By The Atlantic•
As somebody who’s paid to tell stories about the economy, I always find it satisfying to assemble data points to produce a compelling pointillist picture about the state of the world. But these are rough times for economic pointillism. The data are all over the place, and the big picture is a big mess.
I look at the stock market, where valuations have collapsed. Okay, so markets are trying to tell us that future growth will be slower. Then, I see that consumers expect persistent inflation over the next five years. A growth slowdown with sticky inflation? Unusual, but not unprecedented. Consumers are glum about economic conditions but optimistic about their own finances, and they’re spending money on services and leisure and travel as if they’re eager participants in a booming economy. So everything is terrible, but I’m doing fine? Okay, that’s psychologically rich. Nominal gas prices are at record highs, but unemployment is near multi-decade lows; mortgage interest rates are rising quickly, but they’re at historically normal levels. So, things are bad, but also good, but also crummy, and maybe fine?
Regrettably, there’s another, significantly more important economic storyteller that also seems deeply confused about the economy. That would be the Federal Reserve.
Just six months ago, the Fed said it expected that prices would normalize in 2022, and it forecast that a key inflation index would average 2.6 percent growth this year. But now it projects that 2022 inflation will be twice as high, at 5.2 percent. Three months ago, the Fed signaled that it would raise a key interest rate by 0.5 percentage points in June. But this week, the Fed changed its mind after getting spooked by a few inflation reports and suddenly decided to jack up the federal-funds rate by 0.75 points, its most significant increase in 28 years.
Fed Chair Jerome Powell’s explanation for the rate change was baffling. He claimed that the number of job openings in the economy pointed to “a real imbalance in wage negotiating” but also said that the labor market had practically nothing to do with inflation. He explained that headline inflation has soared largely because of supply-side issues, such as the war in Ukraine’s impact on the gas market, that the Fed can’t really do anything about. But he also insisted that the Fed had to up the ante on interest-rate hikes to bring down inflation by reducing demand. He insisted that he didn’t want to send the economy into a recession, but the Fed’s own economic forecasts project several consecutive years of rising unemployment—something that generally happens only in a recession.
The full story only barely holds together. In the Fed’s view, inflation is partially caused by the labor market, but also not caused by the labor market; it’s largely a supply-side issue that the Fed can’t fix, but the Fed is going to try desperately to fix it anyway; and we’re hopefully not getting a recession, but we’re probably getting a recession. Like I said: baffling.
What the Fed is actually trying to do here—as opposed to the story it’s telling about what’s happening in the economy—is clear, yet extremely difficult: It is trying to destroy demand just enough to reduce excess inflation but not so much that the economy crashes. This a little bit like trying to tranquilize a raging grizzly bear with experimental drugs: Maybe you bring down its core temperature but also maybe you leave the big guy in a coma. The Fed could succeed. It could get Americans to spend a little less, borrow a little less, and loan a little less, and this synchronized decrescendo in economic activity would almost certainly reduce inflation. But here’s the problem: If global energy prices don’t come down and global supply chains remain tangled by Omicron variants and other natural disasters, we might end up with the worst of both worlds: destroyed domestic demand and constricted global supply. Slow growth and high energy prices could mean the return of the dreaded stagflation.
In the next few months, you should be prepared for the economic situation to get even stranger. Markets might be on the lookout for signs that the Fed is successfully crushing domestic demand. In other words, some investors will be hoping that the housing market stalls and retail spending slows, because these are signs that the Fed’s policy is working. We will be in an upside-down world where bad news (the economy is slowing down) is interpreted as good news (the Fed’s policy is working), and good news (consumer spending is still red hot) is interpreted as bad news (the Fed’s policy isn’t working).
For much of this century, the Fed has been an island of relative competency in a sea of institutional failure. But the Fed is neither an all-knowing artificial intelligence nor a band of wizard oracles sent from the future to stabilize price levels. The people who work there are fundamentally pundits with an interest-rate lever. They’re folks like you and me, telling stories about an economy that they’ve recently gotten wrong, wrong, wrong, and then kinda right, and then wrong again. I don’t know if this is comforting or terrifying to you, but it’s the full truth: Right now, we are truly all confused together.
The U.S. central bank must move “expeditiously” to bring too-high inflation to heel, Federal Reserve Chair Jerome Powell said on Monday, and will, if needed, use bigger-than-usual interest rate hikes to do so.
“The labor market is very strong, and inflation is much too high,” Powell told a National Association for Business Economics conference. “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability.”
In particular, he added, “if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
Fed policymakers last week raised interest rates for the first time in three years and signaled ongoing rate hikes ahead. Most see the short-term policy rate – pinned for two years near zero – at 1.9% by the end of this year, a pace that could be achieved with quarter-percentage-point increases at each of their next six policy meetings.
By the end of next year, Fed policymakers expect the central bank’s benchmark overnight interest rate to be at 2.8%, bringing borrowing costs to a level where they would actually start biting into growth. Most Fed policymakers see the “neutral” level as somewhere between 2.25% and 2.5%.
Powell repeated on Monday that the Fed’s reductions to its massive balance sheet could start by May, a process that could further tighten financial conditions.
