“We are open to new ideas and critical feedback and will take onboard lessons from the last five years and adapt our approach where appropriate to best serve the American people, to whom we are accountable.” Jerome Powell, November 2024.
Fed announces policy framework review, plans for May 15-16 conference | Reuters
Per the above Reuters story, the Fed has announced that they will be holding a conference and soliciting feedback as they undertake their latest 5-year “framework review”. The article notes that the 2% inflation target will not be up for reconsideration under the review. What likely will be reconsidered is Average Inflation Targeting (AIT), the policy that was newly introduced in their previous review of August 2020.
Statement on Longer-Run Goals and Monetary Policy Strategy
We took a rather cynical view towards that review in our own August 2020 Update – “Average Inflation Targeting; the beginning of the end” Convex Strategies | Risk Update: August 2020 – Average Inflation Targeting; the beginning of the end.
“The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.” (bold highlights added by us)” Statement on Longer-Run Goals and Monetary Policy. August 2020.
“So reads the opening paragraph to the “Statement on Longer-Run Goals and Monetary Policy Strategy”. The original version of this statement was adopted January 24, 2012, and amended on August 27th, 2020, ushering in a new era of Federal Reserve (and likely many other Central Banks) policy aimed at Average Inflation Targeting and Maximum Employment. We couldn’t help but highlight the words in bold to note the Edward Bernays-esque nature of the introductory paragraph. Firstly, we are assured that the authors of this policy are all that one could want from a benevolent overseer in support of a functioning democratic society. The fact that they are unelected, virtually unaccountable, ivory tower elites, should not distract us from their good and just intent in the policy document to follow.”
“The freshly revised version, simplified, says that the Fed will no longer worry about “deviations” (the old version) from maximum employment, but only “shortfalls” from maximum employment. They will also target inflation that “averages” 2% over time, thus willingly allow inflation to exceed 2% for unspecified periods to bring the longer-term average back into line. Accordingly, they will no longer pull back from stimulus, or tighten monetary policy, in anticipation of tightness in labour markets leading to inflationary pressures. The Phillips Curve is presumed dead!”
How did that work out? We can update some of the charts that we showed back in August 2020.
Figure 1: US Core PCE Index (white) and CPI Index (blue). Jan1995-Oct2024 (normalized)
Source: Bloomberg, Convex Strategies
From one perspective, we could say that they succeeded. For this time horizon, commencing at the start of 1995, they have hit their bullseye: PCE Core has grown at an annualized rate of 2% over this entire period. Whatever pain and misery was endured by those who had to suffer the annualized rate of 1.70% from January 1995 through July 2020 have, presumably, been made whole by some sort of reward being granted (though possibly not to the very same cohort) with a nearly 4% annual rate of change over the last four years. Hurrah!
On the less favoured CPI Index, they have managed to correct the unacceptable annualized rate of 2.16%, from pre-AIT, to a healthier(?) 2.52%, after bestowing four years of an annual increase of 4.75%.
If we assume, now that they have righted the ship, they will be able to main this optimized rate of change, the indices would look like this over the next decade.
Figure 2: US Core PCE Index (white) and CPI Index (blue). Jan1995-Oct2024 (normalized). Projections through 2034 for PCE Core at 2% (white dashed) and CPI at 2.5% (blue dashed)
Source: Bloomberg, Convex Strategies
As they say, with friends like this…..
Readers will be aware that we like to differentiate between the modern bastardization of the word ‘inflation’, as being the annual rate of change of some randomly constructed price index, and the classical economics meaning of the word, that being an increase in money and credit. We have long suspected that the ample creation of classical inflation has not necessarily been fully represented by the annual change of the various constructed price indices but, rather, may be better seen in the inflation of asset prices. Again, updating a picture that we showed back in the August 2020 Update:
Figure 3: US Core PCE Index (white) and CPI Index (blue). S&P500 Index (papaya). Federal Reserve Balance Sheet (purple). Jan1995-Nov2024 (normalized)
Source: Bloomberg, Convex Strategies
It is very unlikely that we find ourselves with an invitation to the May 2025 powwow but, if we could be of any assistance, we would simply forward them this recent speech from Claudio Borio (we might argue, given Claudio has laid it all out, there is little need for the Fed to go much further). As we have mentioned in past notes, Claudio is departing his long-held role as the Head of the BIS Monetary and Economics Department. Few have been as prescient to the flaws of the recent era of central bank practices as Claudio.
