Crescenzi: Fed Outlook: ‘Strategos’

In the aftermath of the financial crisis, central bankers throughout the world have not had much of an inflation battle to fight; in fact, the risk of deflation has been seen as the bigger foe, prompting central bankers to focus far more on promoting economic growth. In essence, central bankers have sought to reduce unemployment, believing its other adversary—inflation, was not even on the battlefield.

This is no longer true. Inflation is accelerating in many parts of the world and it is making its way to the frontlines at a time when central bankers are fighting other battles.

Central bankers therefore must alter their strategies—ergo reduce their degree of monetary accommodation, or communicate to the public their plan to contain the enemy. Failure to address these fears will strengthen the enemy.

Inflation Expectations are the Enemy

"All warfare is based on deception." Sun Tzu, The Art of War

Inflation is so powerful an enemy that when left unchecked by central bankers it can infiltrate enemy lines and enlist the masses to join its ranks. Such is the danger of letting inflation expectations increase substantially enough that the expectations themselves become a source of inflation. This is currently the biggest danger that central bankers face and, in some parts of the world, they are getting outflanked.

The increase in inflation expectations has not yet been viewed as undesirable. In fact, it was welcome when it began, because it wasn’t the enemy—deflation and the aftershock of the financial crisis were, which is why central bankers deployed their most powerful weapons, including their conventional ammo—interest rates, and unconventional ammo such as liquidity programs and securities purchases, to fend off the effects of the crisis..

United States Federal Reserve
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United States Federal Reserve

Early on, central banks were comfortable using their arsenal because there wasn’t much risk of collateral damage.

Today, however, the risk of collateral damage is escalating, with the costs of maintaining the extraordinary degree of monetary accommodation in increasing relative to the benefits. This is evident on a variety of fronts in the financial markets, the economy, and on the world stage.

If the accommodation is not reduced in time, the beneficial effects of keeping low interest rates and unconventional policy actions in place will morph and become deleterious, manifested in faster rates of inflation and misallocations of capital.

The Strategoi: Officials with Dual Roles

“In War, resolution; in defeat, defiance; in victory, magnanimity.” Winston Churchill

Section 2A of the Federal Reserve Act states that the monetary policy objectives of the Federal Reserve are to "...promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

The so-called dual mandate of the Fed is therefore to promote conditions that foster maximum employment and stable prices. Politicians care most about the former, while the latter you could say is achieved in battle, by generals.

In other words, each Federal Reserve official is essentially a politician and a general. It is a challenge to be both. Science backs this up, because it and our own experiences make clear that the mind can handle only one complex activity at a time (or even simple tasks such as driving and texting!), yet for centuries governments have created roles that gave officials more than one task to handle at a time. In Greece at around 500 BC, ten strategoi (plural for strategos), were elected annually, each given the formidable task of being both a politician and a general—the same responsibilities Fed officials have.

As generals, the strategoi had many responsibilities, including drafting the citizenry into military service. As any general knows, the strategoi knew that when in battle there is power in numbers, so they did not hesitate to call the citizenry into action. Nor should the Fed. It must battle inflation by “calling up” the masses, first by communicating its unwavering commitment to price stability (Bernanke has done this), then by communicating its strategy for fighting the enemy, and eventually by waging war against inflation, taking shots across the bow by withdrawing excess bank reserves and by raising interest rates. If the Fed plays to the political side of its dual mandate for too long, it will be outflanked.

When to Sound the Battle Cry

It will be time to sound the battle cry when, as New York Fed President William Dudley said, there is a “sustained rise in medium-term inflation expectations.”

Inflation expectations need be stable if the Fed is to keep its zero interest rate policy in place. The Fed has said as much, including inflation expectations among the three conditions it has said “are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” The other two are: low rates of resource utilization and subdued inflation trends. Neither of these latter two conditions is likely to change any time soon, leaving inflation expectations as the only game in town.

The Fed will act when it is confident that the benefits of waging war against inflation will exceed the costs. For now, the Fed feels it is not yet time, and no hike is likely this year.

Concluding Remarks

Today, central banks have fights on several battlefields and deciding where to pick their battles is complex. Each "strategos" on the Fed will have to move away from policies designed to combat emergency conditions and act as generals to assure the public of the Fed's readiness for the next battle.

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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."