U.S. stocks extended earlier losses after his remarks and traders boosted bets that the Fed will deliver a half-percentage-point rate hike at its policy meeting in May.
“This is not just going to be a near-term tactical phenomenon,” said Kevin Flanagan, head of fixed income strategy at WisdomTree Investments in New York. “This is a more strategic type of messaging, I think, from the Fed.”
A consensus for more aggressive tightening – or at least an openness to it – appears to be growing
Atlanta Fed President Raphael Bostic, who expects a slightly gentler path of rate increases than most of his colleagues, said earlier on Monday he is open to bigger-than-usual rate hikes “if that’s what the data suggests is appropriate.”
Speaking on Friday, Fed Governor Chris Waller said he would favor a series of half-percentage point rate increases to have a quicker impact on inflation.
The U.S. unemployment rate currently is at 3.8% and per-person job vacancies are at a record high, a combination that’s pushing up wages faster than is sustainable.
“There’s excess demand,” Powell said, adding that “in principle” less accommodative monetary policy could reduce pressure in the labor market and help stabilize inflation without pushing up unemployment, generating a “soft landing” rather than a recession.
Inflation by the Fed’s preferred gauge is three times the central bank’s 2% goal, pushed upward by snarled supply chains that have taken longer to fix than most had expected and that could get worse as China responds to new COVID-19 surges with fresh lockdowns.
Adding to the pressure on prices, Russia’s war in Ukraine is pushing up the cost of oil, threatening to move inflation even higher. The United States, now the world’s biggest oil producer, is better able to withstand an oil shock now than in the 1970s, Powell noted.
Although the Fed in normal times would not likely tighten monetary policy to address what in the end may be a temporary spike in commodity prices, Powell said, “the risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher.”
Last year, the Fed repeatedly forecast that supply chain pressures would ease and then was repeatedly disappointed.
“As we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief,” Powell said on Monday. Policymakers began this year expecting inflation would peak this quarter and cool in the second half of the year.
“That story has already fallen apart,” Powell said. “To the extent it continues to fall apart, my colleagues and I may well reach the conclusion we’ll need to move more quickly and, if so, we’ll do so.”
Fed policymakers hope to rein in inflation without stomping on growth or sending unemployment back up, and their forecasts released last week suggest they see a path for that, with the median view for inflation falling to 2.3% by 2024 but unemployment still at 3.6%.
Powell said he expects inflation to fall to “near 2%” over the next three years, and that while a “soft landing” may not be straightforward, there is plenty of historical precedent.
“The economy is very strong and is well-positioned to handle tighter monetary policy,” he said
The Federal Reserve signaled Wednesday that it will likely raise interest rates in March as part of a monetary policy shift to temper an over-heating economy and soaring inflation.
With inflation far exceeding the central bank’s 2 percent target, the Fed plans to increase the cost of borrowing to slow down economic activity, which will hopefully moderate the price surges across commodities and commercial sectors. Prices are increasing at the fastest pace in almost four decades, with 7 percent annual inflation in December. A supply-chain crisis marked by prolonged shipping delays and production bottlenecks is still ongoing and exacerbating inflationary pressures.
Powell also said that the Fed will start to unload its massive balance sheet by tapering off its large-scale purchases of bonds and other assets, a program which the Fed has sustained for many years and which has injected enormous monetary stimulus into the economy. The Fed currently maintains a portfolio of over $8 trillion worth of U.S. government bonds and mortgage-backed securities (MBS).All Our Opinion in Your Inbox
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He said that inflation “has not gotten better. It has probably gotten a bit worse. . . . To the extent that situation deteriorates further, our policy will have to reflect that,” Reuters reported. “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy we put in place to deal with the economic effects of the pandemic.”
However, Powell still kept a sense of optimism that the inflation so many consumers are feeling at the gas pump and across a diverse range of products will have an expiration date, possibly in the near term. “Like most forecasters we continue to expect inflation to decline over the course of the year,” Powell said Wednesday.
The stock market tumbled in response to Powell’s monetary tightening announcement. Low-interest policies often have the effect of fueling financial market booms, which is why warnings of rate hikes rarely bode well for them.
It has long been an open secret that the Biden administration has adopted, hook line and sinker, the hard-line positions of the progressive wing of the Democratic Party. Nowhere is that more apparent than in two recent developments that threaten to make mischief at both the Securities and Exchange Commission and the Federal Reserve Bank—perhaps the two most powerful regulators of financial markets.
The two major initiatives are, first, to increase the control that the SEC exerts over nonpublic corporations, and second, to increase the authority of the Federal Reserve over activities affecting climate change. Thus Allison Lee, now an SEC commissioner, first appointed by President Trump as one of the Democrat commissioners and then reappointed by President Biden, is determined to bring to heel private corporations—those that are not listed on public exchanges like the New York Stock Exchange or NASDAQ. She wants to both require extensive disclosure of their financial operations and restrict their access to capital, reversing a Trump-era decision that went the other way. Next, Biden has nominated Sarah Bloom Raskin, a Duke Law School professor, to serve in a key position at the Federal Reserve as vice chairman for supervision. Raskin’s top goal appears to be strengthening the Fed’s role in promoting climate change regulation through its oversight function for banks.
