Welcome to Inflation II: How Late is the Fed?

Summary

• Rising inflation will persist through 2022, not fall suddenly midyear.
• The Fed is at least 11 months late on changing its quantitative policies, that is, expanding the monetary base by buying US Treasuries and mortgage-backed securities. And it is between 15 and 24 months late on raising the Fed Funds rate.
• The Fed’s inflation-fighting credibility is declining.

Market Implications

• The US Treasury market selloff has a long way to go, with intermittent recoveries, but a solid march to much higher rates.

Introduction

Even Fed Chair Jerome Powell has given up on ‘transitory’ inflation. The prevailing narrative now is that inflation will rise for a few months, then fall significantly by midyear.

I disagree. I see no reason for inflation to fall suddenly during 2022. The only way that could happen is if the Fed had stopped buying bonds in March-June 2021 and signalled rate increases by the end of the year. And it did not.

I think the Fed is so behind the curve that even if they stop buying mortgage-backed securities (MBS) and Treasuries today and start raising rates, lower inflation will only come in late 2022 at the earliest. Such action by the Fed does not seem in the cards, and their reaction later in 2022 may prove even more drastic. In fact, the narrative that inflation will fall mid-2022 is already starting to wane, and the discourse on Fed tightening is accelerating. The December CPI of 7% YoY make answering this question even more pressing.

Inflation and the Fed Funds Rate

Demographics are important to explain the low real interest rates over the past two decades. But for that to translate into low nominal rates, central banks need a credible, inflation-fighting framework – whether inflation targeting or not. In this scenario, investors and consumers believe the central bank will successfully resist an inflationary or deflationary shock. However, any relaxation in that commitment changes the dynamics of inflation, and central bank credibility starts to erode. We are well into this process now.

Chart 1 shows the nominal Fed Funds rate (FFR), the ex-post inflation-adjusted (or real) Fed Funds rate (RFFR), and the inflation rate. Lags in inflation’s reaction to changes in the Fed Funds rate are difficult to see. Moreover, there is clearly a feedback mechanism as the Fed has reacted to inflation shocks over the years, so causality may run the other way. Finally, forward-looking expectations can bring forward any inflationary change due to expected changes in the Fed Funds rate.

Notably, in the early 1980s, the inflation rate starts to react to higher real and nominal FFRs by about 12-18 months. This follows the Volker Fed’s massive effort to reduce the persistent inflation surge of the 1970s. Also notable is that the RFFR is more negative than in the 1970s.

The problem with following RFFR is that it is completely endogenous and hard to control directly unless you raise or lower the FFR drastically, as happened in 1968-1979, 1979-1983, 2008-2014, and 2020-now. Moreover, besides this endogeneity, an interest rate rule can suffer from multiple equilibria, and bad equilibria – e.g., stagflation – are possible with low credibility.

This is especially true when the central bank becomes ‘data dependent.’ If people have forward expectations, current inflation will depend on their expectations of future monetary policy and inflation. When a central bank is data dependent, agents struggle to formulate forward expectations and set current inflation, interest rates, activity levels, etc. It is analogous to solving for two unknowns with one equation; there are an infinite number of outcomes.

I performed VARs on the CPI inflation rate and nominal FFR (AIC, SC, LR, LogL, etc.). I found the optimal lag was eight quarters or 24 months.

Simple Granger-causality tests reveal causality runs from the nominal FFR to inflation but not from inflation to the FFR. This result probably reflects the sensitivity of inflation during high Fed credibility (1984-2019).

However, we are now in a world of massive quantitative easing (QE) along with an interest rate policy tool. The Fed acts by intervening in prices, that is, the interest rate. The central bank can either control the FFR or the monetary base, but not both simultaneously. That means adjustment in the market comes through changes in stocks, that is, the money supply, and the yield curve. With the massive central bank intervention across the curve, the money supply data contain even more information than changes in the yield curve.

Inflation and Money Growth

In an era of massive QE, we cannot ignore Milton Friedman’s warning that ‘inflation is always everywhere a monetary phenomenon.’