Here is the full speech, as well as a condensed version published by OMFIF.
Whither inflation targeting as a global monetary standard?
Toughest challenges for monetary policy are probably still to come – OMFIF
Claudio sings straight from our hymn book, raising questions around the endogenous risk built through time as a result of central bank efforts to achieve their Goodhart’s Law-esque target.
“The more controversial part concerns the challenges that Inflation Targeting (IT) has faced. To what extent are they exogenous to the regime or the result of how the regime has been operated, ie endogenous to the regime itself?”
“One could say that low rates beget lower rates… At each point in time, what central banks took as an exogenous interest rate was to some extent the result of their own past actions.”
Regular readers will know, this is one of our leading pet peeves. The concept that somehow, they (central bankers) are masters of the universe, guiding and controlling all future outcomes, yet never are their past policies a part of the accumulated challenges that they find themselves in as they stumble forward into that future.
Claudio touches, ever so politely, on the issue around asset inflation, aka “financial imbalances” and the shift away from the classical economic viewing of “inflation” as a money and credit issue.
“…the new IT regime could inadvertently accommodate the build-up of financial imbalances. There would be no incentive to tighten monetary policy as long as inflation remained under control, especially since the new regime dispensed with credit and monetary aggregates… Put differently, inflation became an unreliable signal of the sustainability of economic expansions. That role was largely taken over by the unsustainable build-up of financial imbalances.”
Claudio zeroes in on fiscal and financial dominance.
“Lower rates could, over time, encourage further indebtedness, which would in turn make it harder to raise rates without causing damage to the economy.”
“Fiscal positions ease during downturns but do not consolidate during upturns to the same degree… The belief that interest rates would remain low as far as the eye could see no doubt played a significant role.”
Claudio goes on to stress the attributes that monetary policy should strive toward. Robustness. Long time horizons with a recognition of second-order effects. Safety margins. “Realistic views of what monetary can and cannot deliver.”
His comment on safety margins aligns exactly with our mantra for investment and risk management.
“In all walks of life, the need to retain safety margins is an explicit guide to action. Why should it be different in monetary policy? If something is valuable, it should be worth paying a price for.”
Claudio unloads a barrel of common sense:
- Maintain a priority around a low-inflation regime. Do not raise the current target levels.
- “Greater tolerance for moderate, even if persistent, shortfalls of inflation from narrowly defined targets.”
- Broader focus on the financial cycle. Incorporation of indicators such as financial conditions, credit aggregates, property prices. More focus on “approaches that allow for endogenous and possibly unstable fluctuations”. Hallelujah!
- Less reliance on forward guidance. More emphasis on exit strategies. Smaller, more flexible, balance sheets.
Claudio sums it up beautifully.
“It is a regime in which the central bank keeps a sharp focus on the medium term. The central bank seeks to ensure that the financial side of the economy, which it influences and through which it operates, does not end up derailing the economy, whether through inflation or financial instability, broadly defined. That is, the central bank sets the monetary preconditions for sustainable growth but does not end up being relied on as the engine of growth.
It is a regime in which the operational definition of the inflation target is consistent with that overarching objective. This means the target is low enough so that inflation does not materially influence agents’ behaviour, but flexible enough to allow the central bank to take into account the financial forces that can generate damage down the road.
It is a regime in which the central bank’s reaction function calls for forceful responses when inflation threatens to get out of control but allows for greater tolerance for moderate, even if persistent, shortfalls from target.”
Hopefully, Chair Powell is listening.
What we have termed above as “common sense” might more accurately fall under the realm of what is known as “bounded rationality” or “ecological rationality”. Following on from the works of Herbert Simon, Gerd Gigerenzer is today’s leading proponent of the concepts of heuristic decision making and the realm of ecological rationality.
We referenced some of Gerd’s works back in our February 2024 Update – “Where’s the Risk?” Convex Strategies | Risk Update: February 2024 – Where’s the Risk?. Yet again, we were writing about central bankers needing to act more like risk managers.