Both moves are deeply problematic.
Turn first to the SEC’s effort to expand its control over private corporations. Commissioner Lee’s case starts with the simple proposition that private capital markets have raised huge pools of fresh capital without any public oversight whatsoever. By appealing only to wealthy investors, new firms are able to avoid the extensive costs and liabilities associated with going public, and subsequently being subjected to constant oversight by the SEC and the public exchanges. As a matter of first principle, there is no ideal way to determine the proper mix of public and private companies, because each has advantages over the other. One common pattern is for companies to start small and private and then grow into unicorns with $1 billion or more in assets. There are about four hundred of these businesses in the United States, and nearly nine hundred worldwide. Once these companies thrive, the original investors can either cash out or retain their shares when the company goes public, allowing the growing firm greater access to capital markets.
For many years this trend has been slowing down, creating the unfortunate situation in which individuals with the skills and wealth to run new ventures have found it more difficult to move out of relatively low-risk firms to free up capital to start the cycle anew with another set of private firms. Fortunately, the willingness in the post-COVID age to go public has increased substantially, but there were still far fewer public corporations in 2021(about 4,200) than there were in 1997 (about 7,200). Public oversight is in general far too onerous.
Hence the question arises: why does SEC Commissioner Lee want to regulate these private corporations by forcing them to reveal information on a biennial basis? Normally, the claim for additional regulation should follow on the heels of some well-identified market failure. But Lee points to no such failure in the private equity markets that continue to thrive. Instead, she makes this startling claim: “When they’re big firms, they can have a huge impact on thousands of people’s lives with absolutely no visibility for investors, employees and their unions, regulators, or the public.”
This charge makes no sense at all. Her use of the term “investor” contains a deliberate ambiguity. The investors in each of these firms are contractually entitled to receive relevant information. And there is no reason why the general investment community should be entitled to information about the internal operations of any firm in which they have no stake. The same ambiguity covers employees. Those who work for the firm will get information on wages and benefits. The employees of other firms should receive nothing at all. The current labor law, moreover, contains detailed rules that establish that “[an] employer has a statutory obligation to provide requested information that is potentially relevant and will be of use to a union in fulfilling its responsibilities as the employees’ exclusive bargaining representative, including its grievance-processing duties.” Private corporations are not exempt. These corporations are also subject to multiple disclosure regimes as part of their ordinary business obligations, such as making loans or issuing insurance policies. And it is downright dangerous to encourage widespread disclosures, as that information often contains trade secrets that are of great interest to competitors but of little relevance to the public at large, which has direct access to the price and quality of the goods and services offered for sale.
What makes this especially galling is that the SEC does not have an unmoored authority to regulate, as Lee claims, in the “public interest.” As Bernard Sharfman of George Mason University has written, “Whenever the term ‘in the public interest’ appears in the [security] Acts, the term ‘for the protection of investors’ is almost always sure to follow.” Without that connection the SEC can move with impunity to regulate the entire economy, including private corporations whose sophisticated investors are well able to protect themselves. No principle of deference should ever allow the SEC to unilaterally expand the scope of its jurisdiction.
The question of mission creep is equally apparent in the looming fight over the Raskin nomination. The Fed’s mission is “[c]onducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of maximum employment and stable prices.” The “in pursuit” language is a source of real uneasiness because is unclear how the Fed’s ability to deal with interest rates allows it to obtain “maximum employment.” On employment, direct regulation, or (better) deregulation, of labor markets is a far more efficient way to proceed, and it eliminates the need to resolve difficult question when the objectives of monetary policy and full employment clash. A single instrument—the control of the quantity of money—cannot be sensibly pressed into service to mediate between two conflicting ends.
The situation will not get any better if the Fed injects itself further into climate policy by seeking to shift the balance of returns from carbon-intensive investments to other forms of energy, which is why the confirmation battle over Raskin is so important. Nothing that she has ever said or written indicates any awareness of the complex trade-offs that are needed in dealing with energy issue. She is just gung-ho when she writes that regulators “need to ask themselves how their existing instruments can be used to incentivize a rapid, orderly, and just transition away from high-emission and biodiversity-destroying investments,” without once asking whether various improvements in the production and distribution of fossil fuels could be better than the blunderbuss approach that she apparently favors.
Yet the warning signs of energy breakdown are everywhere, given the evident difficulties of both wind and solar energy, which today can operate only because of massive subsidies in cash and in-kind — but only when the wind blows and the sun shines. Climate change is best addressed by some mix of private initiatives by corporations in the management of their own supply chains and regulators who deal with the emissions directly. Even without Raskin, Fed head Jerome Powell already takes it as his mission to starve the fossil-fuel companies of the capital that they need to survive, even as coal consumption worldwide continues to increase, especially in China, which today produces about nine times the amount of coal produced in the United States. The Fed, however, has no jurisdiction over China. Thus, its effort to rebalance the US energy portfolio will have little or no effect on the global output of coal or any resulting changes in global temperatures.
