“When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes
A couple of nights ago, I was helping my son tune his cello. I have no musical talent or knowledge of string instruments other than I like how they sound. However, my son tells me I do a pretty darn good job turning the tuning pegs to help him get the instrument in tune. There are four strings on the cello and hence, four pegs. Usually it is one pesky string (C, I believe) that needs tuning. I know the C string is the top left peg, so I am used to tuning that one. This time my son needed the A string tuned. I honestly didn’t know which peg corresponded to the A string. Considering there are only four strings and I could eliminate two strings—C and D—as they are on the same side of the cello’s neck, I had a 50% chance of turning the right peg. My son told me to turn the bottom right peg, so I did without thought. He bowed the string and no change. I tightened a little more like an idiot and again, no change. Suddenly my son and I looked at each other in horror as we realized we were tightening the wrong string—a millisecond before the string snapped violently!
I thought of this embarrassing personal event this morning when Bloomberg News reported, “Federal Reserve Bank of St. Louis President James Bullard, in a prepared text for a speech in Philadelphia, says a tightening labor market with falling unemployment is unlikely to budge inflation because price expectations have been held in check by an explicit inflation target.”
I think that is a rather dangerous assumption for a central banker to have; however, it is understandable. Since 2008, the Federal Reserve and global central banks in general have been responsible for managing their respective economies through monetary policy. One could argue that President Bullard’s claim is that the Fed can centrally plan the economy. Certainly the Fed has seen what their awesome set of new monetary policy tools, like Quantitative Easing (QE), can do. In Europe and Japan, the European Central Bank (ECB) and the Bank of Japan (BOJ) took it a step further and ran QE while taking their member bank deposit rates below zero. With regard to interest rates and many financial asset prices, central banks have essentially reversed the laws of nature for nearly a decade. The low volatility, the steadily increasing prices of risk assets, and the constant, annual disappointment for bond-bears who have called for the end of the three-decade bond-bull market have a lot to do with extraordinary monetary policy, even if the central bankers refuse to admit it.
Whatever the case, a lot of what the Fed has done has worked so far! While there’s still an extremely tricky road ahead to withdraw a tremendous amount of monetary stimulus, the U.S. economy as well as the global economy seems to be firing on all cylinders now. With that in mind, I think it is time for the Fed to recognize that without a tremendous increase in labor productivity, we are at or maybe past full employment here in the U.S. There is a labor shortage, and wages will indeed “budge.” When we add the potential of a stricter immigration policy to this mix, I am concerned that wage inflation can zoom past the “right where we want it” point to the “oh shoot” (I cleaned that up) point pretty quickly. If that happens, the long end of the yield curve can surge up very quickly and dangerously. A 3% ten-year Treasury note can pop a lot of risk bubbles. Assuming as President Bullard does, that wage inflation is under control because “price expectations have been held in check by an explicit inflation target,” is a bit of hubris in my opinion.
I hate to say it just as the party is really getting started, but I think the Fed may have to manage a hopefully small recession very soon to keep the long end from breaking out of its multi-year box. It actually is a good opportunity to normalize monetary policy and financial asset prices carefully as opposed to the calamity that will ensue if the longer end of the yield curve gets out of control. The Fed has to be careful not to tune the wrong string.
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