Folly and the Fed
Interest Rates, Inflation, Recession, and the Fed
Inflation is Roaring
The average prices of food and fuel rose more than 16% in February from a year earlier and are expected to rise further by the war in Ukraine. Consumers are paying much more for meat, bread, milk, shelter, gas, and utilities.
Only a small amount of food consumed in the U.S. is imported, and most of that is from Mexico and Canada. But Russia provides 15% of the world’s fertilizer and other agricultural chemicals that are now in short supply as planting season approaches.
Wheat futures are up 29% since Feb. 25 and corn is up 15%. There is no shortage of wheat in the U.S., but global supply was the tightest in 14 years before the conflict, and dramatic shortages and price spikes are expected.
And the Fed is Not
The Fed is about to begin raising interest rates. It has signaled that it intends to raise rates by about .25 percentage points (and perhaps up to .50 percentage points) each of its next six to 10 sessions. But, perhaps the most impactful event will not be the unsurprising interest rate increases, but the nuance and meaning attached to the specific words Chairman Powell uses in written statements as well as testimony and news conferences. The obsession is with the number and magnitude of anticipated rate increases over the next couple of years.
The Fed’s balance sheet is another big concern, and understanding the schedule for selling down its assets, especially those accumulated during the last couple of years, may be perhaps even more critical. The Fed engaged in an economic stimulus program derived mostly from bond buying. Now, it has signaled it will begin divesting those fixed income securities, and meaningful economic stimulus moved from the economy and combined with increasing interest rates. This is a potent cocktail, but will it accomplish the Fed’s primary mandate to control inflation?
Hope versus Experience
The hope is that the Fed can engineer a soft landing, whereby inflation returns to somewhere around 2% to 3% annually while keeping the economy relatively robust and preventing any substantial increase in unemployment or decrease in economic activity. Judging by their statements to date, Powell and his colleagues seem to believe they have a good chance of success.
Anything is possible, and wishful thinking can sometimes prove self-fulfilling.
However, recent history is not encouraging. First and foremost, significant policy changes need some foundational substance from which they can be altered. It seems that more than anything, the Fed has committed more blunders than encouraging maneuvers over the last 18 months, and the magnitude of their errors is not fully understood.
The Fed appears to be operating with an inappropriate and dangerous framework (when hope challenges experience — experience wins), and far stronger action seems to be required for price stability than the Fed’s hopeful strategy will produce. The Fed’s current policy trajectory is steering the U.S. dangerously close to a future of economic stagnation combined with uncontrolled inflation (“stagflation”), with unemployment and inflation both averaging over 5.0% annually over the next few years. This toxic mix of economic stagnation and higher inflation creating higher unemployment typically results in a recession.
We All Know What Happens
It is no surprise that recent research, especially from colleagues at Harvard University, has shown that a combination of conditions — high inflation and low unemployment lead to stagnation followed quickly by recession.
A year ago, the Fed thought inflation would be back to around 2% for the next 12 months. The logic for this was that supply chain disruptions and other causal effects for inflationary pressures a year ago would subside quickly as the pandemic subsided. Therefore, inflation was temporary and the economy would transition to a more moderate rate of inflation relatively quickly. This did not happen.
Six months ago, the Fed continued its message that inflation was transitory. Nothing to worry about, regardless of what the data was showing. This too shall pass, and pass relatively quickly. Another hopeful message that experience trampled once again.
Two weeks ago it seemed obvious, as more and more factors became clear and the disastrous effects of the Ukraine war were still to reverberate fully throughout the economy, we had, what appears to be, out of control inflation. Not only have energy prices soared, but the effect on a broad range of commodities, and the ripple effect this will cause throughout the global economy, are not being factored in at all.
We can Ignore Food, Energy, and Commodities, Right?