Yet its focused actions can wreak havoc not only in oil but also in natural gas. Just that grim transformation is evident in both Great Britain and Germany. Ironically, the inefficiency of solar and wind energy has forced Germany to increase its reliance on dirty coal—yet another application of the law of unintended consequences.
And matters are still worse from a geopolitical perspective, given that the constriction in fossil-fuel products from both the United States and the EU gives the whip to Vladimir Putin, from whom no public-spirited action has ever taken place, or ever will. Energy prices throughout the United States are already on the rise, and this country, already in the throes of an inflation spiral, could easily be next in line for major dislocations if Powell and Raskin have their way. It is a huge mistake to think that stopping the use of efficient fossil fuels, especially natural gas, is the path toward climate control.
So in both cases progressive policies make the common error. Mission creep is dangerous. The SEC should lay off private corporations; and the Fed, which already has too many things on its plate, should stay out of the energy and credit business. It is far superior to do one thing well than to do many things badly. The Senate should understand that a little humility is needed in the selection of powerful positions in the Fed, and turn down the Raskin nomination.
In a pandemic, you can send people all the money in the world and they still won’t go out to dinner or book a flight, especially if those services are suspended by government fiat. A pandemic is like a blizzard: If people get a lot of money when the snow is falling, they will fuel inflation once it has been cleared.
Inflation continues to surge. From its inflection point in February 2021 to last month, the US consumer price index has grown 6% – an 8% annualized rate.
The underlying cause is no mystery. Starting in March 2020, the US government created about $3 trillion of new bank reserves (an equivalent to cash) and sent checks to people and businesses. The Treasury then borrowed another $2 trillion or so and sent even more checks. The total stimulus comes to about 25% of GDP, and to around 30% of the original federal debt. While much of the money went to help people and businesses severely hurt by the pandemic, much of it was also sent regardless of need, intended as stimulus (or “accommodation”) to stoke demand. The goal was to induce people to spend, and that is what they are now doing.
Milton Friedman once said that if you want inflation, you can just drop money from helicopters. That is basically what the US government has done. But this US inflation is ultimately fiscal, not monetary. People do not have an excess of money relative to bonds; rather, people have extra savings and extra apparent wealth to spend. Had the government borrowed the entire $5 trillion to write the same checks, we likely would have the same inflation.
Other purported factors – including “supply shocks,” “bottlenecks,” “demand shifts,” and corporate “greed” – are not relevant to the overall price level. The ports would not be clogged if people were not trying to buy lots of goods. If people wanted more TVs and fewer restaurant meals, the price of TVs would go up and the price of restaurant meals would go down. Greed did not suddenly break out last year.
By contrast, inflation, when all prices and wages rise together, comes from the balance of overall supply and demand. The economy’s capacity to produce goods and services turns out to be lower than expected. Here, the labor shortage – the “Great Resignation” – is a key underlying fact. Employers can’t find people to work because many people remain on the sidelines, not even looking for jobs.
The US Federal Reserve was completely surprised by the surge of inflation, and through most of the year insisted it would be “transitory,” and go away on its own. That turned out to be a major institutional failure. Is it not the Fed’s main job to understand the economy’s supply capacity and fill – but not overfill – the cup of demand?
One might expect that among the thousands of economists the Fed employs, there is a group working on figuring out ports’ capacity, the effects of microchip shortages, how many people have retired or are not returning to work, and so forth. One would be disappointed. Central banks have sketchy ideas of supply, mostly centered on statistical trends in labor markets.
Why did this fiscal stimulus produce inflation when previous stimulus efforts from 2008 to 2020 fizzled? There are several obvious possibilities. First, this stimulus was much bigger. Former US Secretary of the Treasury Lawrence H. Summers correctly prophesied inflation in May 2021 by simply looking at the immense size of the spending packages, relative to any reasonable estimate of the GDP shortfall.
Second, officials misunderstood the COVID recession. GDP and employment did not fall because there was a lack of “demand.” In a pandemic, you can send people all the money in the world and they still won’t go out to dinner or book a flight, especially if those services are suspended by government fiat. To the economy, a pandemic is like a blizzard. If you send people a lot of money when the snow is falling, you do not get activity in the snowdrifts, but you will get inflation once the snow has cleared.
Third, unlike in previous crises, the government created money and sent checks directly to businesses and households, rather than borrowing, spending, and waiting for the effect to spread to incomes.
