A Deflationary Mindset That Isn't In Our Minds
The timing could not have been worse, though in the grand scheme of things it is just perfect. It was barely two weeks ago when Jay Powell was announcing what he and others were claiming was a huge, massive deal. No longer a specific inflation target, but one that would be averaged high against low. The Federal Reserve had been unable to achieve its inflation goal for such a long time officials could no longer use their favorite word, so they wanted you to know they were going to do something big in response.
For years, that word was “transitory.” Whenever the CPI or PCE Deflator would inevitably come up short, Ben Bernanke and especially Janet Yellen would declare the shortfall nothing more than a product of temporary factors. By their very nature, temporary factors dissipate leaving the way opened for monetary policy to eventually succeed.
That’s what “transitory” had always been meant to convey: monetary policy is working, you just couldn’t see it working at that particular moment in time. Tomorrow, though, bet on it!
And let’s be clear here. Though the topic is inflation and inflation means consumer prices, that’s not really what’s been at stake. The CPI and PCE Deflator were supposed to have been corroborating signals, inflation the symptom of the very thing everyone truly wants. Accelerating consumer price increases should have been the byproduct of a tight labor market, the generously happy jobs condition called “full employment.”
Recovery, in other words. Full. Honest. Complete.
Transitory was commonly used as a way to say give monetary policy more time, but how many more times could monetary policymakers use the word transitory before it proved their time was up?
We now have our answer. Surprising only those who continue to place the central bank at the center of their monetary and financial worldview, there had been no transitory factors at any time. There were factors, of course, just that Economists and central bankers cannot satisfactorily identify them nor how and how long they might stick around.
And since they never did go away, these factors, policymakers have instead ended up discarding more than the word transitory. The entire idea of full employment has been grossly rewritten inside of the Federal Reserve’s most sacred strategy document.
This is no small challenge, rather a cosmic shift away from the way the central bank had been operated for decades. Full employment had been its North Star, the fixed guiding light by which all other decisions had been made; in the absence of any real money in monetary policy it was the means by which everything else had been set; could be set.
Monetary policy would signal to consumers and businesses (as well as fund managers in the financial services industry) who would take those signals and act predictably in the way John Maynard Keynes had theorized when he called this “pump priming.” People would see and hear the Fed doing something “inflationary”, they would then act in an inflationary manner, voila, economic acceleration produces an inflationary breakout confirming full employment and full recovery.
What the new strategy document now says is the word “shortfalls.” It used to say “deviations.” Both terms were compared with some “maximum level” as judged by the FOMC and its staff. In other words, when full employment was at monetary policy’s center there could have been deviations in both directions; the first a shortfall, but another possibility of the economy going beyond maximum meaning full employment.
The latter had been the inflationary scenario policymakers using the word “transitory” had tried to keep alive. And the unemployment rate, at least, had been cooperating. The lower that sucker dropped, the more confident Fed officials became. If inflation didn’t show up today, and it didn’t, then whatever might’ve been holding it back will definitely be gone by tomorrow.
By striking “deviations” and putting “shortfalls” in its place, the Fed has, essentially, struck “transitory” from its vocabulary.
Implicit in this act is the central bank admitting to a substantial error.
But what’s the error?
There have been, of course, any number of clues along the way. A huge one showed up at exactly the moment the recovery had been expected to truly take off. I’m talking about the middle of 2014. After all, GDP here in America during that year’s two middle quarters averaged around 5%, something we hadn’t seen in a very long time.
Not only that, you might remember the slogan “best jobs market in decades” since it had been tossed around widely throughout especially 2014’s second half. With GDP high, payroll gains the best since the late nineties, and the unemployment rate tumbling, inflation was practically guaranteed as the final piece validating successful design and execution of (four) QE’s.
That didn’t happen. Instead, already by the early summer of 2014, the oil market headed south; way, way south. This was a problem for Janet Yellen taking over from Ben Bernanke and winding down the last (to that point) two QE’s as she did. Without oil, what for inflation?
Late 2014 and early 2015, the word “transitory” showed up as complications from what Yellen’s view claimed had been too much success. The oil patch had been stimulated so much that a “supply glut” had materialized causing benchmark crude prices to plummet worldwide. Not only was this shale investment good for the US economy, lower oil prices would further help by acting like a “tax cut” for consumers who would end up paying lower prices at the pump.
