The Fed Tries Boiling the Frog
If you put a frog in a pot of water and gradually turn up the heat, the frog will sit there until it boils to death. If you toss a frog into an already boiling pot of water, the shock will cause the frog to immediately leap out to safety.
Powell’s plan to deal with inflation is like boiling the frog.
The CPI measure of Inflation is over 9%. (Core Inflation, excluding food and energy for those of us who don’t eat or drive, is a mere 5.9%)
Thus far, Powell has not established enough credibility with the market or consumers that he is serious about inflation. The best evidence of this is that interest rate futures expect Fed Funds to peak around 4% in January 2023, declining rapidly after that. This is not enough to kill off the emerging wage-price spiral. Don’t take my word for it:
“At a minimum, then, according to the usual wisdom, the interest rate should be above 8.5 percent. Now. The Taylor rule says the interest rate should be 2 percent (the Fed’s inflation target), plus 1.5 times how much inflation exceeds 2 percent, plus the long-term real rate. That means an interest rate of around 12 percent. Yet the Fed sits, and contemplates at most a percent or two by the end of the year.”
– John H. Cochrane “More to Fight Inflation”
By the way, what is that long-term real rate?
The Federal Reserve rode into a box canyon on a horse called quantitative easing. It has been clear for some time that the policy of buying bonds to add liquidity to the market had incumbent inflationary risks. With a $9 trillion balance sheet they have been buying fully 50% of all new treasury issuance.
The bond buying has the Fed manipulating rates across the entire yield curve which has blinded them to free-market reactions. As we saw in the sub-prime mortgage crisis, when a non-price sensitive player like the government owns 50% of a market there is no real price discovery. Imagine if the $5 trillion in pandemic relief bonds were sold to real market participants rather simply moved to the Fed’s balance sheet? What would be the market clearing price? Could that have given the Fed a better notion of the market’s emerging inflationary expectations?
What is a normal balance sheet for the Fed? Prior to the sub-prime loan meltdown in 2008, they managed their function with less than $1 trillion in treasuries or around 6% of nominal GDP. The economy has grown since, so let’s target $2 trillion to support the Fed’s day-to-day management of monetary policy. Powell’s plan is to run off a mere $50 billion a month from their portfolio, so it will take them more than 11 years to get back to normal. If you need an indicator that Powell is not a serious inflation fighter, this is a good one.
More importantly, Powell does not seem to have a grip on his real objective. The Fed and the Biden administration need to change inflationary expectations. As the chart nearby demonstrates, expectations began to change with the arrival of the free spending plans of the Biden administration. Expectations for higher prices are getting worse yet they are now running behind the actual inflation data. This means, there will be more upward adjustments in the consumer psyche. Just to be clear, if people expect prices to rise 7% next year, how will they feel about a 3% raise?
Exploding Fiscal Bombs
The Fed lit the fuse for inflation with a massive 27% increase in the money supply (M2) in 2020-21. Then in March of 2021, the Biden administration foolishly attached a multi-trillion-dollar fiscal bomb to that fuse. What we are experiencing today is the aftermath of that explosion.
But wait, there is more. The Orwellian-titled “Inflation Reduction Act of 2022”, is another $430 billion fiscal bomb. (As an aside, Governor of California, Gavin Newsom, just approved sending an additional $9 billion into the hands of the state’s consumers, demonstrating his own lack of economic common sense.)
As Biden advised us during the campaign, “We choose truth over facts.” Unfortunately, in economics the numerical facts ultimately will win out over a manufactured “truth.” We note that Janet Yellen and others are working the press to redefine recession so that they can spin the combined Q1 and Q2 GDP contraction as something else. Well, why not? If Georgia’s voting laws are “Jim Crow 2.0”, and Afghanistan was “the largest most successful evacuation in history”, and inflation is, “Putin’s price Increase”, then anything is possible.
The Biden administration compounded their mistake of a highly inflationary fiscal policy with the re-appointment of Jeremy Powell. Powell is a go-along to get-along type of central banker, which is probably why Trump appointed him in the first place. In his Senate hearings, Powell dismissed the importance of the growth of the money supply as a factor in inflation. That comment alone should have brought a no vote from every Senator in the room, assuming they had even a cursory knowledge of monetary economics. That, as it turned out, was an assumption too far.
Reappointing Powell was yet another economic blunder by this Administration. Powell does not have the stature or intestinal fortitude to deliver the money supply shock treatment as Paul Volcker did in 1979, with an increase in the reserve requirement. What would shock this market into changing their expectations? The Fed should reduce their bond portfolio by $1 trillion a quarter for seven quarters.