Everything's the Fed's fault.

I see it every day on the internetz.

Whatever happens, you can blame it on this... ๐Ÿ‘‡

Doesn't matter if it's true.

I honestly don't get it.

This from Greenlight Capital's Q3 report (on inflation) is a great example ๐Ÿ‘‡

Over the summer, the Federal Reserve characterized inflation as โ€œtransitory.โ€ As inflation has refused to resolve itself quickly and on its own, Fed Chair Powell revised his description to โ€œfrustrating.โ€ But why should he feel frustrated?
Itโ€™s not like he has done his best to fight inflation without success; he hasnโ€™t lifted a finger to fight inflation. Instead, he has maintained a policy designed to create inflation. As a result, inflation is here and it appears poised to worsen.

Let's quickly take it back a step so I can explain how this is both right and wrong.

Depending on your school of economic thought inflation is:

  • An increase in production costs or an increase in demand for products and services OR...
  • A decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy.

Inflation isn't caused by money-printing alone (Japan, anyone?) ๐Ÿ‘‡

Inflation wonโ€™t be caused by money printing alone
Will printing money lead to inflation? We doubt it.

Let's start with this idea that he has maintained a policy designed to create inflation.

Can't argue with that.

They've been fighting a losing battle for years, trying to get inflation to the magic 2% level and falling short.

That's the whole reason they designed the FAIT framework. ๐Ÿ‘‡

The Fedโ€™s Dovish Taper
Taper hints at Jackson Hole and a formal announcement in September is certainly possible, but donโ€™t expect hawkishness alongside the announcement

Now we can move on to the he hasnโ€™t lifted a finger to fight inflation comment.

Obviously it's correct. Powell's done nothing to fight inflation.

I'm not convinced this is the right way to frame things though...

I mean, what should the Fed have done differently?

Taper sooner? When? Why? What would that have solved?

As recently as two months ago, the US government was still sending out stimulus cheques to a large portion of the population to support the recovery.

Should the Fed be withdrawing monetary support and tapering at the same time?

It would make NO SENSE.

The fiscal side has been far more of a driver than monetary policy (you could say that the spending was ackshually enabled by the Fed, but that's missing the point).

See, inflation is essentially a demand phenomenon.

People need or want stuff.

If there's no demand then it doesn't matter if there's 1 unit of stuff or 1 million units of stuff.

The value of that stuff is precisely 0.

Now, the inflation we're currently seeing is because of the mismatch between supply and demand.

Demand can be turned on and off at the click of a button. Literally.

And it has been: Furlough, stimulus payments, all led to more button clicking as we all bought more stuff.

Supply on the other hand, takes quite a bit longer to recover (I, Pencil is a great model for this)

How can the Federal Reserve affect this demand mismatch?

They can hike interest rates & decrease aggregate demand by increasing the cost of credit.

Great, but would that be the right response?


Monetary Policy operates with a time lag (economists debate just how long that is precisely but it definitely exists) so let's just focus on the transmission mechanism.โ€Œ ๐Ÿ‘‡๐Ÿ‘‡๐Ÿ‘‡


Look at that right hand column.

You can definitely make the case that changes in risk premia and changes in bank capital ARE influenced by central banks. Certainly not 'out of their control'.

Those last three though?

All three occurred. At. The. Same. Time.

  • Changes in the global economy โœ…
  • Changes in fiscal policy โœ…
  • Changes in commodity prices โœ…

Back to Greenlight's Q3 letter

As we discussed last quarter, some price spikes due to bottlenecks are likely to reverse at some point. Others, however, are likely to persist.
Last quarter we discussed how the lack of cheap equity capital for capital-intensive companies is likely to suppress investment and prevent high prices from becoming the cure for high prices.

(The cure for high prices is ALWAYS high prices)

How about this part? ๐Ÿ‘‡

A lack of cheap equity capital for capital-intensive companies will suppress investment.

I don't follow the logic. How is this resolved by increasing interest rates (the cost of capital)?

There's not enough cheap capital and that's suppressing investment, so let's make capital more expensive...

Back to what the Fed should do...

Ever since the GFC in 2008, the Fed and other central banks have been fighting to bring inflation back to the 2% level.

Here's a chart of headline CPI since October 2008. Even with the recent surge, the mean average still isn't above 2%. ๐Ÿ‘‡

US CPI including volatile food and energy costs

Here's the same chart over the past 5 years, and the mean is only just above 2%...

It's worth remembering just how long the Fed have been fighting this battle.

Yes, we're seeing some inflation now, but they definitely haven't won the war.

Hiking interest rates in a panic now would put all of that work at risk.

The recovery is well underway, but it's still some way from complete.

Getting the prime age working population back to pre-pandemic levels would be a good start.

1.76 million jobs brings it back to 83%...

So what should the Fed do?

Start the taper. And then...