordo and Mickey Levy. NBER Working Paper 28195 is entitled “Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record,” https://www.nber.org/papers/w28195.
The next two are links to two newsletters offered by Bill Kennedy, CEO of RiskBridge Advisors.
“Reflation Resumes,” https://mailchi.mp/riskbridgeadvisors/risk-report-may-2021
“Inflation: Who’s in Charge?” https://mcusercontent.com/d300e81bfcafb5e69bf17a06f/files/14e77c16-9b48-4fef-a58f-a2c74ee883c6/RiskBridge_Inflation_final_.pdf
We thank Bill Kennedy for granting permission to share these missives with our readers.
David R. Kotok
Chairman of the Board & Chief Investment Officer
Email | Bio
Disclosure: RiskBridge Advisors is an OCIO firm. RiskBridge acts as an outsourced asset allocation advisor and as an outsourced chief investment officer role for large institutions, foundations, insurance companies, and large family offices. Their website is https://www.riskbridgeadvisors.com. David Kotok is a member of the RiskBridge Advisory Board. Cumberland Advisors is a manager within the RiskBridge group of selected asset managers. David Kotok has waived advisory board compensation from RiskBridge to avoid any perception of conflict of interest.
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