A key fear of market participants and policy makers is a repeat of the 1970s (disco era) episode. While many pundits continue to argue that the current inflationary cycle will be a short-lived phenomenon that will transition away, the reality might be very different. From our perch, inflation is becoming more entrenched. That is evident in core services ex shelter and despite the moderation in goods and headline inflation (chart 1). Note Chair Powell has explicitly referenced core services ex shelter. The upside surprise in the PCE data last Friday has also brought this into focus as it is the official target for the FOMC.
Wage gains are now firmly embedded in the economy and the Federal Reserve will likely to have to take action to shock the business cycle into creating layoffs. Although the Federal Reserve front loaded over 450 basis points of policy tightening over the past year, it is not obvious that policy is restrictive enough given resilience in the labour market. To be fair and as we noted last week, policy tightening impacts macro conditions with a 12–18-month lag.
Nevertheless, implication is that the Federal Reserve will hike the terminal rate to around 5.5% in this cycle and maintain the policy rate higher-for-longer. Clearly that shift in consensus beliefs has contributed to a 100-basis point rise in the December 2023 euro dollar implied yield since the end of 2022 and a renewed phase of US dollar strength and cross asset volatility (chart 2).
A related risk is that although the Fed’s policy tightening will eventually lead to a deterioration in the labour market, it might coincide with the 2024 election cycle leading to a promise of handouts if elected and a renewed fiscal impulse (recall it is the change in the fiscal deficit that contributes to growth). This is reminiscent of the 1970s, where the volatility of inflation increased, and significant dislocation became more common.
In finance, volatility clustering refers to the observation, first noted by Mandlebrot (1963) that “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.” While the Federal Reserve successfully suppressed macro and inflation volatility over most of the period after 2008, the combined fiscal and monetary response to the COVID episode was roughly 6 times larger. It was also more effective because it was more coordinated. Of course, the required opposing policy reaction to combat inflation has also been very large. The big picture point is that the longer inflation remains, the more entrenched it will become, leading to greater potential asset price volatility and dislocation.
As one of the godfathers of the vol market in this region noted to me recently, policy makers had spent most of the post-2008 regime attempting to lift inflation expectations higher. However, very few (if any) have paused to consider what might happen if they were successful in achieving that goal. For Japan unanchored inflation above 2% is probably not consistent with stable yields (yield curve control) or sustainable fiscal outcomes. However, the macro adjustment is likely, in the first instance, to occur via a much weaker Japanese yen (higher USDJPY) and eventually to repatriation of Japan’s large foreign assets back to Japan. Long phases of stability, eventually lead to a large episode of instability (when a peg like YCC eventually breaks). From a behavioural perspective, the peg tends to exacerbate consensus beliefs and positioning the longer it remains in place.
The broader point is that the cost of protection (volatility) is very cheap relative to the potential payoff given the global policy tightening cycle that has already taken place. The Fed is acutely aware of the policy error in mid-1970s when they eased policy too soon and experienced a second episode of inflation (chart 3). However, that does not mean that they will avoid making the same mistake again.
