SIMON BROWN: I’m chatting now with Dr Adrian Saville of Genera Capital, the gentleman I always go to when I realise that I might not fully understand something. In this case [there’s] a phrase that I’ve been using and I suddenly thought, hang on, does it mean what I think it means?
Adrian, I appreciate the early morning time. The phrase is used often around central bankers at the moment, being aimed a lot at the [US] Federal Reserve, Jerome Powell and his team in the US. These folks are saying that they are ‘behind the curve’; what are we meaning when we are talking about being behind the curve?
ADRIAN SAVILLE: Simon, great to be with you. ‘Behind the curve’ is probably best captured in a statement by William McChesney Martin in the 1950s. He was governor of the [US Fed] and he spoke about the punch bowl at the party. He said it’s equivalent to a person who’s chaperoning a party, and they leave the punch bowl on the table and the party gets out of hand. That’s what being ‘behind the curve’ is.
The job of the Fed is to keep prices low and stable, not to eliminate inflation but to keep inflation palatable, tolerable, predictable – and just keep an even keel. And when the suggestion is that they are ‘behind the curve’, it means the punch bowl is on the table and the party is getting going.
SIMON BROWN: I understand that completely. That’s the interest rates, and that’s the inflation that we are seeing, because the interest rates have remained low. We have now got the US at 40-year highs on their CPI, at 7% – last seen since the eighties. Is the response then as easy as to aggressively raise rates? That’s got its own challenges in terms of the broader economy. Is it possible to sort of yank that bowl away, or do you then create other problems?
ADRIAN SAVILLE: Well, I should’ve perhaps been more full in my reference to the ‘punch bowlers’. Not only should they have pulled it away a long time back, but the policy actions that have been going on in recent times have actually been dipping a couple of extra beverages into the bowl.
So it’s not just that the party’s getting going, it’s that the party is getting out of hand.
So when you have this elevated inflation – and it looks like it’s set to stay, so the word ‘transitory’ has been banned from economic conversations; it now looks far more than transitory and [is] increasingly sort of resident – the appeal then from a policy perspective is that the Fed must remove the quantitative easing component, where they’ve been putting money into the market by buying a up financial paper for years now – all the way back to 2008.
The second is that that financial lever then needs to be tightened further by interest rates being hiked. Now it’s easy on paper, but to get that into practice and to not destabilise the economy and capital markets while you tame inflation – I think we are now in the world of miracle magic because the Fed is so far behind the curve.
There are two good guides here. The one comes from the Harvard economist, Gregory Mankiw, the so-called Mankiw Rule, and the other comes from John Taylor, who was the economic advisor to the Bush administration. They have tools or models, the Taylor Rule and the Mankiw Rule, which use inputs like economic slack, the existing rate of inflation, the targeted rate of inflation. From that [they] work out what the appropriate interest rates should be, the model interest rate.
And whether we go to the Taylor Rule or the Mankiw Rule, they both are pointing to 6% and 7% interest rates in the US, and the Fed is at 0.25%. It’s a long way behind.
SIMON BROWN: I think the markets are saying four increases this year. Even if we have five or six, even at half a percent – and no one is saying we’re going to get six half-percent increases, even if we did, we’re not even halfway to that yet.
ADRIAN SAVILLE: Well, let’s say, with our party analogy, we’re not even on the dance floor. We have to rewind some time to find a Fed hike. Understandably they have been reticent to hike. There is an incredible amount of uncertainty, but this distance from where the Fed is in the interest rate to where models and inflation suggest they should be is almost unprecedented. You have to go back to the 1980s to find the Fed so far behind the curve.
I think investors need to be thinking about what this means if inflation sticks around in an elevated form in the world’s biggest market for much longer than we had anticipated – and then, in response, what happens if we get into a long haul of price hikes that would get us back into the world of disciplined monetary management.
SIMON BROWN: We’ll leave that there. Dr Adrian Saville of Genera Capital. I’m now smarter. Truthfully I’m now also scared-er. I really appreciate the time this morning.