Will inflation continue? Fundamentally, inflation breaks out when people do not think the government will repay all its debts by eventually running fiscal surpluses. People then try to get rid of the debt and buy things instead, which drives up prices and lowers the real value of debt to what people believe the government will repay. Given that prices have risen 6%, people evidently believe that of the 30% debt expansion, the government will not repay at least 6%. If people believe that less of the debt expansion will be repaid, then the price level will continue to rise, as much as 30%. But inflation will eventually stop: A one-time fiscal helicopter drop leads to a one-time rise in the price level.2
So, whether inflation will continue depends on future fiscal and monetary policy. Fiscal policy is the big question: Now that we have crossed the Rubicon of people believing that a fiscal expansion will not be fully repaid, will people think the same about additional persistent deficits? The danger here is obvious.1
If fiscal inflation does erupt, containing it will be difficult. If monetary policymakers try to curtail inflation by raising interest rates, they will run into fiscal headwinds as well as a political buzz saw. First, with the debt-to-GDP ratio above 100%, if the Fed raises interest rates five percentage points, interest costs on the debt will rise by $1 trillion – 5% of GDP. Those interest costs must be paid, or inflation will just get worse. Similarly, if the European Central Bank raises interest rates, it increases Italy’s debt costs, threatening a new crisis and imperiling the ECB’s vast portfolio of sovereign bonds.Sign up for our weekly newsletter, PS on Sunday
Second, once inflation works its way to higher bond yields, stemming inflation requires higher fiscal surpluses to repay bondholders in more valuable dollars. Otherwise, inflation does not fall.
Monetary policy alone cannot contain a bout of fiscal inflation. Nor can temporary “austerity,” especially sharply higher marginal tax rates that undercut long-run growth and therefore long-run tax revenues. The only lasting solution is to get the governments’ fiscal house in order.
Finally, supply-oriented policy is needed to meet demand without driving up prices, to reduce the need for social spending, and, indirectly, to boost tax revenues without a larger tax base. Given supply constraints from regulations, labor laws, and disincentives created by social programs, potential solutions here should be obvious.
Having adopted a more flexible policy framework in response to the low-inflation conditions that preceded the COVID-19 crisis, the US Federal Reserve now finds itself confronting an entirely different economic regime. The balance of forces is thus weighing heavily against decisive action to control today’s price increases.
Price increases in the United States are spreading across goods and services, and inflation also can be seen in broad-based business inputs such as transportation, energy, and increasingly labor. How should we expect central bankers to react?
For its part, the US Federal Reserve has emphasized that it will contemplate raising interest rates only after it is done tapering its monthly asset purchases, which will be sometime in July 2022 at the current pace of unwinding. Nonetheless, some members of the Fed’s rate-setting Federal Open Market Committee worry that the central bank will have fallen behind the curve by that time, forcing it to raise rates more abruptly, to higher levels, and for longer than anticipated. Hence, Fed Vice Chair Richard Clarida recently indicated that the Fed might consider speeding up the taper (so that it can raise rates sooner) when its members meet again in December.
Notwithstanding the growing (but often unspoken) worries at the Fed, central bankers nowadays are reticent to see inflation as a problem. In the past, the current levels of inflation would have prompted them to square their shoulders, look determinedly into the TV cameras, and say, “We hate inflation, and we will kill it” – or words to that effect. But now they are more likely to make excuses for inflation, assuring the public that it will simply go away.
Clearly, the prolonged period of low inflation after the 2008 global financial crisis – when the Fed had great difficulty elevating the inflation rate to its 2% target – has had a lasting impression on central bankers’ psyches. The obvious danger now is that they could be fighting the last war. Moreover, even if they do not fall into that trap, structural changes within central banks and in the broader policymaking environment will leave central bankers more reluctant to raise interest rates than they were in the past.
To adapt to the pre-pandemic low-inflation environment, the Fed changed its inflation framework so that it would target average inflation over a (still-undefined) period. This meant that it could allow higher inflation for a while without being criticized for falling behind the curve – a potentially useful change at a time when elevating the public’s inflation expectations was thought to be the key problem. Gone was the old central-bank adage that if you are eyeball to eyeball with inflation, it is already too late. Instead, the Fed would stare at inflation for a while and act only when it was sure that inflation was here to stay.
Moreover, the new framework places a much greater emphasis on ensuring that employment gains are broad-based and inclusive. Because historically disadvantaged minorities in the US are often the last to be hired, this change implied that the Fed would potentially tolerate a tighter labor market than in the past, and that it would have more flexibility to run the economy hot, which is useful in an environment of weak demand. Yet now the Fed is facing an environment of strong demand coupled with supply-chain disruptions that look unlikely to abate quickly. Ironically, the Fed may have changed its policy framework just as the economic regime itself was changing.
But shouldn’t greater flexibility give decision-makers more options? Not necessarily. In the current scenario, Congress has just spent trillions of dollars generating the best economic recovery that money can buy. Imagine the congressional wrath that would follow if the Fed now tanked the economy by hiking interest rates without using the full flexibility of its new framework. Put differently, one of the benefits of a clear inflation-targeting framework is that the central bank has political cover to react quickly to rising inflation. With the changed framework, that is no longer true. As a result, there will almost surely be more inflation for longer; indeed, the new framework was adopted – during what now seems like a very different era – with precisely that outcome in mind.
But it is not just the new framework that limits the effectiveness of the Fed’s actions. Anticipating loose monetary-policy and financial conditions for the indefinite future, asset markets have been on a tear, supported by heavy borrowing. Market participants, rightly or wrongly, believe that the Fed has their back and will retreat from a path of rate increases if asset prices fall.
This means that when the Fed does decide to move, it may have to raise rates higher in order to normalize financial conditions, implying a higher risk of an adverse market reaction when market participants finally realize that the Fed means business. Once again, the downside risks of a path of rate hikes, both to the economy and to the Fed’s reputation, are considerable.