“Regular readers will know that we are advocates that central bankers should act more as risk managers than as shaman, or even manipulators, of the future. In a complex world, the answer to uncertainty is not precision but rather simplicity, what folks like us term as heuristics. A German psychologist by the name of Gerd Gigerenzer (little known inside Sharpe World) is a wonderful resource on the use of heuristics.”
Gerd recently published this wonderful paper titled “The rationality wars: a personal reflection”.
The rationality wars: a personal reflection | Behavioural Public Policy | Cambridge Core
In essence, “the rationality wars” are what we have been engaged in since we started down this path of trying to aid people in their understanding of convexity. The “wars” breakdown into three factions.
- Logical Rationality. What in finance and economic space we have dubbed “Sharpe World”. At its core is the assumption of “Homo Economicus”, the rational agent that maximizes utility in a realm of logical reasoning and complete information.
- Behavioural Economics. Led by the likes of Daniel Kahneman and Richard Thaler, this branch noted that, empirically, people did not behave rationally but, rather, along the lines of cognitive biases. People are irrational.
- Ecological/Bounded Rationality. Put in motion by Herbert Simon and advanced by the likes of Gigerenzer and Vernon Smith. They recognize the limitations of human decision-making in a world of complexity and argue that people use heuristics and tacit knowledge to chart a path through a world of uncertainty and ambiguity/intractability.
We consider ourselves firmly in the camp of ecological rationality. As with so much of what we talk about, it all comes down to uncertainty. There are things that we just don’t know, ie uncertainty. Things with probabilities but that are unknown or unclear to us, ie ambiguity. Things that are so complex that we have neither the means nor the time to compute them, ie intractability. This is the world of heuristics, tacit knowledge, skin-in-the-game.
Gigerenzer, referencing Simon, discusses how the differing factions try to cope with situations of uncertainty and intractability.
“The first is to convert the original problem into a small world to calculate an optimal course of action and hope that the solution will generalize to the original problem. The second is to face uncertainty and intractability, dispense with the ideal of optimality, and study how individuals and institutions actually make good decisions in the large world. Following (Milton) Friedman, the majority of neoclassical economists and decision theorists have taken the first route; following (Frank) Knight and Simon, a minority of social scientists, including my own research group, have taken the second.”
Figure 4: Risk, Ambiguity, Uncertainty, Intractability
Source: The rationality wars: a personal reflection | Behavioural Public Policy | Cambridge Core
Referencing Vernon Smith, Gerd notes “ecological rationality emerges from the unconscious brain rather than from the conscious mind, from traditions, heuristics, norms, and other cultural and biological processes.”
This is a great little paper, very worth a read to get your head around how these differing factions see and project their respective views of the world. Also, it should trigger the relevance of Taleb’s emphasis on skin-in-the-game. There is an obvious lazy-bias to applying small world methodologies to large world problems when there is not accountability at the end of the road. The relevance of tacit knowledge, importance of brakes on the car, is just not the same when you are in the driving seat.
The concept of small world vs large world aligns directly with our own equivalent framing of probability vs possibility. We discussed it at some length in our March 2023 Update – “Probability vs Possibility” Convex Strategies | Risk Update: March 2023 – Probability vs Possibility. As relates to skin-in-the-game, we said this back then:
“To our view, this comes down to the same old premise, it is all about skin-in-the-game. For years we have given presentation after presentation that close with these two slides:
- Question: What is the Key to Risk Management?
- Answer: Accountability.”
Chair Powell, in the opening quote of this note, as well as in the opening paragraph of the previous operating framework, makes reference to the claim that they are, somehow, accountable. We wonder to whom central bankers are accountable. To our perception, they float back and forth between the first two camps in the rationality wars. They formally espouse the logical rationality mindset, applying simplistic models, undergirded by Homo Economicus, with no empirical support. Then, at times, they behave as though their guidance and well-targeted communications can shape not just expectations but actual outcomes, gently nudging along the irrational rubes of behavioural science lore.
We can’t speak of a lack of both accountability and real-world perspective without touching on our friends over in the European Union.