Chart 2 shows the evolution of two measures of money: 1) the monetary base (MB), comprising the monetary liabilities of the central bank, and 2) M2, which includes currency in circulation, demand deposits, time deposits, money market accounts, and other liquid deposits.

MB growth had a somewhat stable relationship with M2 growth between 1960 and 2008. Since 2008, MB growth exploded and became much more volatile, while M2 growth did not follow until the current pandemic.

The difference between M2 and MB, a broader measure, is money created by the banking system – sometimes referred to as inside money – that expands and contracts through iterations of lending (paying back) and depositing (withdrawing) the proceeds of loans. Therefore, inside money is determined by banks and borrowers and so is endogenous. The ratio of M2 to MB is the M2 Money multiplier and is a good measure of banking system leverage.

After steadily trending higher since the late 1950s, the Volker stabilization caused a gradual fall in leverage (Chart 3). But the financial crisis of 2008-9 caused a collapse, as banks tried to collect – sometimes failing – on their loans and borrowers scrambled to pay them back.

Leverage has remained low since because of banks’ risk aversion and significantly increased regulation. This also means that the current expansion in M2 is principally financed by the QE-induced increase in the MB with little expansion in banking system leverage.

What about inflation? Because the multiplier is low, fairly stable and determined mainly by MB growth, we will only look at the relationship between M2 growth and inflation. Chart 4 shows that M2 growth still explains inflation well, especially in recent years.

To repeat, if the Fed controls the FFR and intervenes to affect the yield curve, monetary aggregates go a long way to inform us about what is happening.

What about the lags? A simple VAR shows that the estimated lag between changes in M2 and inflation is about 11 months. Using that same VAR, another Granger test shows that causality goes both ways between M2 and inflation. That is, changes in M2 predate and help forecast inflation, and inflation increases the nominal demand for M2 as households and firms must pay more for most products.

Market Implications: The Fed Is Very Late

This analysis shows the Fed is at least 11 months late on changing its quantitative policies, that is, creating MB by buying US Treasuries and MBS. It is also between 15 and 24 months late on raising the FFR. And this is if the Fed immediately stops buying assets and starts unwinding and starts raising the FFR today. Any remaining hopes for a decline in inflation mid-2022 are a pipedream, in my view.

The market over the last week has started to get wind of this. The final 2021 CPI number came in at 7%, a significant acceleration from 2020’s 1.4%. MB growth stood at 25.6% YoY and M2 growth at 12.7%, while the RFFR is at -6.5%. There is nothing to hold inflation in right now.

The Fed’s increasingly hawkish statements give temporary reprieve to the sell-off in US Treasuries. In emerging markets, central banks learned long ago that when you have an external inflationary shock, you do not fight the shock but lean into the secondary, tertiary, etc. increases in prices to ensure that inflation is truly ‘transitory.’

The Fed, however, is doing nothing of the kind. We are way beyond the secondary and tertiary price increase, with the Fed waiting for the last variable of all to react: wages. This strategy, combined with its move to average inflation targeting, has ensured that the Fed is extremely late.

Therefore, I expect its expressed confidence in its ability to control inflation to become less and less credible. Therefore, I think that the US Treasury market sell-off has a long way to go, with intermittent recoveries, but a solid march to much higher rates.

Appendix: Monetary Policy Lags

There are two types of monetary policy lags:

1. The inside or recognition lag refers to the time it takes the central bank to realize it may have to change policy.
2. The outside or effectiveness lag refers to the time a policy change takes to affect the inflation rate.

The inside lag to the current inflation is still ongoing as the Fed is slowly and repeatedly iterating to tightening earlier and earlier The start date for the cessation of bond buying is now set for March, with rate rises coming in late 2022 or early 2023.

The latest estimates of the outside lag are between 12 and 18 months. A simple VAR gives a 8-quarter lag from the federal funds rate to inflation or 24 months. Of course, the outside lag is not a parameter as it depends upon credibility and the state of the economy and financial system. I suspect that more credibility brings a longer outside lag and less a shorter one. The outside lags could become negative if agents anticipate monetization of future fiscal deficits, for example. Arguments exist for the opposite relationship, however.