The Breakdown - Is the Fed About to Start Promoting Inflation?

Episode Date: July 22, 2020

Today on the Brief: EU leaders agree on $2 billion stimulus package LinkedIn job cuts show weakness in the professional sector Has DeFi jumped the shark? Our main discussion: The Fed’s changing inflation strategy University of Oregon professor and Bloomberg columnist Tim Duy recently penned a piece called “The Fed Is Setting the Stage for a Major Policy Change” arguing that we’re likely to see more inflation, promoted by the Fed.  In this episode, NLW breaks down: Why the Fed is turning away from its traditional inflation forecasting method  Why the Fed is likely to let real inflation hit 2% before doing anything Why some are calling the move “simply asinine”  Why some think the Fed is full of hot air and has no power to actually create inflation Why the Fed is trapped by its definition of inflation Audio clip featuring Alhambra Investments head of research Jeffrey Snider in an interview with Emil Kalinowski.

The Fed's twin mandate is stability and low unemployment. But isn't low unemployment just a proxy for people's ability to live? In my mind, there is no doubt that these policies have had the net impact of making living harder. And the only conclusion that I can come to is that in many ways the Fed is a prisoner of their own definitions. If all we do is worship at the Almighty Temple of a 2% inflation rate, but that inflation rate doesn't actually represent important things in the world, or at least it leaves out these incredibly important things in the world, then how do we actually have any sense of our ability to move and make the economy better for how people really live in it and experience it? Welcome back to the breakdown, an everyday analysis breaking down the most

important stories in Bitcoin, Crypto, and Beyond. This episode is sponsored by BitStamp and crypto.com. The breakdown is produced and distributed by CoinDesk. And now, here's your host, NLW. What's going on, guys? It is Tuesday, July 21st, and today we are talking inflation, and specifically whether the Fed is about to start promoting inflation in a major policy shift. Before that, however, let's do the brief. First up on the brief today, one of the big pieces of macro news was the EU has adopted a recovery spending plan. After the longest summit in 20 years, EU leaders agreed to a 1.8 trillion euro spending package, which is worth about $2.06 trillion U.S. dollars. Importantly, it's built around the bloc's first ever issuance of hundreds of billions of common

debt. And this common debt is a lot of what both people are hailing this for, as well as lambasting it for. The Wall Street Journal writes, the agreement represents a significant step in the EU's move towards a more genuine fiscal union. Some have hailed it as the Block's Hamiltonian moment, referring to Alexander Hamilton, the first U.S. Treasury Secretary who had the federal government absorbed the debts of U.S. states. Some economists, however, say the cash may only make a modest difference to revive depressed economies. This is important because, coming into the crisis, there were serious questions about the Block's ability to survive. There were questions about the willingness of member states to go in for each other, basically. Back to the WS.J, without

the bailout plan, Italy's national debt risks ballooning to a level that could endanger the euro. Wealthier northern countries decided that helping Rome now was preferable to facing a currency crisis later. So this is a pretty seminal moment in not just European monetary policy, but European Union history in general. In fact, the critics of this say that same thing. Tuamus Malin, who has been on this show before, called this stealth federalization. And he says, why does the recovery fund lead to federalization? Because, One, it establishes an unlawful process that allows the EU to acquire debt and distribute funds. Two, EU-level debt will eventually require EU-level taxation.

Everyone who supports this supports federalization. So effectively, you're seeing play out two very different versions of what Europe is supposed to be, with some folks like Malinan arguing for a lighter-touch version and others, including, it seems, the leaders of the bloc, advocating for deeper integration. Second up on the brief today, LinkedIn is laying off 6% of its workforce. So what happened? LinkedIn is cutting 960 jobs specifically that relate to their recruiting services because of falling demand for those recruiting services.

This is important because it shows the long-term impact of this crisis, and specifically it shows that the impact is not just specific to the industries that are on the front lines, right? It's not just travel and tourism. It's not just business travel. It's not just these areas that we're obviously going to be impacted. It has to do with jobs further down the line, both in terms of white-collar professionals in those industries and in the service industries that help them, consultants, et cetera. And as there is less demand for people in those white-collar positions in many of these industries, there's less demand for hiring services. So I think that the point here and the reason that it's a notable data point, is that we have this perception that this is really just

sort of a very front line of people who are negatively impacted and that we can write off the employment numbers because of that. But it's having knock-on effects in a variety of ways that kind of level up from where it started. Third and finally on the brief today, has Defi jumped the shark? Defi is undoubtedly super buzzy right now, and the question is whether it's getting too frothy. Dan Robinson from Paradigm said exactly this. He tweeted, out yesterday, yield farming has jumped the shark. Hayden Adams of Uniswap responded and said this, there are so many things wrong with this latest round of yield farming. Stay safe. They're responding to the introduction of YFI, Urewn. Finance, which I'll let you go read. I'll include a link to it, but it basically,

