A few months ago I said I was breaking my rule about trading, and moving most of my IRA (which I expect to be punitively taxed or totally confiscated, Argentina style) into bond funds. I said I was doing this because I expected the Fed to tighten policy when inflation started coming in hot.
My primary evidence for this is the inflation-indexed bond market: https://fred.stlouisfed.org/series/T5YIE
Since the great recession, the Fed has got cold feet whenever core-PCE inflation moved above 2%. Bernanke got cold feet, Yellen did, and even Powell, though at least Powell stuck it out longer. If PCE is above 2%, then CPI is a little further above 2%, which means various regional Fed bosses, bank CEOs, and talking heads will be freaking out, losing their minds and accusing the FOMC and the Chairman of being reckless and the next Arthur Burns. You have to understand, in the banking world and in the academic economics profession, everyone is gets a moral high from signaling against inflation.
Being Real about inflation
The only problem with moderate levels of inflation, say, below 5% per year, is that it becomes a de facto wealth tax, by inflating the value of risk assets, which are taxed on their nominal cost basis. This problem would be easily solved by doing away with the capital gains tax. Otherwise, inflation is a more or less harmless phenomenon, a trade off for steady nominal GDP growth. Moderate levels of inflation even have some positives, conditional on money illusion being an unavoidable constraint. A positive inflation rate allows businesses in declining industries to cut real wages, without cutting nominal wages. Typically, if you find you need to cut wages to stay afloat, you lay off workers and hire new ones at lower wages, as nominal wage cuts poison motivation and invite sabotage. You have seen this in the grocery industry, and in customer-facing retail more broadly.
The point here is that CPI inflation is currently expected to average 2.7% for the coming five years, and while it would be fine, even good if this happen, because it would mean about 5% NGDP growth, it’s unlikely to happen, as the Fed doesn’t have the balls for it. At some point soon, there’s going to be an inflation report that sets off a cascade of hysteria among people with clout. Chairman Powell will find himself beset on all sides by people who matter, telling him he’s a bad man, and without Trump in there to pressure him the opposite way, he’s gonna fold.
He’s gonna say something that amounts to: “this whole business of Average Inflation Targeting really means we’re going back to the old Obama-era rule of the 2% year-over-year inflation ceiling, so that in practice, inflation averages 1.5%, instead of our 2% target.” At this point, the market’s implied NGDP assumption for coming years will plunge from 5%, to 3.5%, and the S&P 500 will plunge with it, because the S&P 500 is substantially tied to NGDP expectations. This may happen in an afternoon, or it may happen over a few weeks, but it will happen.
Today, the market thinks we’re gonna get enough NGDP to give us 2.7% average CPI inflation, or ~2.5% PCE, from now through 2026. That ain’t happening. We’ll be lucky to get NGDP sufficient to yield 1.8% PCE, because institutionally, there’s a fetish for low inflation, and 2% is a line you do not cross. The resulting realignment in expectations might be enough to cause a recession in 2022, or maybe it will only give us a noticeable slow down, without major layoffs, the way Yellen’s 2015-2016 growth slowdown hit real production numbers, but didn’t trigger layoffs.
1. The TIPS are indexed to the CPI btw, which is like 0.20 or 0.30 percentage points above PCE inflation, on average