Wednesday, October 1, 2014

Is the Federal Reserve Just That Good?

As the discussion of the persistently low inflation economic environment continues, the ideas, theories, and explanations continue to be formulated as to why this is the case. One argument that I found particularly interesting is the one for a market-neutral interest rate. The concept is basically the Federal Reserve aligning monetary policy with what is perceived [not empirically observable] to be an interest rate level that has a minimal effect on employment. This in theory, should allow monetary policy normalization to occur without slowing employment growth, and hence, GDP growth as well. If the Fed could indeed accomplish such a fete, then investors’ expectations of future inflation should remain anchored to the Fed’s long-term target of 2%.

Inflation expectations have also received its fair share of scrutiny as well. An interesting argument has also grabbed my attention on this topic. The argument poses that inflation expectations can be considered as the drag between real (time) economic activity and monetary policy. This is a fairly intuitive idea to internalize, as the Federal Open Market Committee (FOMC) along with investors and other market participants are basing their decision making on backward facing economic statistics when participating in market transactions. That disconnect between timely information and decision making is the alleged source of the expectations of higher future prices.

When we combine the two views, they paint a cohesive picture with one very important caveat; the Fed is extremely good at what it does. If the Fed is efficient at interpreting and re-acting to the real economy, then investor inflation expectations should remain well anchored. But, alas, as investors keep taking cues from the financial markets, while the Fed takes its cues from the macro-economy, a decoupling may occur between investor expectations and FOMC actions. This should [in theory] increase the drag between the real economy and monetary policy as market participants alter their real world investment decisions based on the evolving environment in the financial markets, which in turn affects the outcomes of monetary actions by the Fed.

Long story short, these theories and arguments are perfectly adequate until their underlying relationships breakdown. For the last five years, market participants have known what to expect from monetary policy because monetary policy has not changed in five years. All other FOMC actions have been isolated to the balance sheet relationship between the committee and the commercial banks. Somehow I believe that once the Fed starts its long road to normal, investors, academics, and pundits will be attempting to rationalize the dynamic economic environment that will result, and the underlying relationships that will be developing, in terms of inflation expectations and monetary policy evolution.

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