Once the economy adjusted to a lower price for WTI, around the time the tight labor market would really assert itself in wages, it all added up to “transitory.”
Assuming, of course, you hadn’t been paying attention to anything else that was going on at the time.
While oil prices were crashing, the dollar was screaming higher (those two things related). In fact, the latter had been moving upward against several key currencies, China’s in particular, from the very outset of 2014. What that had suggested, against China’s currency in particular, was the terrifying prospect that the global dollar shortage which had already plagued the global economy twice during the preceding seven years hadn’t been fixed by QE’s, rather it had shifted to another level – centered more on Asia and China in particular.
At the same time Janet Yellen was just getting cozy in her new office, settling in with dreams of being the Fed Chairman who finally got to complete the success story of QE courage, I was writing in the middle of March 2014 that this other was no joke. Whatever might’ve been encouraging about GDP, the Establishment Survey, or the unemployment rate, it was about to be, if not already, undermined and then superseded by the true underlying global monetary condition:
“What all this data shows, as opposed to conjecture about the supernatural powers of central banks, is that yuan’s devaluation may be directly tied to dollar shortages. In fact, as I argue here, it is far more plausible that a dollar shortage (showing up as a rising dollar, or depreciating yuan) is forcing the PBOC [People’s Bank of China] to allow a wider band in order that Chinese banks can more ‘aggressively’ obtain dollars they desperately need. Worse than that, the PBOC itself cannot meet that need with its own ‘reserve’ actions without further upsetting the entire fragile system.”
Quite disturbingly, those very things were what actually did happen; the PBOC by mid-2014 felt it had no other choice but to intervene with “its own reserve actions” which, sure enough, ended up only making things worse (further confirming the world’s fragile, rather than robust, situation). And that would go on to mean a very different set of global circumstances for 2015 (and beyond).
QE hadn’t solved the world’s monetary problem; quite the contrary, four of them had proved beyond a shadow of a doubt how the Federal Reserve just wouldn’t ever be able to fix the mess. Japanese central bankers had long before taken to calling this a deflationary mindset because they know as much about money as every other set of central bankers.
And since this was 2014-15 already, six and seven years since the first (US) QE and ZIRP were put together, this third eurodollar system eruption was a very clear sign that these monetary factors were obviously not transitory.
What had driven oil prices to crash wasn’t too much oil, a supply glut; for one thing, oil futures traders had known for years in advance the US would be mining and pumping as much crude as this country’s energy sector would end up producing. That was never a surprise, not in 2014 nor at any time thereafter.
This was one reason why the CNY/dollar shortage signal for China had been so important; global demandwas already being impaired months and months before US Federal Reserve policymakers had even become so confident about their expected inflationary substantiation. Forget transitory; the whole thing never had much of a chance.
What small chance it may have had was in the conveniently isolated interpretation of largely the unemployment rate (even the payroll numbers softened) as well as, for a time, the Japanese yen’s seeming counterweight to China’s falling yuan.
Ever since Shinzo Abe stormed into Japan’s Prime Minister’s office late in 2012, JPY had been pleasantly (to central bankers) falling against the dollar. While that was primarily in anticipation of “money printing” insanity in the form of what became QQE in April 2013, a falling yen/rising dollar situation had been consistent with a falling dollar against everything else: better global liquidity (redistributed via Tokyo) and therefore some plausible scenario for economic growth.
By June 2015, however, Janet Yellen could no longer count JPY among those already few signals. Rather, it was the currency’s decline which ended up being temporary and at the worst moment the yen’s reverse began to indicate instead even worse conditions than those already presented by CNY and WTI. Those things collided first in August 2015 with the shocking yuan “devaluation” (which wasn’t devaluation, just the global dollar shortage I had written up a year and a half earlier reaching toward its period climax) and then the terrifyingly turbulent first few months of 2016.
A rising yen is a bad sign – even if what’s falling against it is the US dollar’s exchange value. In this one case, a falling dollar works out to all the bad things an otherwise rising dollar suggests when crossing every other currency (except, at times, the euro). Increasing global dollar strain and shortage.