We opined a bit on the European competitiveness report put together by Mario Draghi back in our September 2024 Update – “Emergence” Convex Strategies | Risk Update: September 2024 – “Emergence”.
Not surprisingly, the European Council, at least publicly, did not share our cynicism. After a gathering in the Hungarian capitol, they released the below linked “Budapest Declaration”, wholeheartedly accepting Mario Draghi’s competitiveness report, as well as Enrico Letta’s “Much more than a market” report from earlier in the year.
Budapest Declaration on the New European Competitiveness Deal – Consilium
“We welcome the reports ‘Much more than a market’ by Enrico Letta and ‘The future of European competitiveness’ by Mario Draghi that identify critical challenges and make future-oriented recommendations. They provide a solid foundation on which we will ambitiously advance our work. We seize their wake-up call.”
We seize their wake-up call. Give us a break!
We haven’t discussed Mr. Letta’s report, but it is much as you would expect.
Enrico Letta – Much more than a market (April 2024)
“Europe has changed fundamentally since the single Market was launched, to a large extent thanks to its own success.”
“Over the past three decades, the EU’s share of the global economy has diminished, with its representation among the world’s largest economies sharply decreasing in favour of rising Asian economies… Furthermore, even without considering Asian economies, the EU Single Market is lagging behind the US market.”
Just like the Draghi report, all their efforts for more Europe have been successful. Now, they need to fix a bunch of unrelated things because the place is failing.
Anyhow, the Budapest Declaration, in line with the two reports, stresses their commitment to pursue the proposed solutions (more like ambitions).
- Intensifying efforts to ensure a fully functioning Single Market.
- Decisive step towards a Savings and Investment Union, a Capital Markets Union and a Banking Union.
- Ensuring industrial renewal and decarbonisation.
- Launching a simplification revolution, ie less regulation.
- Defence readiness.
- Putting themselves at the forefront of innovation.
- Dual objective of energy sovereignty and climate neutrality.
- A more circular and resource-efficient economy. (What is a circular economy?)
- Strengthening technological capabilities.
- Harnessing talent.
- Sustainable trade policy.
- Sustainable agricultural sector.
Of course, they close off with a call for resources. They, the rulers at the centre, are going to need a lot of money to pull this off. Hunger Games.
“The need for a unified response has never been more compelling. We call on al EU institutions, Member States, and stakeholders to urgently implement and deliver this New European Competitiveness Deal. We will continue to provide further strategic guidance and regularly review over the coming year.”
Good luck, comrades.
This chart of the EUR/CHF exchange rate might give a realistic indication of what the actual plan is. Good old-fashioned currency wars. Again.
Figure 5: EUR/CHF FX Rate. Dec 2018-Nov 2024
Source: Bloomberg
We can’t talk about currency wars without referencing our old friend, Russell Napier. Russell just published the below note, “America, China, and the Death of the International Monetary Non-System”, inside American Affairs Journal.
America, China, and the Death of the International Monetary Non-System – American Affairs Journal
Russell lays out how he sees the current “International Monetary Non-System” that settled into place in 1994 with the China devaluation that year, and their unilateral decision to begin managing their exchange rate.
“Today, we have an international monetary system that does not have a name. Just because something does not have a name does not mean that it does not exist, yet the lack of a name has obscured the profound impact that this system has had on distorting credit, money, asset prices, and the economy… We are now living with the imbalances that followed this failure to move away from the Chinese-imposed system, and we will have to create a new international monetary system that can unwind those imbalances while sustaining, hopefully, both democracy and free markets.”
This is a phenomenal note if you want to understand the evolution of today’s global monetary structure, its accumulated imbalances, and the role played by China in the whole messy construct. Russell’s premise around the inevitable necessity of capital controls and financial repression parallels our analogy of the Hunger Games.
“With a government debt-to-GDP ratio of 106 percent, it is no surprise that the French government is turning to private sector savings to fund the industrial policy it believes is now essential. Whatever our new international monetary system will look like, it is unlikely to permit the free movement of capital. Governments need to bottle up their domestic savings to finance the investment they believe is necessary, and to inflate away the debts that threaten to engulf the developed world in a debt-deflation spiral.”
Hunger Games.
