How Transitory is Transitory?
The interplay between a central bank’s forward guidance and market expectations are where the rubber hits the road on long-term interest rates. It’s not as easy as divining what a central bank wants to do or what market participants think is likely to happen. It’s the interplay between the two that matters because, while central banks can manage expectations, they can’t control them.
This is what I am thinking about this morning because of the signs of inflation popping up everywhere. And in that context, the word ‘transitory’ takes on significance because what seems transitory now might seem more pernicious at some point later on. And that could have a devastating impact on interest rates, and therefore, on the economy.
Let me give you an example of what I mean. Here’s an excerpt from an article in the South China Morning Post:
A wave of shutdowns and temporary production stoppages is sweeping through a number of factories in China’s southern manufacturing hub as the surging cost of raw materials eats away at profits and raises concerns over inflation risks in the world’s second-largest economy.
Across Guangdong province, small and medium-sized enterprises in the industrial chain – producing everything from steel castings to home appliances – lament that it may be even more difficult to stay afloat this year than it was last year.
China is one of the countries furthest along in terms of a full-reopening. And inflation is a big problem there – so big it is threatening the very survival of small and medium-sized business. So, we can expect the Chinese government to do something about it. For example, the government is cracking down on speculators and hoarders in the commodities market. How much success they will have in keeping inflation in check remains to be seen. But you can think of this as a harbinger for the future, as a sign of what’s to come everywhere as economies fully re-open.
The US central bank, the Federal Reserve, has been telling you these inflation shocks are transitory, parts of a supply chain disruption that is associated with the pandemic. And once we work through these bottlenecks, inflation will pass. I tend to believe they’re right. But what if the inflation shock is so great before we get beyond the transitory phase that inflation expectations become unanchored? What then?
That’s the question I am thinking about now. And here’s the model I’m using to figure this out.
First, let’s remember that the Federal Reserve is a monopolist. The US government, as monopoly issuer of its own fiat currency, has given the Fed monopoly power in the market for base money. And the Fed exercises its monopoly power by targeting the overnight rate for money, the fed funds rate. Any monopolist can only control either price or quantity, not both. And after the failed Volcker experiment with quantity targets 40 years ago, the the Fed – and every other modern central bank – has moved to targeting rates i.e. price. And remember it can’t maintain that rate unless it supplies banks with all the reserves they desire to make loans at that targeted rate. That means that they must be committed to supplying as many reserves as banks want or need because a failure to supply the reserves means demand for reserves that causes rates to rise and a failure to hit the federal funds rate target.
Some of this has been obscured in the age of quantitative easing since the world is awash in excess central bank reserves. But markets know that the Fed, as a monopolist, will always be able to hit its federal funds target. As a result, future expected overnight rates reflect market expectations of future Fed Funds target rates as set by the Federal Reserve (plus a risk premium). We can, thus, think of long-term interest rates as a series of future short-term interest rates smashed together.
And so the goal of the Fed and other modern central banks is to both set target base rates that will optimize their medium-term inflation (and employment) objectives and to signal to markets some level of forward guidance about future policy so that the central bank can influence market expectations of future overnight target rates.
This is how the Fed exerts a dominant influence across the yield curve, not just on the short end.
But what if events on the ground are so counter to the Fed’s stated policy and forward guidance that markets don’t believe the Fed? What if inflation expectations become unanchored despite the Fed Presidents and Governors’ choreographed statements? I think long-term interest rates rise.
So, going back to what’s happening in China right now, if that’s a harbinger of what’s to come, the question is how long that kind of inflation can last before what policymakers are telling us is transitory unmoors inflation expectations. How transitory is transitory?
I think the answer is likely a few months at most, meaning that by the end of the summer, if we have signs of inflation all around us, then long-term interest rates will rise irrespective of Fed guidance simply because markets will want to frontrun a future Fed policy guidance about-face. And if that frontrunning is extreme enough, it can cause massive financial market turmoil and real economy stress, even if the Fed doesn’t change tack.
Scylla and Charybdis
The problematic aspect of all this is that the risk isn’t just one-sided. It’s not all about the risk of rising inflation and interest rates. There is also the real and ever-present risk of altered private portfolio preferences from accommodative monetary policy.
When central banks keep rates low and drive down real returns on risk free assets, investors alter their portfolio preferences both to take advantage of the signal the central bank is giving them to continue to expect low rates and to overcome the hurdle of low and negative real returns on safe assets.
If inflation and interest rate expectations remain both muted and relatively certain because the Federal Reserve is telegraphing future policy, investors will then shift portfolios to higher-yielding and riskier asset classes. They will reach for yield, they will reach for duration and they will increase risk. That greatly alters the pattern of capital investment in the economy. Ceteris paribus, longer-lived, higher-yielding, riskier and more speculative investments will be made. This is exactly what is occurring right now. The mania in cryptocurrency is emblematic of this.
And the question is how long it can last before it forces the Fed to change tack – for fear of being blamed for blowing a speculative bubble. That means the Fed faces a Scylla and Charybdis choice situation here where it has to navigate a narrow path between the bubble-promoting impacts of low rates and the recession-inducing impacts of higher rates. Somewhere between the two lies the path to Nirvana!
The news out of China worries me. It;s a story where the ‘transitory’ inflation effects are so large that it could potentially mean life or death for businesses. And so, what could end up being transitory can still wreak havoc on the economy as we wait for the inflationary phase to pass.
The Chinese authorities are taking a centralized approach to the issue by trying to increase the supply of raw materials and stepping up regulatory intervention of the space. Let’s see if that works. But even if it does, that’s not likely to be the approach in the West, where a more laissez-faire attitude dominates. If we encounter the same issues, companies will be unprotected and face the full force of transitory inflationary pressures. Some will pass those through to consumers. Others will fail.
For the time being, I am more concerned about the Scylla of bubble-promoting negative real rates on safe assets because that’s the devil we know. The devil we don’t yet know, growth-sapping levels of ‘transitory’ inflation, is something we may never come to know. Let’s hope so.