A Cheap Bet On Inflation

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“If I seem unduly clear to you, you must have misunderstood what I said” was Fed chair Alan Greenspan’s response during testimony to the Senate in 1987. Transparent communication has come a long way since then. Greenspan continued the policy of obfuscating responses, reflecting a belief that it improved the Fed’s operating flexibility by disguising mistakes. This inspired Secrets of the Temple: How the Federal Reserve Runs the CountryWilliam Greider’s 1989 scripture describing faith-based monetary policy.

Today, the Fed’s projections are public. Their meeting minutes are published. The mystery has gone, although they still are the most important market participant. Transparency allows for comparison between market forecasts of interest rates and the Fed’s. Of course, the latter has the advantage of being able to make their forecasts correct through their actions, should they be so moved. Fortunately, the Federal Open Market Committee (FOMC) is not burdened with excess vanity, so serially inaccurate interest rate projections do not bother them.

In recent years it’s been mildly amusing, in a nerdy sort of way, to show how the FOMC’s long term forecasts for inflation and the Fed Funds rate have followed bond yields lower, conceding the market’s prescience. Fixed income investors have been ahead of this for years, exhibiting greater accuracy about Fed policy than the FOMC itself (see Bond Market Looks Past Fed). Covid made such games irrelevant, but as markets look beyond the pandemic, revisiting FOMC Projection Materials is becoming worthwhile again.

In August, Fed chair Powell gave a speech where he addressed persistently low inflation and how this had caused FOMC members to continually lower their rate forecasts. He explained how 2% inflation remained their definition of price stability, but since recessions typically cause it to undershoot, the FOMC would henceforth be more tolerant of greater than 2% during a strong economy. The inference, reflected in subsequent FOMC projection materials, is that short term rates will remain low for a long time, at least long enough for inflation to exceed 2%.

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Disclosure: We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track ...

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