We regularly show our Bitcoin chart as the reverse report card for central banking. The 24/7, free and global, market for Bitcoin, along with its obvious speculative nature, is telling us what it thinks about the sustainability of the current non-system. The Bitcoin market agrees with Russell, something has to give.
Figure 6: Bitcoin 5-year chart
Source: Bloomberg
From an investment perspective, how does one deal with this dichotomy of coming fundamental change? How does one prepare for the unknowability of the paths that Russell’s transition entails? Will it be hyper-inflation? Will it be debt deleveraging? Or can it be the gradual inflating away of unsustainable debt-to-GDP through a prolonged period of higher nominal growth than credit creation, imposed through capital controls and financial repression?
We don’t know!
Nor does anybody else. The answer is always the same – stop trying to guess what is going to happen. Apply some of those ecological rationality heuristics that say convexity is the solution to uncertainty and intractability. As we like to put it, participate and protect. Construct investment portfolios with strong protection against unforeseen shocks, allowing active participation should asset inflation continue to be the policy-choice du jour.
We have, over the many years of sharing our notes and thousands of direct conversations, shown any number of barbell-based strategies. These are hypothetical investment structures that incorporate explicit protection strategies allowing for more aggressive participation to the upside of markets. We give them various names, eg. ‘Always Good Weather’ and ‘Dream Portfolio’. When we show people portfolios that include some upside participation in Crypto assets, we have dubbed them ‘MegaBell’ portfolios.
We can do a simple hypothetical example of our usual sort of transformation, from a traditional 60/40 ‘Balanced Portfolio’, ie 60% in S&P (SPXT Index) and 40% in US Treasury Bonds (LUATTRUU Index), into a ‘MegaBell’ utilizing the additional availability of upside participation to strap on some exposure to Bitcoin. As we normally do, get rid of the dead-capital investment in bonds, the ‘40’, and split that into a 20% allocation to our protection proxy, the CBOE EurekaHedge Long Volatility Index (EHFI451 Index) and an additional 20% in S&P. Take advantage of the capital efficiency and risk benefit of the LongVol exposure and 2x it. Now take advantage of the overall risk improvement (measured with something like Downside Volatility or Max Drawdown) and switch 10% from S&P into Bitcoin (XBT Currency).
This leaves us with a MegaBell version that is 70% S&P, 10% Bitcoin, and 40% LongVol. The 5-year hypothetical performance of this versus the old Balanced Portfolio is pretty eye-popping.
Figure 7: Hypothetical MegaBell 70% S&P, 10% Bitcoin, 40% Long Vol (blue) vs Balanced Portfolio 60% S&P and 40% US Treasury Bonds. Scattergram and Return Distribution. Dec 2019-Nov 2024
Source: Bloomberg, Convex Strategies
Figure 8: Hypothetical MegaBell 70% S&P, 10% Bitcoin, 40% Long Vol (blue) vs Balanced Portfolio 60% S&P and 40% US Treasury Bonds. Compounding view. Dec 2019-Nov 2024
Source: Bloomberg, Convex Strategies
In this notably short time horizon, and hypothetical construct, we can look at how the two sample portfolios compare in their ability to participate and protect:
- MegaBell has slightly less Max Drawdown. 19.2% vs 19.6%.
- MegaBell has lower Downside Volatility. 5.1% vs 6.4%.
- MegaBell has a slightly lower Downside Beta. 0.54 vs 0.56
- MegaBell has a higher Upside Beta. 0.95 vs 0.59.
- MegaBell has a higher CAGR. 23.0% vs 9.2%
- MegaBell has a higher Sortino Ratio. 4.5 vs 1.4.
Obviously, the past doesn’t project the future. Still, this is a pretty good example of our old saying – “when you are positively convex, more risk is less risk.” The point being that bonds, and so many other ‘Sharpe World’ constructed supposed risk diversifiers, are not adding value to a portfolio. They are neither participating nor protecting. Add negatively correlating, positively convex, explicit protection and push volatility into the good side of the return distribution. Stop thinking of ‘negative carry’ as a cost. Think of it as an investment in convexity that will fundamentally change your compounding path.
One more time from Claudio Borio.
“If something is valuable, it should be worth paying a price for.”
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