The original intent in making central banks independent of the government was to ensure that they could reliably combat inflation and not be pressured into either financing the government’s fiscal deficit directly or keeping government borrowing costs low by slowing the pace of rate hikes. Yet the Fed now holds $5.6 trillion of government debt, financed by an equal amount of overnight borrowing from commercial banks.
When rates move up, the Fed itself will have to start paying higher rates, reducing the dividend it pays the government and increasing the size of the fiscal deficit. Moreover, US debt is at around 125% of GDP, and a significant portion of it has a short-term maturity, which means that increases in interest rates will quickly start showing up in higher refinancing costs. An issue that the Fed did not have to pay much attention to in the past – the effects of rate hikes on the costs of financing government debt – will now be front and center.
Of course, all developed-country central banks, not just the Fed, face similar forces that push toward restraint on rate hikes. So, the first large central bank that moves may also cause its currency’s exchange rate to appreciate significantly, slowing economic growth. This is yet another reason to wait. Why not let someone else move first, and see if they invite market and political wrath?
If the post-2008 scenario repeats, or if China and other emerging markets transmit disinflationary impulses across the global economy, waiting will have been the right decision. Otherwise, the current impediments to central-bank action will mean more and sustained inflation, and a more prolonged fight to control it. Fed Chair Jerome Powell will have a lot to weigh as he begins his second term.
With growth so uncertain, it is understandable that central banks would be wary of beginning to taper monthly bond purchases before it is clear that inflation has taken off. But they would do well to recognize that prolonging quantitative easing implies significant risks, too.
Inflation readings in the United States have shot up in recent months. Labor markets are extremely tight. In one recent survey, 46% of small-business owners said they could not find workers to fill open jobs, and a net 39% reported having increased their employees’ compensation. Yet, at the time of this writing, the yield on ten-year Treasury bonds is 1.24%, well below the ten-year breakeven inflation rate of 2.4%. At the same time, stock markets are flirting with all-time highs.
Something in all this does not add up. Perhaps the bond markets believe the US Federal Reserve when it suggests that current inflationary pressures are transitory and that the Fed can hold policy interest rates down for an extended period. If so, growth – bolstered by pent-up savings and the additional government spending currently being negotiated in Congress – should be reasonable, and inflation should remain around the Fed’s target. The breakeven inflation rate also seems to be pointing to this scenario.
But that doesn’t explain why the ten-year Treasury rate is so low, suggesting negative real rates over the next decade. What if it is right? Perhaps the spread of the COVID-19 Delta variant will prompt fresh lockdowns in developed countries and damage emerging markets even more. Perhaps more nasty variants will emerge. And perhaps the negotiations in Congress will break down, with even the bipartisan infrastructure bill failing to pass. In this scenario, however, it would be hard to justify the stock-market buoyancy and breakeven inflation rate.
One common factor driving up both stock and bond prices (thus lowering bond yields) could be asset managers’ search for yield, owing to the conditions created by extremely accommodative monetary policies. This would explain why the prices of stocks (including “meme stocks”), bonds, cryptocurrencies, and housing are all a little frothy at the same time.
To those who care about sound asset prices, Fed Chair Jerome Powell’s announcement last week that the economy had made progress toward the point where the Fed might end its $120 billion monthly bond-buying program was good news. Phasing out quantitative easing (QE) is the first step toward monetary-policy normalization, which itself is necessary to alleviate the pressure on asset managers to produce impossible returns in a low-yield environment.
The beginning of the end of QE would not please everyone, though. Some economists see a significant downside to withdrawing monetary accommodation before it is clear that inflation has taken off. Gone is the old received wisdom that if you are staring inflation in the eyeballs, it is already too late to beat it down without a costly fight. Two decades of persistently low inflation have convinced many central bankers that they can wait.
And yet, even if monetary policymakers are not overly concerned about high asset prices or inflation, they should be worried about another risk that prolonged QE intensifies: the government’s fiscal exposure to future interest-rate hikes.
While government debt has soared, government interest payments remain low, and have even shrunk as a share of GDP in some countries over the last two decades. As such, many economists are not worried that government debt in advanced economies is approaching its post-World War II high. But what if interest rates start moving up as inflation takes hold? If government debt is around 125% of GDP, every percentage-point increase in interest rates translates into a 1.25 percentage-point increase in the annual fiscal deficit as a share of GDP. That is nothing to shrug at. With interest rates normally rising by a few percentage points over the course of a business cycle, government debt can quickly become stressful.
To this, thoughtful economists might respond, “Wait a minute! Not all the debt has to be rolled over quickly. Just look at the United Kingdom, where the average term to maturity is about 15 years.” True, if debt maturities were evenly spread out, only around one-fifteenth of the UK debt would have to be refinanced each year, giving the authorities plenty of time to react to rising interest rates.
