Wednesday, October 6, 2021

"Transitory" inflation, the failure of imprecise language, and unanchored expectations


There are two major inflation themes or questions currently being discussed. 

One, what the heck does transitory mean in terms of forward guidance for investors? The Fed started this discussion and has been unable to stop it. When will inflation come down, and if it mean-reverts, what is the new normal?

Two, do we have any idea of how inflation works in the economy? The Jeremy Rudd Fed paper has exploded in the macro discussion marketplace with the provocative view that no knows how inflation moves through the macro economy and no one know the link between inflation and inflationary expectations. See "Why do we think inflation expectations matter for inflation? (And should we?)". We can add to this issue the introspective work by the ECB that concludes it does not have any skill forecasting inflation. 

These discussions are more that inside ball between macroeconomists. The failure of imprecise language with respect to transitory inflation is creating uncertainty. If there is uncertainty, investors should be paid a premium to hold risky debt instruments. Forward guidance for central banks should be simple. if you cannot be precise in your language, don't say anything. 

If inflation numbers are not grounded in a well-define theory with variables that can tell us something about the future direction of prices, it is hard to understand why investors should again hold risky debt instruments in a rising inflation environment.  

Without beating a drum, if the underlying variables that drive inflation cannot be articulated and if the Fed cannot define transitory for the variable it is responsible for managing, investors should only focus on market opinion driven by dollar votes. Follow the price trend action. The fundamentalists may not like it, but the burden is on them to give a good reason why this should not be the rational choice.

No comments: