Jun 9, 2021Liked by Edward Harrison

I would tend to agree with this thesis, most of the time. However, just because CPI inflation isn't yet permanently out of hand (it's certainly out of control on a transitory basis, but when taking account of quirks due to the pandemic, such as used car prices, and issues with new cars due to chips, it's not as bad as it seems), it's not clear just how much above the 2% target it will end up once we let employment run up, while global demand pushes on materials prices and commodities. But even if we assume the eventual running rate is around 2.5-3.0%, well above target, we have seen before where the Fed ignores this as well, long enough for other situations/shocks to crash the party.

The problem this time around, more than ever, is that low rates (especially when combined with massive fiscal stimulus) have teed up epic asset price inflation. Eventually the third leg of the stool is going to reassert, and even if UE isnt below 4% and inflation is comfortably below 3%, they aren't going to be able to ignore this much longer in the name of reining in risks to financial market stability. The longer this bubble inflates, the worse the damage when it goes down. (See 2001) Macroprudential controls via regulation, etc, arent going to rein in the mortgage industry. Just talking with people around the country, the bubble behaviors are back in force - maybe not lending to dead people or dogs, but appraisals being adjusted after the deal to hit targets...that isn't going to end well. And the COViD demand has run its course, as will the reluctance to list properties due to COVID, or waiting for still more home price inflation. First sign of a slowdown, a flood of properties is going to hit the market. And they havent even figured out how to end forebearance!

I just dont see how we keep asset prices at these levels; equity valuations are way too dependent on their own valuations propping demand across the economy (which provide money for home downpayments, which in turn provide money for homeowner spending), and low rates. Actual underlying demand is much weaker than before the pandemic once you remove the transitory fiscal expenditures. And it looks like Congress is fully dysfunctional again, so there isn't going to be an infrastructure or any other spending to keep that game going. And once equities unravel a bit, especially if caused by any less accomodative Fed policy, housing will unravel next, then confidence, etc, then the Fed will be in its box, grabbing its hammer (low rates) and looking at everything that appears to be a nail.

I dont know how we get out of this boom and bust cycle, especially now that Manchin and Sinema are going to tank the Democratic agenda, and we will get two years of nothing before going back to Republican control.

So, as for the widowmaker, yeah, that is a boom bust too, but at a very low level of rates, with people getting constantly caught on the wrong side of things. For now, they will see a brief slump in rates, but if it turns out the Fed has guessed wrong on actual sustained inflation, or even more out of control asset prices, and has to change its tune, bond prices crater. But they can only crater so long before they take down the leverage based growth system. Then back down bond prices go. This is the path to negative rates in the next cycle.

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Your response addresses what I wrote in bullet two about frontrunning: "Just maybe some frontrunners are starting to actually believe inflation is transitory. We're at the period of maximum uncertainty on the transitory inflation score. So, beliefs on this are completely speculative."

We just don't know what inflation will look like and what the Fed will due if it turns out not to be transitory. For now, the Fed has won this round. But, down the line, we could see problems.

One question to keep in mind is how inflation develops if CBs are at loggerheads, meaning if the Fed is out of step with other CBs, what will the release valve be then? Something I am thinking about

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At this point, it isn't even about whether they believe it, only whether they can control the narrative that it is transitory. A few months of ugly CPI numbers are baked in, but it will be the underlying detail where the dangers lurk. Core CPI, PCE price inflation, anything that starts to get out of range will be the trigger for "we've lost the narrative, sell sell sell". And a little bit of front running in THAT direction is far more dangerous to the economy.

The other problem is that we are months away from understanding the real nature of wage inflation. And that would be a real kicker to overall inflation. For now, the jobs we are going to be pulling back in are service sector jobs, so by their nature, they are lower paying, so the push on overall wage gains will be minimal. But factoring in state minimum wage gains, the push from some employers to raise wages that can become entrenched in a region/industry, and give a temporary bump to hourly wage growth on a SAAR basis. It will take a few months, now that the economy is fully reopened, for all the hiring needs to be filled, assuming demand renormalizes for the blue states for travel, leisure, hospitality industries. Public hiring isnt comign back, and a lot of businesses went bust, so even after a few big months of job gains, we have a multi year slog to get back to full employment, even after adjusting for early retirees. Just look at total employment and the 25-54 labor force employment rate. Long way to go. And no way in hell the Fed just keeps the pedal to the metal for years given the situation in asset prices.

As to global CBs, that I have to ponder more...it's mostly what the ECB and BOE do that will set the board layout; too many other countries will have their hands tied by Fed policy. And BOJ is going to do the BOJ thing forever it would seem.

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