But that is no reason for complacency. The average maturity for government debt is much lower in other countries, not least the US, where it is only 5.8 years. Moreover, what matters is not the average debt maturity (which can be skewed by a few long-dated bonds), but rather the amount of debt that will mature quickly and must be rolled over at a higher rate. Median debt maturity (the length of time by which half the existing debt will mature) is therefore a better measure of exposure to interest-rate-rollover risk. Sign up for our weekly newsletter, PS on Sunday
More to the point, one also must account for a major source of effective maturity shortening: QE. When the central bank hoovers up five-year government debt from the market in its monthly bond-buying program, it finances those purchases by borrowing overnight reserves from commercial banks on which it pays interest (also termed “interest on excess reserves”). From the perspective of the consolidated balance sheet of the government and the central bank (which, remember, is a wholly owned subsidiary of the government in many countries), the government has essentially swapped five-year debt for overnight debt. QE thus drives a continuous shortening of effective government debt maturity and a corresponding increase in (consolidated) government and central-bank exposure to rising interest rates.
Does this matter? Consider the 15-year average maturity of UK government debt. The median maturity is shorter, at 11 years, and falls to just four years when one accounts for the QE-driven shortening. A one-percentage-point increase in interest rates would therefore boost the UK government’s debt interest payments by about 0.8% of GDP – which, the UK Office for Budget Responsibility notes, is about two-thirds of the medium-term fiscal tightening proposed over the same period. And, of course, rates could increase much more than one percentage point.
As for the US, not only is the outstanding government debt much shorter in maturity than that of the UK, but the Fed already owns one-quarter of it. Clearly, prolonging QE is not without risks.
Policymakers should be cautious about adding more to the national debt and the money supply.
The sharp increase in consumer prices this spring may be a blip but may also be a sign that inflation is returning as a chronic problem. For those of us who can accurately recall the 1970s economy, it is a frightening prospect. Everyone else would benefit from reading contemporaneous news coverage.
Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.
Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.
Like 2021, the post-election year of 1965 saw the inauguration of an ambitious unified Democratic government. That year, Congress enacted Medicare and Medicaid, began providing federal aid to local school districts, and greatly expanded federal housing programs. At the same time, the Johnson administration was expanding U.S. involvement in Vietnam, increasing the defense budget. The federal budget deficit expanded from $1.6 billion in the 1965 fiscal year (which ended on June 30 in those days) to $27.7 billion, or 3% of GDP, in fiscal 1968.
Although the Federal Reserve made some attempts to ward off inflation, it generally accommodated the government’s fiscal policy according to Allan Meltzer’s detailed history of this period published by the St. Louis Fed. Between calendar years 1965 and 1969, annual CPI growth surged from 1.6 percent to 5.5 percent, setting the stage for the Nixon administration’s closure of the U.S. Treasury’s gold window and imposition of wage and price controls. Inflation reached double digits in 1974 and again between 1979 and 1981. Notably, these were also recession years, refuting the fallacy of the Phillips Curve, which depicted a supposed policy trade-off between inflation and unemployment. By the early 1980s, we had ample evidence that ill-considered policies could give us a combination of high inflation and unemployment, known back then as “stagflation.”
This policy mix was also not great for equity investors. The Dow Jones Industrial Average moved sideways during the inflationary period, closing at the same level in December 1982 as it did in January 1966. One lesson from that period was that high interest rates can be bad for stocks.
That may be one reason the Fed remains reluctant to allow interest rates to rise today. Although messaging from the latest Federal Open Market Committee meeting showed greater willingness to normalize interest rates, action is not expected until 2023.
Rate hikes may bring other worries for the Fed in today’s environment. Given the large volume of variable rate mortgages and corporate loans outstanding in the U.S. today, a rise in interest rates could push highly indebted homeowners and companies into bankruptcy, potentially triggering a recession. The federal government would have to roll over its record stock of short-term debt at higher interest rates, ballooning its interest expense and potentially crowding out more popular spending priorities.
But if private capital is to continue participating in debt capital markets, such as those for corporate bonds and bank loans, interest rates will have to rise to compensate them for the loss of purchasing power on their principal.
Although annual growth in CPI fell sharply after 1982, it is not strictly correct to say that inflation was defeated. Except for a few years around the turn of the century, the federal government continued to run deficits, a portion of which were monetized. Notably, the government began running trillion dollar deficits, and the Fed drove interest rates down to near zero during the Great Recession, but CPI growth remained muted.
But CPI does not tell the whole story. Some sectors of the economy have experienced substantial inflation, but they are not fully incorporated in the consumer price index. Home prices, healthcare costs and college tuition all soared in recent decades. Meanwhile, apparel and consumer electronics remained affordable due to globalization and improved technology.
Back in the 1970s, most of the world was not part of the global economy. Eastern Europe was in the Soviet bloc, while China, Vietnam and India had yet to become major exporters. As more low-cost producers of goods and services came online during the 1980s and 1990s, prices were pushed downward (often and regrettably at the expense of American manufacturing jobs). The trend toward developing countries joining the international trading system and producing inexpensive consumer goods is now over. Indeed, the recent increase in protectionism is, if anything, rolling back the wave of international price competition.
