Fed’s critical juncture – a few links for the record…

Date:21Jun2017

Remember this is not a blog in the traditional sense — I just simply write (irregularly) some (random) thoughts with hyperlinks on issues that interest me (and the people I deal with in my daily job, like students, colleagues). One super-interesting topic these days is the inflation outlook in the U.S. or specifically, Janet Yellen’s bet “that falling prices are a temporary blip that will soon be forgotten.” The issue has taken an interesting turn, when another Fed heavy weight NY Fed President Bill Dudley struck a similar tone to Yellen. Markets reacted, including some weakening in EM currencies, especially the high-beta ones like the Turkish lira, which has been having a hard time breaking through the 3.5 mark against the dollar, despite the recent positive sentiment toward the currency.

Who will prove right? This is a crucial question that will prove decisive on Turkey’s fortunes as well. Our feeling is that unless we enter deflationary territory, the Fed is likely to continue its “normalization voyage”. (Here is a nice overview speech on where things stand on that.) And this is so largely because, as explained in this FT op-ed by Mohammed El Erian, the issue is not so much about confidence on the inflation outlook, but concerns over financial stability — that “the central bank is now focusing more on excessive risk-taking by investors and traders, including its potential negative impact on the economy down the road”—or the risk of a sharp market correction at some not too distant future, depressing consumption and investment.

So the controversy is mainly about how seriously the financial stability concerns should be taken – an issue on which Fed also seems divided  between those that dismiss these concerns (focusing instead on the weak inflation outlook, as done by the Minnesota Fed President here) and those that take it more seriously, as the Boston Fed President here.)

This debate has been going on for a while and is unlikely to end any time soon.  Humbly, I feel much closer to “let’s keep normalizing” school, simply because this is the only way we can start fixing the “addiction” (of having to rely on constant central bank support) and return to a healthier mode in which “fundamentals” matter again.