The Power of FAIT

My dream career has long been that of Envoy from the Bourgeoisie. I want nothing more than to travel the world uniting nations with power of schoolboy latin verse and the eloquence of my bad puns. (🎵Dear Future Husband, Here's a few things you'll need to know... 🎵)*

Last year, my dream edged a little bit closer.

In August 2020, the Federal Reserve announced a change in its approach to monetary policy with respect to its mandate of price stability, promising that it would adopt a strategy of flexible average inflation targeting (FAIT)....and a gazillion corny tag-lines were born.

FAIT accompli, Have a little FAIT, FAIT and Fortune... I and a hundred others like me woke up almost a year ago, sniffed the air, detected a whiff of paronomasia on the breeze and reached eagerly for our Saturday-night specials. "FAIT" is not just an oven-ready quip...it's a glamorous dinner invitation to the House of Finansplanation.

So what exactly is FAIT?

Oh, I'm so-o-o-o glad you asked.

FAIT is a policy of seeking inflation that averages 2%. It allows the Fed to take a long and broad view, to accept that the inflation target may occasionally be overreached to the upside as well as to the downside and, in essence, to fret less about that.

FAIT represents a shift because the previous Fed policy was to target 2% inflation in such a way as to apply the monetary brakes going into the inflationary corner, in order to avoid taking it at speed and losing control. And that meant not only that 2% was never exceeded but, in practice, the target became pretty much unattainable. As inflation rose towards 2% the Fed would metaphorically change sides and shift from playing forward to goalie, running out of the net to pre-empt the unthinkable.

So, why is FAIT important now? Well, when FAIT became the new orthodoxy, price inflation had been subdued for quite some time. In such circumstances, it’s easy to feel comfortable about loose monetary policy, to see normalisation, tightening and higher interest rates as distant prospects. And it's also easy to believe that FAIT and its "goal-keeping" predecessor would converge on the same monetary policy recommendation. But as inflation moves towards 2% and crosses over into the territory above the target, FAIT necessarily comes under much greater scrutiny. This year, core price inflation hit almost 2% in the figures for March (allocated in the diagram below to May 2021), rose to over 3% the following month and has established steady, if marginal, gains since then--

🎵Listen hot stuff.🎵

according to Core PCE, which is...

🎵I'm in love with this song. So just hush.🎵

...a less volatile measure of consumer prices...

🎵Baby, shut up!🎵

...which excludes seasonal food and energy.

🎵Heard enough.🎵

Other measures of price inflation are...

🎵Stop ta-ta-talking that blah, blah, blah.🎵**

Now we're in what feels like new territory, as evidenced by the fact that the Fed is talking about talking about tapering, and a number of questions have come to the fore surprisingly quickly. First, how long is too long for the Federal Reserve to "look through" inflation >2% before average inflation exceeds the target? Second, should FAIT weigh in the appointment of the next Fed Chair? And third, what is a steepener trade?

Fortunately, we can dispense with all three pretty quickly.

1. How long is a piece of string?

2. The observation that FAIT has created a kind of crisis of opacity which invokes the axiom "no time to swap horses" would be circular or, worse, self-fulfilling. (NB, I generally leave questions about horses to cleverer people.)

3. Ah. Now you're asking.

So, in our next blogpost...

What? Oh, the steepener? Well, if you insist.

A curve steepener trade is a strategy that uses derivatives to benefit from escalating yield differences that occur as a result of increases in the yield curve between two Treasury bonds of different maturities.

Yeah, me too.

There's a kind of law-of-market-nature that says long term interest rates are higher than short-term ones. That's because there's more opportunity cost and/or risk in lending money over 30 years than over 5 years, say, so, all other things being equal, we pay more for the privilege of borrowing long-term. But there's no universal fixed ratio (or "spread") between short- and long-term rates and no guarantee, either, that the law will always hold true.

When it comes to bills, bonds and notes--debt instruments that are traded in the capital markets--expectations about interest rates are implied in the yield (YTM) of the instrument, which is something like the difference between the discounted, tradable market price now and the total return on the bond if you (qua lender) bothered to hold it to maturity. Prices fall and yields rise when inflation is expected because the face value will have less purchasing power at maturity as a result of inflation-erosion. The price-impact of a shift in inflation expectations, however, will differ across maturities. A yield curve is simply a line that plots the yields of bonds of different maturities--it tends to rise across the page from short to long term maturities.

A steepening yield curve for US Treasuries usually indicates that investors expect higher growth and inflation, leading to higher interest rates in future--and that's the link. This year, the curve was steepest in February and flattened out as figures were released showing a significant rise in consumer prices. That's probably because investors were already factoring higher interest rates into shorter-term notes and weaker growth into long-term bonds, possibly reflecting a view that sectoral rising prices will force an interest rate hike and prevent the economy running hot long enough to establish real prospects for long-term growth.

That could mean that investors hadn't really factored in the shift to FAIT or it could mean they have little faith in the ability of any inflation targeting strategy to withstand the shuddering weight of the economic behemoth that is the American used car market as it roars into post-pandemic life.

Whatevs. Jerome Powell is having none of it right now. Speaking at a press conference to conclude the July FOMC meeting, he was keen to display his nerves of steel, saying sternly:

As the Committee reiterated in today’s policy statement, with inflation having run persistently below 2 percent, we will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. We expect to maintain an accommodative stance of monetary policy until these employment and inflation outcomes are achieved.

This broadly translates as:

Si tu oblitus es, at di meminerunt, meminit Fides, quae te ut paeniteat postmodo facti faciet tui.***

Or, to put it a little more succinctly:

Oh ye, of little FAIT. 😞

* Songwriters: Kevin Kadish / Meghan Trainor Dear Future Husband lyrics © Amplified Administration

** Songwriters: Benjamin Levin / Kesha Sebert / Sean Foreman / Neon Hitch

Blah Blah Blah lyrics © Emi Blackwood Music Inc., Where Da Kasz At?, Matza Ball Music, Dynamite Cop Music, Master Falcon Music, Cagje Music

*** If you forget, but the gods remember, Faith remembers, who later will make you regret your deed. (Catullus 30)