Did Big Ben Answer the Question?

A recent interview with the former Chairman of the Federal Reserve Dr. Ben Bernanke was illustrative on the subject. Rather than focus on the full extent of the comments, let’s focus on the question he was asked and whether he answered it.

The interviewer asked the former Fed Chairman the following question (emphasis by the author):

“That inflation uncertainty is something we want to talk about in more detail.  Is there a risk that we end up with unexpectedly high inflation, and in other words what’s the risk that policy is too easy?”

The former Fed chairman responded with the following:

“…..My best guess is that inflation will remain well within the Fed’s goals.  I think there are a number of reasons why we would not expect to see inflation reach levels that are really uncomfortable with the Fed.” 

The interviewer asked about the risk of inflation and Dr. Bernanke answered with his expectations for inflation.  As practitioners of asset allocation appreciate, risk and expectations are two different inputs into the structuring of capital. 

Risk is a nebulous notion because the real world unfolds sequentially, one outcome after another. For example, in 2020 a global pandemic broke out, Joe Biden won the presidency in November and Tom Brady won another Super Bowl the following February.  Those are all facts and everything else are just counterfactuals. But were those events pre-ordained? Of course not. 

Let’s take the case of crypto enthusiast Tom Brady.  In the Super Bowl, Tom may have thrown one long pass for 45 yards. One long pass thrown; one long pass caught. But in practice, Brady may have tried that same play nine other times. Five of those plays resulted in similar outcomes plus or minus five yards. But two plays in practice ended with a touchdown and two ended with interceptions.

Expectation (median may be more accurate) is about those middle six plays.  Risk is about the outliers, the tails, in other words the low probability but extreme events.  Using our football analogy, risk is the four plays that resulted in either touchdowns or interceptions by the defense. And more accurately from the Buccaneers' viewpoint, risk is really the two left-tail events resulting in interceptions.

Let’s get back to Big Ben’s answer to the question “Is there a (increased) risk that we end up with unexpectedly high inflation?” This is an inflation right-tail question.  He may be correct to state that the expectation of inflation is the same. Honestly, we are ambivalent about changing our long-term expected inflation assumption with both sides of the transitory debate convincing.

In setting the risk parameter of inflation, a strong case can be made to increase it, or better yet to account for the risk in models and portfolios. In other words, if you have an event in which there is no history that leads to uncertainty^[1] then it is all about the tails. Let’s go through a list of current events and ponder how many of these could be categorized as seldom or never happening before:

To be clear, many of the items above may be good policy and may not change expected inflation over the long term. But they almost certainly increase the fatness[1] of the inflation right tail.

To take a few of these as examples, globalization has been a linchpin behind the past two decades of disinflation. However, the elephant in the room regarding the future of globalization is China. Let’s not fall into the behavior trap of recency bias. China is different today than it was in the early 2000s when it stormed into the WTO. Will China continue to be the marginal manufacturer suppressing wages? Maybe. Is there a greater risk (tail event) today that China will shift from pure mercantilism to a more balanced economy with the concomitant willingness to exert pressure on global wages?  Feels like a higher probability than twenty years ago, particularly in light of greater world tensions.

Over the last decade, shale oil fracking has been a behind-the-scenes contributor to modest inflation.  This enabled U.S. oil production to rocket from five to 13 million barrels a day in production. Is this a secular phenomenon or a one-time reprieve with production levels ready to fall off a cliff at any moment?

In the past, critics of the current global monetary system, in which the U.S. dollar is king, were relegated to being cranks and gold bugs. Now it is cutting edge (and profitable) to dismiss the long-term sustainability of the dollar as the world’s reserve currency. Bretton Woods was 1944 and Nixon’s free-floating currencies was 1971; are we due for monetary reset?

Is there a right-tail probability of uncomfortable high and sustained inflation? Yes! Has that risk increased over the last couple of years? Yes! The challenging questions are:

• How much has the new coordination between fiscal and monetary authorities in response to the pandemic changed the right tail risk of high and sustained inflation?
• Has the market priced that in?
• Does this increased risk affect some investors more than others and if so, who?
• What, if anything, should clients do with respect to that increase in tail-risk?

After listening to the interview numerous times, we noted that Dr. Bernanke did not shed any light on those questions. But in follow-up blogs we will pick up where Big Ben left off and answer the question.  What is the inflation risk we should be concerned with? For example: Are conventional TIPS the solution or are more esoteric strategies, such as shorting inflation break-evens, the best strategy to hedge the tail risks?

Key takeaways:

• The inflation question is back and important for investors to explore.
• Cases can be made for current inflation being transitory or regime-changing but much of the debate centers on expectations.
• Risk is a different consideration than expectations.
• There is less ambiguity regarding inflation risk which has increased over the last couple years with the policy responses to the pandemic — think right tail.
• How much has the risk of uncomfortably high inflation increased and how can investors position against that risk? We will explore this in future blogs.
• And no, Big Ben did not answer the question.

_[1]The famous economist Frank Knight bifurcated between risk and uncertainty and that topic alone would make an excellent blog. In the meanwhile, trust us that uncertainty, while different from risk, manifests in a similar way through the probability of greater extreme events.
_[2] A benchmark for risk is the Gaussian curve and a “heavier” or “fatter” tail refers to having greater risk.