Weekly Commentary: Under Fire

The week had an ominous feel. Ten-year Treasury yields dropped another seven bps to 1.29% - completely disregarding much stronger-than-expected reports on consumer and producer prices, along with inflation expectations.  German bund yields fell another six bps to a three-month low negative 0.35%. Equities were down for the week in Europe, but the notable equities weakness was posted by the broader U.S. market. The Midcaps dropped 3.3%, and the small cap Russell 2000 sank 5.1%. Risk aversion typically leaves its initial mark at the “Periphery.”

Silhouette, Fall, Falling, Collapsing


Treasury market notwithstanding, inflation has become a problem in more ways than one. Consumer Prices (CPI) jumped 0.9% in June, versus expectations of a 0.5% increase. Year-over-year CPI was up 5.4% (expectations 4.9%), the strongest jump since 2008. And for analysts with issues with year-over-year “base-effects”, consumer inflation was up 3.3% in only five months. Core CPI also gained 0.9% for the month, with a 4.5% y-o-y increase. Producer Prices rose a data series record 7.3% y-o-y. Import Prices jumped 1% for the month and 11.2% y-o-y. University of Michigan one-year Inflation Expectations rose to 4.8%, the high since the summer of 2008. Also, at 4.8%, the New York Fed’s survey of one-year inflation expectations jumped to the highest level in data back to 2013.

To this point, inflation has not been an issue for the markets. It has become a problem for millions of Americans. For the institution of the Federal Reserve, it’s a metastasizing malignancy.

I understand why each Fed official sticks tightly with the party line “inflation will be transitory.” They don’t want to rattle the markets with thoughts of a traditional tightening cycle. And I think I understand why they adopted their framework aiming for a period of above target inflation – and why they swore off responding to incipient inflationary pressures. Again, they sought to retain flexibility to maintain highly accommodative monetary policy, ensuring financial conditions would remain exceptionally loose (and markets high).

Now they’re in a pickle. Things are not proceeding according to plan, and many, including Washington politicians, have serious issues and questions. For starters, what does the Fed mean by transitory? When would heightened inflationary pressures move beyond transitory? And, regarding the new inflation framework, how much beyond target would be too much? And for how long? The Fed does not have answers for some pretty fundamental questions.

Our central bank is trudging into a mine field. I’m concerned about climate change, inequality and racial justice. But those are not within the Fed’s purview. The Federal Reserve has an incredibly important role in our society – to maintain sound money and price stability. It’s an exceptionally challenging responsibility. It’s no exaggeration to suggest the consequences of failure are calamity. The world was in the throes of momentous change, while finance was evolving. They needed to be razor fixated on financial stability, but lost their focus.

Once our “activist” central bank ventured into bolstering the securities markets and using unconventional measures to reflate the economy, it was going to be extremely difficult to refrain from venturing into all types of measures to support various groups and causes. Add QE to the toolkit, and it will become virtually impossible not to be compelled to allocate Fed money to satisfy political interests. After buying Trillions of Treasuries, supporting markets in MBS, muni bonds, corporate debt, ETFs and stocks was going to be inescapable.

The Fed basically risked everything. They thought the changing world meant no more worries of surging inflation and actual tightening measures. Keeping the markets elevated became their unstated priority. But they’re now on the wrong side of a losing bet, a predicament that became increasingly clear this week with Chair Powell’s beltway testimony. The Fed, understandably, is Under Fire for surging inflation.

The institution and its beloved QE have also ensured it today sits right in the middle of an epic political battle. Fiscal conservatism has awakened from a prolonged deep coma. The Republicans have a cause that will increasingly resonate. They see Fed QE financing the liberal agenda and inflation provides the Republicans with additional impetus to confront Federal Reserve policies and doctrine.

The Fed risked their credibility and independence. One can see their credibility erode in real time. Before this is over, their institutional independence will also be in tatters. This is especially distressing considering the collapsing trust in many of our principal institutions.

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Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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