Economics and Strategy

Flip-Flop, Flip-FLOP

— David Zervos, Chief Market Strategist

Since early October I have found Fed communications quite difficult to understand. And based on the increased turmoil in financial markets, it appears I’m not alone. Now, we could spend an enormous amount of time parsing through the potential reasons for this increase in Fed opaqueness, but I doubt we would ever uncover the truth. In any case, some possibilities might include:

  1. A deliberate attempt by the Fed to add volatility to financial markets in order to stave off future criticism for aiding in bubble creation
  2. A move by the Fed to assert its independence in the face of increased criticism from the POTUS
  3. A more malicious political motive at the Fed to undermine the agenda of the current administration
  4. A rookie chairman who likes to go off script, make incongruous statements, and then stubbornly refuse to take responsibility for the blunders

I’m going to go with number 4, but I’m certainly open to other possibilities. The reason I say number 4 is the way Jay answered the December FOMC press conference question on his neutrality flip-flop from the time of the PBS interview to the NY Economic Club speech. His response was, “Let’s look forward, not backward.” This revealed a lot about Jay’s character: He doesn’t like to admit fault, and he is extremely stubborn. I’m afraid therefore that his hubris has played (and will continue to play) a more important role in communication than actual policy considerations. Further, this hubris may also imply that reasons number 2 and 3 above are coming into play a bit! In any case, this is all extremely dangerous for the Fed policy reaction function.

And to be sure, my beloved risk-parity trades rely heavily on a well-functioning Fed policy reaction function. When disinflation risks rise (as they have done recently), this trade needs to see some healthy doses of Fed dovishness. We cannot have a sanctimonious Fed leader looking to abdicate responsibility because pride gets in the way. If that happens, we will be following in the unholy footsteps of the Bank of Japan.

Now, if it were just Jay making the decisions going forward, I would honestly be binning my risk-parity trades right here. But I am going to put faith in two other senior leaders on the FOMC: Rich Clarida and John Williams. These two individuals will recognize the very serious developments brewing on the disinflationary front. And they will understand that the Fed can ill afford to head into the late stages of this business cycle with embedded disinflationary expectations. I’m banking on these two seizing control of the monetary policy reaction function in 2019.