Why I'm Bullish Equities--But Not Too Bullish--Right Now

Although it didn’t happen until after the U.S. market had closed – funny how that happens – there is Paul Kasriel of Northern Trust , who is consistently one of the nation’s top forecasters) by essentially saying that the failure of inflation to immediately surge following aggressive Fed easing meant that all of those forecasters were “clueless.”

One of those economists, Stephen Stanley of Pierpont Securities, took umbrage at being called “clueless” and fired back a broadside that is fantastic in that it points out clearly many of the weaknesses in the reasoning of the “I heart Bernanke” lobby (readers of this column will be familiar with many of these arguments). I have not always agreed with Stanley’s perspective on the economy – no honest economist always agrees with anyone – but he hits the nail on the head here and I will quote a large part of his response. He first points out that the article attacks a straw man because no reputable economist forecast a huge immediate surge in inflation just because of a surge in bank reserves. He then notes:

"… And keep in mind that the inflation rate accelerated in 2011 by roughly a full percentage point for both headline and core.  That is in fact a pretty “rapid” pickup in inflation that would get us into trouble if it persisted.

Importantly, this acceleration in inflation in 2011 was absolutely not predicted by the Fed or its apologists.  The Phillips Curve model that dominates the FOMC’s thinking (and evidently Lonski’s and Gertler’s) does not even allow for the acceleration in inflation seen in 2011.  In fact, the Fed models are unambiguous that inflation should be falling substantially now (because there is a lot of slack in labor markets), which is a main reason that Fed officials had such unwarranted concerns about deflation in recent years and why they now so confidently predict that inflation will decelerate from here, even as growth improves and “slack” diminishes.  And herein lies the problem.  We have a central bank that apparently believes that inflation is driven by wages which are in turn driven by the degree of slack in labor markets (i.e. the unemployment rate).  I had thought that this dusty old Phillips Curve framework was thrown in the dustbin of history after the disaster of the 1970s, but clearly (like some bad 1950s horror film) a new generation of academic economists has dug it out of the trash, cleaned it off, and attempted to dress it in new clothes and sell it as the unquestioned consensus of the economics community.  When the central bank does not allow for an important role of money in the determination of inflation, an acceleration in prices is a clear and present danger.

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… The problem with the Fed is not so much that inflation is currently way too high, it is that the reaction function from economic and inflation data to policy is radically easier than it has been at any time in the Fed’s history.  I do not disagree that policy should be accommodative, but there is no credible framework to defend the notion that it needs to be as or more accommodative in late 2014 than it is now.  This is a train wreck waiting to happen, but it is a train wreck that will play out over years, not minutes.  Happily, this means that much of the damage is preventable/reversible if the proper course correction is taken soon enough.  If not, the latter part of this decade may look a lot like the 1970s."

As I say, he makes some powerful points that you have read in this space before. Economists who say we don’t need to worry about inflation because of slack growth (the Phillips Curve argument) need to explain away several data points that don’t fit that model. For example, the 1970s. They also need to explain why prices haven’t fallen over the last few years (outside of energy) despite immense slack in the economy. And he absolutely nails the vulnerability now, which is less that the transactional money supply is growing at a steady 10% rate (although it is) and more that there is no reason at all to expect that the Fed is about to take drastic actions to trim its balance sheet and begin to restrain the money supply. Indeed, quite the opposite is true.

We will get money supply later today, and next week CPI. But no matter what those numbers say, some of us will still be called clueless. I guess I don’t mind being clueless, as long as I’m right.

Written By: Michael Ashton