No trout fishing at Jackson Hole this year, just a lot of bull.

The main news to come out of this year’s virtual Jackson Hole economic symposium last week (apart from no fly fishing) was U.S. Fed Chair Powell’s new trick for inflation targeting.

Essentially, Powell told markets that his Fed will be happy to see the economy ‘run hot’ for extended periods, allowing the Fed to achieve its desired 2% long run inflation target over time, i.e., an average rate.

He also added that unemployment can never get too low. That’s not very Phillips Curve of him.

As per the graph, Phillips says that as the unemployment rate improves (e.g., drops from 6% to 3%) inflation goes up (e.g., rises from 2% to 5%).

What Powell seems to be saying is that his Fed’s full monetary arsenal will be utilised to support policies (presumably growth policies from government) that generate maximum employment.

This may include letting the economy run hot for extended periods to make up for the ‘shortfalls’ in inflation – no matter how low unemployment gets, and as a result he is happy to see inflation exceed 2% for extended periods to achieve this, and to make up for inflationary shortfalls.

He is proposing that the world has changed to such an extent that the Phillips curve no longer has meaning (when interest rates are this low).

Here’s a non-verbatim summary of Powell’s theory. I’ve added the words in brackets, but it goes something like this:

1. Persistently too low inflation (which we have at present) can lead to a longer term unwelcome fall in Inflationary expectations and pull actual inflation lower (which we have at present).

2. That creates an adverse cycle of ever lowering inflation (disinflation which we have at present and deflation which was confirmed in Australia last quarter) which is problematic as expected inflation feeds into the general level of interest rates (central bank jawboning and buy/sell manipulation).

3. So, if inflation were to fall below 2% (which it has for years) and interest rates were to fall in tandem (which they have for years), the Fed will have no further powder to cut rates to help employment when the economy hits the skids again (yup, we’re already there, based on the size of welfare fiscal).

4. Looking at other countries in the world (aka Japan) once this downward spiral sets in it’s difficult to reverse (aka Japan).

So, for the moment and under the Powell Fed, the Phillips Curve has been trashed along with the risk-suppressing Volcker Rule (recently redefined with the blessing of Powell’s Fed).

Bye bye Volcker, bye bye Phillips.

The Fed in a historic shift will now engage in a flexible form of average inflation targeting, with no fixed formula in order to support as much employment in all sectors as possible – and with the almost tongue in cheek comment that if it leads to a long term overshooting, the Fed will not hesitate to act (i.e., manipulate interest rates up).

As I’ve mentioned before, since the GFC inflation has been in assets, not prices, due to continual bond buying and more recently coronavirus welfare chimney money. Perhaps Powell is of the opinion that it won’t blip on the price radar unless unemployment can literally go to zero and super-charge inflation.

If inflation can be jump started with assistance from government (still waiting to see this), Powell is saying he will let the bulls run and make up for the shortfalls, i.e., the 6 past years in 10 plus a fairly anemic forecast (as per below).

And, just maybe, if price inflation returns he will let it run so hot that it melts money out of risk assets and into spending. Now that’s a cunning plan, and if he can somehow get government to create a scenario where workers are no longer in fear of losing their jobs, that would be a good start.

But this feels far from home just now and question whether government would prefer to develop and roll out fiscal growth spending policies, or pressure the Fed into buying more bonds and allowing treasury to supply more guarantees.

The short squeeze and a few questions.

There are more than a few questions and potential problems with Powell’s bullish approach, that leave markets in an uncomfortable suspension.

1. Firstly, just because you say inflation can run above 2% doesn’t mean inflation will even get to 2% for extended periods, if at all. In the last decade it’s only hit 2% or exceeded that level 40% of the time.

2. The Fed itself says long term growth will no longer hit 2.5%, but only 1.8%, and productivity is still decreasing – so by their own admission that sounds like inflation will be contained for awhile.

3. Inflation as measured by the CPI is a price measure and not a volume measure, and it misses out on measuring the economic impact of technology on prices (i.e., the amazon effect). A volume based growth measure would be a better measure (which was verbalised to an extent at Jackson Hole two years ago).

4. While people are still in lock-down and/or fear for their jobs, they will curtail spending and will save (or buy cheaper online) which is counter to Powell’s policies. So, he will need a lot of help from the government (not just welfare, but growth investment) so that households can get enough job comfort to stop dis-inflating the economy.

5. Saying that unemployment can never be too low implies that you are willing to let the economy move all the way to the Y axis and run white hot, not red hot.

The Fed is effectively shorting the dollar and will seek to stop out by selling bonds if lower unemployment leads to white hot inflation. And, while it might be secretly hoping that price inflation might encourage some investors to transfer money out of assets in favour of spending, the real question is how the Fed will achieve lower unemployment and higher productivity when fiscal spending has so far been welfare and not growth based.

And, down-under, the RBA follows.

Yesterday, the Reserve Bank of Australia published its corporate plan for 2020/21, covering reporting periods from 1 July 2020 to 30 June 2024. First point is that it’s a four year plan and potentially a four year lock-in.

The plan outlines the Bank's mission and key objectives, the activities that it undertakes to achieve them and how it measures performance. It also discusses the external environment in which the Bank operates, the Bank's organisational capability and its approach to managing and overseeing the key risks it faces.

Here’s a link.

If you go to Section 6, take a look at the first objective of price stability and full employment (extract only below).

The bank will let the economy run hot to create full employment by adopting flexible medium-term inflation targeting of between 2% and 3%, on average, over time.

Same ‘averaging’ as in the U.S., other than for the 3% upper bound.

Implications for WA industries and business leaders.

The above points to a weaker USD which is positive for WA importers and negative for inbound capital flows and USD denominated exporters.

On the other hand, we are seeing a commodity price boom which is providing a tailwind for many mineral producers, and for new gold and precious metal developers, which will no doubt spill-over into other metals. This is counteracting the FX effect. Agribusiness is a mixed bag as regional food security and protectionism become priorities.

We are seeing some some nice growth in engineering, construction and mining, both products and services with opportunities for capital raising and M&A activity.

Over time, if USD swap lines are further curtailed and the virus is brought under control in the U.S., demand for the USD may slowly build again adding some upwards pressure on the USD and downward pressure on the AUD. If materials are still on the up at the time and China relations improve, it could create a perfect storm for WA.

WA has many advantages in its favour and we have much to be thankful for. Healthy families and communities being the most important of all.

Stay tuned.

Mike.

Next Level Corporate Advisory is a leading independent advisory firm with a multi-decade track record. We specialise in transformative M&A, IPO, growth capital, special situation and strategic corporate advisory solutions designed to take your business to the next level, in and out of Australia.

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Image attributions: Fox News, EPA via The Sun.