to me, reads almost like a performance stunt to show how Defi is getting too frothy in some ways. Chow Wang says, I'm bipolar with regard to Defi. Some days I'm excited, other days I feel uninspired by the hype, fomo, and stuff built on air. Last couple of days, it was the latter. No one who has actually immersed themselves in yield farming can tell me with a straight face that this market isn't frothy. My take is basically what I've said before on this show, and I'll probably say again,

which is that at least the frothiness is contained when it comes to defy. This is a sandbox that has very high barriers to entry. You really have to study and figure out how to do this stuff to participate in yield farming and whatever else is going on, liquidity mining. this is not something that your average person can just hop into. It's not something that you're not average person who's even in crypto can just jump into. It's very different than signing up for Coinbase and buying something or signing up for Binance and buying something. And that is, I think,

to the defy space's benefit. So my take is that absolutely this is frothy. When everything that has those initials, defy, is going up at the same time, you can tell something's frothy. However, in terms of the negative impact of that, it doesn't seem to me yet to be a concern about spilling over into the mainstream in a way that would actually long-term set Defi back. In effect, DeFi has the ability to learn and make its own mistakes right now in a relatively low-risk environment, not because it's not risky, but because the people who are taking that risk are pretty aware of what's happening. BitStamp is the original global cryptocurrency exchange. Since 2011, BitStamp has been the preferred exchange for serious traders and investors, trusted by over 4 million

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I'm excited to share that one of this month's breakdown sponsors is Crypto.com. Crypto.com offers one of the most cost-efficient ways to purchase crypto out there, as they've just waived the 3.5% credit card fee for all crypto purchases. What's more? With crypto.com's MCO Visa card, you can get up to 10% back on things like food and grocery shopping. When you buy gift cards with the crypto.com app, you can get up to 20% back. Download the crypto.com app today and enjoy these offers until the end of September. Let's switch to our main topic.

Is the Fed about to start promoting inflation? So the context for this discussion is an article. by Tim Zwee in Bloomberg called the Fed is setting the stage for a major policy change. Policymakers have begun talking about letting the inflation rate rise above its 2% target. Look for a formal statement soon. So here's Tim's argument in a nutshell. He's basically arguing that the Fed learned during the last crisis not to tighten monetary policy too early. And so instead, this time around, they're going to be doing two things.

The first is emphasizing actual inflation over forecasted inflation, and the second is that they'll be attempting to push inflation above the 2% target rate that has been in place for a while now. So let's discuss what this means. One, actual inflation over forecasting inflation. The Fed uses something called the Phillips curve to model inflation, and basically this is a model that suggests that inflation and unemployment have an inverse relationship. In other words, when demand for labor increases, the pool of unemployed workers decreases. Companies increase wages to compete to attract that shrinking pool of talent, and because they are going after a shrinking pool of talent, cost of wages increase, right? They have to increase those wages to compete and attract that shrinking pool of talent. Companies ultimately pass those

increase costs on in the form of price increases of goods and services. The problem is that the Phillips curve model didn't exactly work in the wake of the great financial crisis. Even as the unemployment rate fell to 3.5%, which is below the quote natural rate of 5.6%, inflation didn't show up. Because of that, Zwee argues that the Fed ended up raising interest rates too early in the cycle and was eventually forced to lower them 75 basis points in 2019. This past week, Fed Governor Lail Brainerd said that basically they're not going to pay as much attention to the Phillips curve from now on. The phrase that Zwee used is, the Fed is going to try to

run the economy hot push down unemployment. Basically, instead of trying to reach the inflation target by forecasting when that inflation will come, it's going to wait and see that inflation actually show up before it changes monetary policy. So the key change here is that instead of the Fed saying, because of what we're seeing in unemployment numbers, we believe inflation is likely to reach X in the future, so we're going to change monetary policy, they're saying, we are going to wait until we observe inflation at that 2% rate before we even think about changing monetary policy. The result of this, of course, is that because policy impact lags, it's not just like the Fed pushes a button and all of a sudden things level off, there is a lag to any change they make.