On the other hand, technological improvements may continue to shield us from inflation in certain sectors. For example, the displacement of human cashiers by automated check stands might restrain price hikes at the big box retailers, supermarkets, fast food chains and other establishments that can afford to invest in them. Smaller businesses, facing higher wages, may have to try to pass them through to consumers in the form of higher prices. Already in some parts of the country, restaurants are trying to recoup costs without raising prices on their menus by adding various surcharges ostensibly tied to specific costs.
It is possible that inflation is now moving from assets and human-intensive services to consumer products, but we will need several months of additional data to know for sure. Meanwhile, policymakers should be cautious about adding more to the national debt and the money supply.
The specter of inflation haunts Joe Biden’s presidency
Treasury Secretary Janet Yellen got into trouble Tuesday for telling the truth. That morning, at a conference sponsored by the Atlantic, she raised the possibility that one day the Federal Reserve may raise interest rates “to make sure our economy doesn’t overheat.”
Anyone with a basic understanding of economics knew what she was talking about. The combination of President Joe Biden’s gargantuan spending and the accelerating economic recovery may well lead to a rise in consumer prices and hikes in interest rates. But an end to the Federal Reserve’s program of easy money would hurt asset prices and possibly employment as well.
Which is not what most investors want to hear. When Yellen’s words reached Wall Street, the market tanked. By the afternoon she was in retreat, telling the Wall Street Journal CEO summit that she had been misunderstood. “So let me be clear,” she said. “That’s not something I’m predicting or recommending.”
No, of course not. But it still might happen anyway.
A specter is haunting the Biden administration—the specter of inflation. Past inflations have not only harmed consumers, savers, and people on fixed incomes. They have also brought down politicians. Among the risks to the Democratic congressional majority is a rise in prices that lifts inflation to near the top of voters’ concerns, coupled by the type of Fed rate increase that hits stocks and housing. Inflation is one more signpost on the road to Republican revival, along with illegal immigration, crime, and semi-closed public schools embracing far-left critical race theory.
The classic definition of inflation is too much money chasing too few goods. That might also describe America sometime soon—if not already. The economy has started its post-virus comeback. Jobs and growth are on the upswing. U.S. households sit on a trillion-dollar pile of savings. Over the last year, on top of its regular spending, the federal government has appropriated a mind-boggling amount of money: a $2 trillion CARES Act, a $900 billion COVID-19 relief bill, and a $2 trillion American Rescue Plan. And President Biden wants to spend about $4 trillion more.
Surging this incredible amount of cash into an economy that is rapidly approaching capacity may have unintended and harmful consequences. But the Biden administration is either unconcerned about inflation or afraid of bringing it up in public.
Why? Well, one reason is that earlier warnings, after the global financial crisis in particular, didn’t seem to come true. (The inflation may have shown up in the dramatic ascent in prices of stocks and bonds, as well as in odd places such as the market for high-end art.) Another reason is that some economists think a little bit of inflation would be a good thing. But the main explanation may be related to status-quo bias: Inflation hasn’t been a driving force in our economic and public life for decades, and so we blithely assume it won’t be in the future.
Which is why an experienced leader worries about repeating the mistakes of the past. And yet, for a politician who came to Washington in 1973, Joe Biden has a lackadaisical attitude toward inflationary fiscal and monetary policy. Was he paying attention? It was the great inflation of the ’60s and ’70s, caused in part by high spending, the Arab oil embargo, and spiraling wages and prices in a heavily regulated and unionized economy, that helped ruin the presidencies of Gerald Ford and Jimmy Carter.
Inflation led to bracket creep, with voters propelled into higher income tax brackets by monetary forces over which they had no control. And bracket creep inspired the tax revolt, supply-side economics, and the Reaganite idea that, “In this present crisis, government is not the solution to our problem; government is the problem.” The eventual cure for inflation was the painful “shock therapy” administered by Federal Reserve chairman Paul Volcker and what at the time was the worst recession since the Great Depression.
Why anyone would want to repeat this experiment in the dismal science is a mystery. Biden, however, is fixated not on inflation but on repudiating the legacy of the man known for describing it as “always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Milton Friedman, whose empiricism led him to embrace free market public policy, was the most influential economist of the second half of the 20th century. But Biden has a weird habit of treating Friedman as a devilish spirit who must be exorcised from the nation’s capital. For Biden, Friedman represents deregulation, low taxes, and the idea that a corporation’s primary responsibility is not to a group of politicized “stakeholders” but to its shareholders. “Milton Friedman isn’t running the show anymore,” Biden told Politico last year. “When did Milton Friedman die and become king?” Biden asked in 2019. The truth is that Friedman, who died in 2006, has held little sway over either Democrats or Republicans for almost two decades. But Biden wants to mark the definitive end of Friedman and the “neoliberal” economics he espoused by unleashing a tsunami of dollars into the global economy and inundating Americans with new entitlements.
The irony is that Biden’s rejection of Friedman’s teachings on money, taxes, and spending may bring about the same circumstances that established Friedman’s preeminence. In a year or two, the American economy and Biden’s political fortunes may look considerably different than when Janet Yellen blurted out the obvious about inflation. Voters won’t like the combination of rising prices and declining assets. Biden’s experts might rediscover that it is difficult to control or stop inflation once it begins. And Milton Friedman will have his revenge.