The Fed’s experiment with inflation … why its goal is totally undefined … will we able to stop inflation if/when we ignite it … how to protect your portfolio

 

The Fed is flying blind — and you’d be wise to recognize this and tweak your portfolio accordingly.

Last Thursday, Federal Reserve Chairman Jerome Powell announced a major policy shift. The Fed will now allow inflation to run “moderately” above the 2% inflation goal “for some time.”

As we noted here in the Digest last week, the idea is that after years of running short of the Fed’s targeted 2% inflation goal, just touching 2% inflation won’t be enough. The Fed will let inflation run above 2% for a while to make sure that the level actually holds.

But what exactly does that mean?

How much is “moderately” above 2%?

And how many months or years is meant by “for some time”?

***You would think that the Fed members would have huddled up ahead of time and agreed on the same story

 

However, it appears they have very different ideas of how to interpret Powell’s comments.

Let’s start with Dallas Fed President Robert Kaplan. He said he would be comfortable with inflation running a “little bit” above the 2% inflation target if the economy were to return to near full employment.

From Reuters:

“And for me, a little bit means a little bit,” or about 2.25%, Kaplan said during an interview with Bloomberg TV. “I still think price stability is the overriding goal and this framework doesn’t change that.”

Okay, so we’re really talking about a limit of 2.25%. And the main goal here is price stability. Got it.

… except St. Louis Fed President James Bullard doesn’t “got it.”

From Bullard:

Inflation has run below target, certainly by half a percent, for quite a while, so it seems like you could run above for a half a percent for quite a while.

Bullard’s lack of conviction is a tad less than inspiring — it “seems like” you could run above half a percent for a while …

So, Kaplan says 2.25%, Bullard says 2.50% … but in the grand scheme of things, this isn’t a huge difference, so we can overlook it, right?

Before you say “yes,” what if the actual number itself isn’t the real issue?

That’s Philadelphia Fed President Patrick Harker’s take:

It’s not so much the number. … It’s really about the velocity.

Harker notes that inflation “creeping up to 2.5%” is quite different than inflation “shooting past 2.5%.”

But wait, there’s more!

Here’s Cleveland Fed President Loretta Mester, adding to the swirl of inconsistency:

This isn’t really tied to a formula. It’s really going to depend on what’s going on with the economy …

So, for everyone keeping track, that’s 2.25% … 2.50% … price stability … velocity … the economy …

Perfectly clear.

To be fair, we shouldn’t expect these Fed presidents to be soothsayers, providing a fully detailed “if-then” roadmap for the economy; but perhaps some shared talking-points would have been helpful to instill some confidence?

***Here’s why this matters …

 

The Fed’s new goal is an “average” inflation rate of 2%.

But the average of what, exactly? Averages require fixed beginnings and endings.

Is the beginning when the Fed adopted this target rate in 2012?

Or since Powell took over in 2018?

Or since, say, 1980, which began the decade that broke the killer inflation of the 70s?

If we’re starting in 2012 and running through the next five years, we’d need 3.2% inflation.

If we’re going from the beginning of Powell’s tenure, we’d only need 2.3%.

If from 1980, then rates need to go negative to the tune of 2.88%.

But what if we don’t want to let inflation run above 2% for all that long?

What if we only want, say, 12 months of above-2%-inflation? Or perhaps just two quarters?

If that’s the case and “average 2%” is still the goal, that means we’d need to let inflation run much higher, since we wouldn’t be tolerating it for a lengthier period.

Lots of question, zero real details.

***How will we get “there,” and how easily will the Fed be able to contain “there”?

 

The next challenge is how we get to sustained 2% inflation.

The Fed has pursued this 2% inflation target since January 25, 2012, but has consistently failed to hit it on a sustained basis.

So, what’s different this time?

In one sense, all the chatter about how much above 2% we should accept, and for how long, is moot — we have to get there and stay there first. And that’s something the Fed has been unable to do for years.

And if you’re saying “the Fed’s 0% rates will do the trick,” I’d direct you back to 2009 through late 2015, when rates were zero (as you can see below), yet inflation was nowhere.

 

 

But let’s say today’s 0% rates are different, and we somehow find ourselves at the undefined destination of “there.”

Can we keep inflation in check at that point?

Or might all the effort to get us there swing the pendulum a bit further than we’d prefer?

In his Jackson Hole symposium webcast, Powell said:

This change (the goal of letting inflation run above 2%) may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

What’s Powell’s basis for saying this?

If we’re to believe that Fed policy will allow the economy to run hot while successfully preventing “too much” inflation, might it be fair to ask how successfully Fed policy has been in overcoming a decade’s worth of “too little” inflation?

If so, then what’s our basis for confidence in Fed policy?

The image in my mind is that of officials attempting a controlled burn of a forest. Unfortunately, only a few trees are catching fire.

Given this, the officials have decided that when the flames get going, they’re going to let more of the forest burn than is usually considered “safe.”

But how many trees is that?

And for how long will this bigger-than-average fire burn?

They haven’t told us … because they don’t know.

But they promise to control these undefined flames without the fire getting out of control.

Borrowing from St. Louis Fed President James Bullard above, it “seems like” this is a good idea.

 

***We’re certainly rooting for the Fed, and perhaps they’ll nail it with this policy shift. But how can investors protect themselves if things don’t go as planned?

 

Many of the world’s greatest investors share similar advice, though said in different ways. It basically reduces to “protect your downside, and the upside will take care of itself.”

With that in mind, what’s the overall “downside” and “upside” of this policy shift from the Fed?

Well, if this was a voting contest between investments (of various asset classes) and the U.S. dollar, the Fed just voted unanimously for investments, while shrugging-off the dollar.

Powell’s comments and the general uncertainty amongst Fed members should help support the stock market — especially for stocks that have pricing power that can hike their prices alongside rising inflation so that real profits aren’t eroded.

The policy shift is bullish for gold, as we noted in last week’s Digest.

Another asset class we focused on two weeks ago that will benefit is commodities in general. This one might have the biggest payoff of all.

In our August 18th Digest, we featured analysis from Eric Fry that’s incredibly bullish for commodities.

From Eric, in that Digest:

Thanks to a newly hatched commodity supercycle, many resource stocks possess considerable profit potential … perhaps their greatest potential in 20 years.

On the other hand, what will suffer under this regime is cash savings.

But just how badly, and for how long, isn’t clear given the inconsistent messages from the various Fed presidents.

When we boil it all down, all the Fed truly did here was give itself license to keep changing the goal-posts so that it will never appear wrong. After all, you can’t miss a target that’s never clearly defined.

We’ll keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg