From initially saying some inflation is good and then giving it a lead, the US Federal Reserve now seems to be in a fix
What has the Zeno’s paradox got to do with the US Fed? Well, for that, let us first understand the Zeno’s paradox.
This is a problem that has enthralled mathematicians and physicists for centuries. The Zeno’s paradox, attributed to Greek philosopher Zeno, refers to an interesting conversation between Greek hero Achilles and a tortoise. Who will win a race between a great warrior like Achilles and the tortoise? The answer appears a be no-brainer. However, the tortoise thought otherwise. It challenged Achilles that if given a lead at the start of the race, it could win the race. How was that possible? According to the tortoise, by the time Achilles reaches where the tortoise started at its lead point (say point A), it would have moved a little further and reached say, point B. By the time Achilles reaches point B, it would have moved even further and reached point C. This can go on and on and, thus, the tortoise would constantly stay ahead of Achilles. The Fed appears to be in a similar paradox of its own making.
The Fed’s conundrum
In order to stimulate the economy, the Fed was very comfortable giving inflation a big lead, with confidence akin to Achilles, that it can catch up. From initially saying some inflation is, in fact good, and then later terming it transitory and claiming to have tools to control inflation, they have now seem to have lost control of the narrative completely in recent months. The US CPI inflation data for May released last Friday was at 8.6 per cent (highest since December 1981), and it shocked market participants as it indicated inflation was continuing to surge, contrary to expectations of many that it had peaked out. To put the impact in perspective, the tech-heavy Nasdaq Composite, which was already reeling deep in bear market territory, fell eight per cent in just two days post the release of the latest inflation data.
Thus, the Fed is not only faced with the Zeno’s paradox — a problem of its own making by keeping real interest rates negative (interest rate minus inflation) for way too long — it also now seeing the tortoise gaining momentum and running as fast as the hare.
Can Powell do a Volcker?
In the early 1980s, after a decade of stagflation in the US, the newly appointed Fed Governor of that time, Paul Volcker, decided to take charge of the inflation narrative and shocked the markets by increasing the Fed funds rate to 20 per cent, to rein in inflation that was hovering in low double-digit percentage. Rather than trying to catch up with the tortoise incrementally (which is what the Fed is attempting now), he decided to make a giant leap that could overcome all paradoxes, and took real rates to positive territory by a wide margin.
Post the US CPI inflation data last Friday, many market participants now expect Jerome Powell to possibly shock the markets. Powell may not do a Volcker, but markets are now indicating a very high probability of a 75 bps hike in Fed funds rate, and maybe even 100 bps hike, versus prior expectations of 50 bps.
However, market participants must not assume any strong move by the Fed as an immediate solution to the inflation and interest rate issue.Problems created by more than a decade of easy money may not have quick endings, unless there is an unexpected shock to the economy. As long as the tortoise has the lead, it is better not to get overconfident and aggressive in your investments.