‘FAITH’ In The FAIT Of Flexible Monetary Policy Is Key To The Fed’s New Framework
The evolution of the Fed’s thinking over the last 30 plus years I have been in the business of investing has been quite remarkable, and it continues to have important consequences for financial markets.
About three decades ago, right around the Volcker rule, the paradigm could be represented by a single letter: “I”, for inflation. And “kill it”, was the mantra, at any cost.
Right around 2000, when I was a young(ish) portfolio manager at PIMCO in the heyday of the bond vigilantes, a new letter was added, “T”, for inflation targeting. I still remember Ben Bernanke, then a professor at Princeton before he was the Fed chair, invited to speak at a firm-wide meeting where he talked about his well-published theories of the advantages of “constrained discretion framework” (as opposed to the black and white choice between “rules” or complete “discretion”) and why inflation targeting with a transparent, publicly announced goal was “IT”, the way to manage the public’s expectations and make good monetary policy.
Last week, in one fell swoop, the Fed added two more letters to the framework to bring it to FAIT: “F” for “flexible” and “A” for ”average”, and gently did away with a lot of the constraints in constrained discretion. Average simply means that instead of setting a 2% target at a given point in time, success or failure would be determined based on an undefined “average” of inflation over an undefined period. “Flexible”, as clarified by Governor Lael Brainard in a speech means this is not a “rule”, and possibly allows a lot of flexibility (here). To quote: “While a formal average inflation target (AIT) rule is appealing in theory, there are likely to be communications and implementation challenges in practice related to time-consistency and the mechanical nature of such rules. Analysis suggests it could take many years with a formal AIT rule to return the price level to target following a lower-bound episode, and a mechanical AIT rule is likely to become increasingly difficult to explain and implement as conditions change over time. In contrast, FAIT is better suited for the highly uncertain and dynamic context in which policymaking takes place.” Definitely a tub of cold-water and a “FAITFUL” death for the dogma of mechanical rules that were so fashionable just a few years ago in academic economic theory, especially in the era of Milton Friedman.
There is a great gamble being taken here on faith that “we know better now” even though there is no reason to believe so; which leads to the unsaid but implicit last letter, “H”, which spells out to the public to just have faith in this new framework, even though the old frameworks have not worked in the US, or for that matter in Japan or Europe. I expect all global central banks to take the Fed’s lead and start moving back in the direction of Greenspanian obfuscation and opaque policy.
Having faith in the power of the Fed to produce an economic outcome (not just a market outcome) has an analog in my recent experience solo backpacking in California’s Sierra Nevada mountain range. It was cold, and most of my matches were too wet to start a fire. I had maybe a couple of dry looking ones. I also had an MSR bottle full of stove fuel. My choices were (1) do nothing, (2) try to get the stove started in the traditional way and risk losing my last dry matches, (3) pour the fuel on the stove against the manufacturer’s recommended lighting procedure and set the whole contraption on fire hoping to light the stove’s burner. I won’t tell you what option I chose, but that’s beside the point. The point is that doing nothing or using the traditional approach were more risky than to take the long shot in principle, even though it meant crossing several “red lines” similar to the ones that Fed Chairman Jerome Powell mentioned in an interview a few months ago (here).
As long as the stock market keeps rallying (akin to “as long as I get the fire started but don’t burn the forest down”) no one complains since everyone feels richer. But once the forest starts to burn — i.e. the negative consequences of the moral hazard wrought by the FAITH framework are realized — a new type of witch-hunt, aka “who killed the economy and the markets”, will begin.
Until that happens, investors need to realize that a heretofore “data-dependent” Fed has finally capitulated to market forces and decided the best course in a world of fuzzy models and weak economic foundations is to pragmatically ignore the data and continue to err on the side of being more accommodative. This is just stating what I consider to be facts and revealed preferences. The pivot from tactical policy making (“data dependence”) to strategic policy making (“FAIT”) in a span of two years is amazing indeed. But the commonality is that the ends (“easy” money) can be justified in either approach.
If this is not clear enough, let me remind you of Pascal’s wager again to put things in context. If you had to choose between the existence or non-existence of God, it always makes sense to bet that God exists to avoid the consequences of not believing: “Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas if God does exist, he stands to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (eternity in Hell)”. (Source: Wikipedia).
In other words, the Fed’s message is clear: have FAITH and go long (the market), bubble or no bubble. Betting otherwise will not be good for your pocketbook. But if and when the FAIT makers change their minds again, or investors’ faith is shattered in the power of the Fed, look out below!