This means that inflation will inevitably rise above 2% in the period between when it's observed at or above 2% and when Fed's changed policy actually kicks in. This was reinforced by Philadelphia Fed President Patrick Harker, who said, I don't see any need to act anytime soon until we see substantial movement in inflation to our 2% target and ideally overshooting it a bit. Here's the way Zwee sum this whole thing up. The implication for financial markets is that the Fed expectations, to hold policy very easy for a long time. They will reinforce this stance with enhanced forward guidance and eventually yield curve control. As long as inflation remains below 2%, the Fed will push back

on any ideas that they will tighten policy anytime soon. And even inflation above 2% wouldn't guarantee tighter policy if the Fed concluded the overshoot was transitory. Don't doubt the Fed's resolve to keep policy accommodative. They will keep reminding you if you forget. Now let's share some of the market's reaction to this article and to this idea more broadly. Daniel D. Martino Booth called it simply asinine. Pinecone Macro wrote, this has been obvious for years. I wrote this over a year ago, and it has been crystal clear for many years. They wrote, the moment the intelligentsia realized QE did not create inflation, our future of monetary madness was secured. We now have a false sense of security about what we can get away

with without creating inflation. In the early innings of high inflation, the Fed will be applauded for finally creating inflation, and they will let it run hot since it has run cold for so long. This will prove to be a tough genie to put back in the bottle, however. Many will confuse fiscal and monetary coordination with the QE of the 2010s and will not respect the inflation risks involved with putting newly printed money into the hands of actual spenders. Others, however, had a different take. Jeff Snyder argues, as he has before, that the Fed is actually quite impotent when it comes to changing or increasing the money supply, and really what they have is the power of self-fulfilling prophecy. This is in his estimation all a ruse to get us to do the inflationary work for them.

Let's listen to him in conversation with Emil Klonowski on their great podcast just a couple days ago. We're now talking about, what is that, three full months since Jay Powell's great flood. So if there's all this massive money printing, then shouldn't it be showing up somewhere? not just the stock market, and it's not really showing up in the stock market, at least not directly. So again, we're right back at what we talked about before, where the Fed is trying to tell you a story, but it's not a real story. It's a fiction. It's a fairy tale. It doesn't actually happen in reality. If you actually pinned down Jay Powell or anybody at the FMC and made them answer you truthfully and honestly, they would say, well, yeah, we know that too. Our intent isn't

to flood the system with money. It's just to get people to think. that we are, so they act like we are. And therefore, they're trying to get you and me to act inflationary, and that will be where the inflation comes from. What this all comes back to for me is a fundamental question over how we measure inflation. It feels to me like we've abstracted away an idea of inflation rather than really understanding how it impacts people's lived lives. On a day-to-day level, two measures that are not included in inflation, food and energy, are what people experience price changes in. Now, the reason that food and energy are exempted from core inflation measures

is that people have to buy them no matter what, so their price can be too volatile. In that way, they don't actually measure a general trend of too many dollars chasing too few goods, which is supposed to be what inflation tells the story of. But to the extent that what we care about when we understand inflation is how people experience the world around them, this certainly impacts that. Food and energy have a huge impact on how people are making

it day-to-day, week-to-week, month-to-month, and that's certainly the case in a scenario where most Americans can't afford a $400 crisis to come up, let alone food going up 5-10% over the course of a few months, which it has in many places around the country during this last period. So then on a day-to-day level, our core inflation measures don't actually get at what people experience in the real world. On a longer-term level, we don't also think enough about inflation in the context of assets and really anything you can purchase with debt. But there is no doubt how impactful these are in people's lives either. Want to save money for a better future? Tough. You have to buy into the market despite valuations being through the moon, despite that what you buy for your money gets you less

and less than it did five, 10, 15 years ago. Want to advance your career? Buy this ever more expensive college package, despite the fact that it's going to shackle you with debt that you have for an incredibly long time. Want a house? We'll just have fun because houses are ludicrously expensive and completely out of reach for most young people. The Fed's twin mandate is stability and low unemployment. But isn't low unemployment just a proxy for people's ability to live? In my mind, there is no doubt that these policies have had the net impact of making living harder. And the only conclusion that I can come to is that in many ways the Fed is a prisoner of their own definitions. If all we do is worship at the Almighty Temple of a 2% inflation rate, but that inflation rate

doesn't actually represent important things in the world, or at least it leaves out these incredibly important things in the world, then how do we actually have any sense of our ability to move and make the economy better for how people really live in it and experience it? All right, guys, that's going to do it for my take on the Fed and this potential shift in policy. Like I said, ultimately for me, it comes down to the definitions and what we're trying to achieve and maybe trying to better align those goals with the lives that people actually live, not theoretical constructs and models. Anyways, I appreciate you listening.

Hit me up on Twitter for ideas, for follow-ups, for comments at NLW. Thank you for your reviews and ratings. They are making a huge difference. Please keep it up. and until tomorrow, guys, be safe and take care of each other. Peace.