To go back to the Fed’s strategy document in 2020, what its central bankers have now implicitly admitted is that the factors holding back inflation all this time, more than a decade, were never transitory like they kept saying. But to explain how this could have been without acknowledging the dollar, and the lack of “dollars” worldwide, policymakers have decided that it would be less controversial (for them) to downgrade and mangle one of their holiest of holies, the very concept of full employment itself.
Bending over backward to avoid what is even more inconvenient.
And, at the worst possible time, the same time as Jackson Hole 2020, oil and yen yet again.
This year, of course, there is no “supply glut” even remotely plausible. On the contrary, supply of crude has been sharply curtailed in the US and worldwide. According to the US Energy Information Administration (US EIA), domestic crude oil production had topped out around the week of March 13, which makes sense.
Since mid-March, production volumes have collapsed. They were down nearly 20% through the end of August when Hurricane Laura looped through the Gulf of Mexico shuttering another 5 or 6% more. Entering September, with about one-quarter of crude capacity taken off-line since March, how in the world are oil prices falling again?
That’s not even the most striking, or possibly most significant, part of the 2020 oil story. The WTI futures curve never once came out of contango; with so much supply restricted, the curve still hadn’t achieved backwardation at any point. A contango curve is one which incentivizes more storage, a physical market imbalance more like 2014-15’s.
As I suggested right at the beginning, this couldn’t have come at a worse time…for Jay Powell and, for one more time, the unemployment rate. The Fed’s Chairman, as noted, made this huge deal about average inflation targets; the next step in the evolution of, essentially, the same policy idea you aren’t supposed to realize is the same policy idea.
In trying to explain why “transitory” was wrong, Economists have settled upon an even more dubious explanation. First forward guidance, then a symmetrical inflation target, and now an average one; all these are very much the same thing. Monetary policymakers, rather than studying the dollar and, you know, money, have opted instead to believe their expectations signals have been, get this, too good.
Forget oil’s downward bend, the dollar’s stubborn buoyancy, or the lack of economic growth in every account not named the unemployment rate. No, what has perplexed the Fed right out of its full employment center is what it thinks the public perceives as its inflation fighting capabilities.
It goes something like this: QE is very powerful, so powerful that regular folks who would otherwise act in the inflationary manner central bankers want instead act in a disinflationary manner because everyone knows that with higher inflation comes the powerful central bank to immediately stamp it out. The more Ben Bernanke led us to believe in future inflation, the more we believed Ben Bernanke would end it.
Seriously. It sounds like I am, but I’m not making this up.
And under that version of events, how would anyone know at what level full employment could even be? Thus, full employment no longer central at the central bank.
With that in mind, Jay Powell has declared a “new” stance for monetary policy, one that emphatically declares (more emphatically than forward guidance and symmetry, apparently) the Fed won’t get in the way of inflation until it has - over the long run - averaged out to the 2% target…which you probably already realize would require an outsized contribution from WTI that right now is going in the opposite direction for the same deep fundamental reasons we’ve already seen too many times before.
The unemployment rate may be falling, again, but there’s something sinister in the oil equation that for the fourth (or fifth) time is pointing the finger at global demand. The lack of a supply glut this time around can mean only just that. Contango in September even after historic supply cuts.
If that wasn’t enough of a 2015 sort of vibe, Japan’s yen has been persistently strengthening against the dollar this whole time. Going back to GFC2, back to March and April, while the WTI futures curve never moved out of contango, JPY, for the most part, has also pushed higher and higher.
In other words, despite the so-called flood of liquidity, despite Jackson Hole and its grand new inflation-embracing pronouncement, despite major improvement in the unemployment rate, key markets, the same key markets, are sending the same deflationary signals we’ve grown quite accustomed to. Jay Powell’s inflationary recovery dream is being priced as fleeting anyway.
Is there another word for “fleeting?” There used to be one in the Fed’s vocabular, now there’s not. And the reason why there’s not is seeing the same things we’ve seen in the oil, dollars, and lack of demand traits forced upon us for more than a decade. There really is a deflationary mindset, but it’s not our minds which have remained rigidly set.