I mean, inflation.

In Hooper, Mishkin and Sufi’s study, they find significant evidence of both negative slope and nonlinearity in the Phillips curve, meaning that the wage Phillips curve is very much alive. Following the study, as late as September 2019, the Fed still believed that the flattening of the Phillips curve (that is, price inflation becoming less sensitive to changes in resource slack in the previous twenty, thirty years) allows them to run the economy hot to give greater support for employment during economic downturns without incurring much cost to price stability.

Indeed, that was what Powell used as a guideline when the pandemic struck the economy hard, when many in the labor force dropped out of work and pandemic-induced supply shocks rippled through the chain. The period was seen as an opportunity to achieve broad employment while moving away from the effective lower bound. In retrospect a few years later, many now think that the Fed had unnecessarily kept the rate too low for too long, and this decision is partly to blame for the current high inflation.

As much as the Fed should learn from the experiences of the Burns and Volcker era, or even Bernanke’s, each era is historically unique. For every period there are significant changes in the mode, transparency and directness of Fed’s communication, differences in the level of sophistication of the intended audience of said communication, the introduction and cementation of forward guidance and in the greater ease of public access and analytics to the data on which the Fed relies on.

All these changes call upon an independent-minded, nimble-acting, credibility-inspiring Fed who can accurately gauge how to effectively convey and set the consensus. As Yellen used to say, “My job was to get everyone to see that off-white was not a bad choice and we can all converge on that and agree that it will function just fine", i.e. stability is not the actual shade but the consensus of it, and off-white the most neutral and uncontroversial.

The market’s view is a culmination of two things: ONE; since the Fed has declared a policy of data-dependancy, then the trend with which the inflation data moves becomes of great interest and the object of scrutiny by market participants and TWO; the market also has to gauge the reaction function of the Fed to the changes in the trends. That is, the reaction function that this current Fed, in its inherited lessons and traumas of the past, will most likely form to quell inflation. The indications thus far is that this Fed is prioritising the 2% ideal above economic growth and financial stability (although will promptly act if things get dire). From the latest speech, the Fed wishes to revert to Brainard’s gradualism and focus more on where the terminal rate should be rather than the speed of the hikes.

As much as the Fed needs to reduce its aversion to pivoting, the markets too, need to be less confident in the direction of the inflation data trends. I have been trying to impart an attitude to some that you must not extrapolate the present situation to the future. Some events do cause a higher probability that another, relevant event will happen, but it’s a mistake to think that trends do not reverse. The Covid virus can still mutate into something that our current vaccines cannot mitigate the effects of, and the Ukraine-Russia situation could still worsen. There might still be another inflation-inducing global challenge around the corner, not to mention that the labor market is still historically too damn tight. Caution and temperament of the animal spirits are key.

Speaking of the labor market, a Morgan Stanley report finds that other services wage-price pass-through is relatively higher than other CPI components. Their statistical model points to a pass-through of 0.3 over a year, which means that a one-off unexpected 1% increase in wages boosts other services inflation by 30bp one year ahead. Hence, their model predicts that the acceleration in services wages that happened since 2021 might increase other services prices by 140bp one year ahead, other things equal.

Still, all these might prove transitory and in another year, we would all breathe a sigh of relief. Paul Krugman and some others are already congratulating ‘Team Transitory’ on their inflation call - but what exactly is meant by “transitory”? To understand that, we must understand what stationary means.

A stationary time series has properties that are independent of time, e.g. the mean stays the same (i.e. mean-reverting). In an economic context, an economy can, in an instant, move from a stationary regime to a non-stationary regime. A stationary regime is when inflation shocks exhibit transitory effects on the economy, whereas in a non-stationary regime, inflation shocks are persistent, causing inflation expectations to become unanchored.

Having said that, rest assured that measures of inflation expectations, so far, points to them being strongly anchored and thus, Fed’s credibility lives to fight another day.