In his most recent commentary, Paul McCulley of PIMCO echoes an argument I’ve been making for some time: We need more inflation, not less — at least more cyclical volatility of inflation.
â€œThe Fed can be too successful in cyclically fine-tuning inflation, if such success breeds irrationally thin risk premiums, the aftermath of which history has not dealt kindly!â€
Thus, I argued, the Fed faced a dilemma (not a conundrum): if it set the inflation target too low and achieved it, asset bubbles would be the inevitable consequence, the eventual bursting of which would create fat-tailed deflation risk. Thus, ironically, the best prospects for achieving secular price stability would involve, I theorized, more, not less cyclical volatility in inflation, in a wider and higher band than 1-2%.
Investors need to have their hands burned regularly, and imagining that you have over-tuned all things economic is an exceedingly dangerous place to be. It breeds inappropriate risk-taking, moral hazard, and a general sense of investing omnipotence — right up until you smash into the wall as an investor and, potentially, as an economy. For example, the Fed would do well to make fewer and larger moves, as opposed to constantly looking like it’s diddling the dials to keep as all safe from our baser motives.