The Eyes of the Market

The eyes of the market are focused on inflation. This is appropriate, given that a sustainable dynamic of inflation would completely change the current dynamics of our economy. The reasoning is simple. If the Federal Reserve removed inflation under Paul Volker's leadership in the early 80s by tightening rates and shrinking the Fed's balance sheet, why wouldn't the opposite actions do the opposite? With the Fed's balance sheet ballooning to nearly $8 trillion shouldn't we be concerned that a view of benign inflation is simply a form of "fighting the Fed"?

This reasoning process is sound but fails to take into account the asymmetrical impact that Fed support has. This impact has been called "pushing on a string," articulating the powerful nature of a string to restrain but its limitations to support. Fed policy is difficult to disentangle from the other powerful force of fiscal policy. To use a model of disentangling, look at the current situation in Europe.

The ECB’s benchmark deposit rate sits at minus 50 basis points, with the seventh anniversary of sub-zero borrowing costs coming up next month, while total assets on the ECB balance sheet were €7.6 trillion ($9.3 trillion) as of last week, equivalent to 57% of pre-pandemic nominal GDP in 2019.  That compares to $7.9 trillion in assets held by the Federal Reserve, equivalent to 37% of 2019 output. Here is a situation of more significant central bank support that is not muddied by the aggressive fiscal stimulus in the US.

Of course, inflation could rise on a sustainable level, but the Fed's role will not be key. The Fed's actions have provided liquidity to the markets as well as a valuation lift. Every asset owner has received a "stimulus check" in the form of this support. Clearly the Fed will withdraw this support at a future date, but not until other forces have successfully driven sustainable inflation. So far those forces seem temporary.