30% of the world’s wheat comes from Ukraine and Russia. What do we think will continue to happen to food prices? On top of that, Russia is the world’s largest fertilizer exporter, supplying approximately 15% world’s needs. Obviously, fertilizer is essential for all crops, and therefore a critical component for all food supplies, and its absence will limit supply and drive all food prices higher.
The ripple effect is yet to hit our shores, but it is coming. Commodities, ranging from nickel to palladium, essential components for stainless steel, batteries, electric vehicles, and other critical economic inputs, are all substantially and unpredictably impaired. The impact is pervasive and likely to be much more profound than Fed actions would indicate.
Another error, in the face of skyrocketing housing prices combined with mortgage rate increases, is that the Fed is still buying mortgage-backed securities. Housing prices and mortgage rates have each risen between 20% to 30% so far this year. No explanation has been offered for why this strategy still seems like a good idea, especially in the face of emerging and critical data.
What data is the Fed looking at, and how is it assessing inflationary risks? It’s hard to feel confident that the right hands are on the wheel because the combination of extraordinary factors, such as extremely tight labor markets and wage inflation (at over 6% annually and accelerating) showed inflation was already a significant risk. Yet interest rates were left unaltered. This is even before the crisis in Ukraine.
The tragedy Ukraine, and I cannot underestimate the magnitude of human suffering, has also put new inflationary pressures in place, and perhaps, most importantly, represent structural economic changes that will produce sustainable inflationary pressures for quite some time. These pressures are hardly transitory.
Higher energy, grain, and commodity prices, and many more extreme and frequent supply-chain interruptions than the pandemic caused are likely. It is reasonable to estimate that the combination of these factors will add up to over 6% inflation in 2022. On top of that, price increases are outstripping wage increases, and a wage-price spiral is a major risk.
Let the Party Roll?
Memories are short and rarely accurate. One example is that just six months ago the Fed said that above-normal inflation (“normal” defined as 2% to 3% annually) is acceptable for an extended period. It then ended the traditional Fed approach of responding to expected inflation before it materialized. Essentially, officials switched from the Fed’s traditional “removing the punch bowl before the party gets out of hand” to an approach of “the punch bowl makes people happy. We will remove it only when we see people keeling over drunk.”
People are drunk, and this is not going to end well.
Do the Unimaginable
Chairman Powell has emphasized his admiration for Paul Volcker recently. Current inflationary conditions are not as bad as those Volcker inherited as Fed chair in 1979, but they are the worst since then. To prevent inflation from metastasizing, Powell and his colleagues need to be clear on two propositions that Volcker took as axiomatic.
First, price stability is essential for sustained maximum employment, while overheating the economy leads to stagflation and higher levels of average unemployment over time.
Second, there can be no reliable progress against inflation without substantial increases in real interest rates, which means temporary increases in unemployment. Real short-term interest rates are currently lower than at any point in decades. Real rates will have to reach levels of at least 2% or 3% percent for inflation to be brought under control. With inflation running above 6%, this means nominal rates of 8% or more — something markets currently regard as unimaginable.
A New Paradigm
If a new paradigm is suggested to deal with an emerging issue, cover your wallet and run screaming. But this is not a new paradigm. The structured approach to successfully fight inflation has been establishing credibility that inflation intolerance is the central mission. The new paradigm has been permissiveness which leads to stagnation and uncontrollable inflation. We should be covering our wallets now.
Central to success in fighting inflation is that the Fed will not alter its fundamental mission to fight inflation. Non-monetary goals such as social justice and environmental protection may be admirable, but it is not the Fed’s mandate and should not interfere with its fundamental mission.
Blocking and Tackling
The Fed should do whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point, and a rapid reduction of its balance sheet. It also means recognizing that unemployment is likely to rise over the next couple of years.
Paul Volcker would not have had to take extraordinary steps, driving the economy into a recession to crush runaway inflation, if his predecessors had not lost their focus on inflation. To avoid stagflation and the associated loss of public confidence in our economy today, the Fed has to do more than merely adjust its policy dials — it will have to head in a dramatically different direction.