Tag Archive for: FederalReserve

Biden and Powell Are in Denial—A Recession Is Indeed “Inevitable”

Estimated Reading Time: 4 minutes

And they are the ones who made it so.

On Wednesday, the Federal Reserve announced that it will “raise” interest rates faster than previously planned in order to “fight” worsening inflation.

In a press conference, Fed Chairman Jerome Powell tried to assure investors and the public that the Fed is, “not trying to induce a recession now. Let’s be clear about that.” As the Wall Street Journal reported, Powell “still believes [the Federal Reserve] can cool the economy and bring down inflation while engineering a so-called soft landing in which the economy and labor market continue to grow.”

On Thursday, President Biden was similarly hopeful, telling the Associated Press that a recession is “not inevitable.”

That same day, investors splashed cold water on Biden and Powell’s hopes. After the Fed’s announcement, markets briefly rallied before tumbling yet again.

Yet it’s not just traders who beg to differ with the rosy optimism emanating from the White House and the Fed, but economic reality itself. Biden and Powell are in denial. A soft landing is impossible, a recession is inevitable, and it is their own policies that made it so.

Media reports tend to leave out why the Fed thinks raising interest rates will fight inflation in the first place. First of all, it is grossly misleading to say that the Fed “raises” interest rates or “fights” inflation.

Imagine a bully pins down one of his victims. If the bully eases up, allowing the victim to stand up on his own, you wouldn’t say that the bully “raised” up his victim. Yet that is basically what the Fed is doing with regard to interest rates. The Fed has been holding down interest rates, and now it’s relenting a bit to allow them to rise somewhat.

And imagine an arsonist pumps gasoline on a fire. If the arsonist eases up on the pump, allowing the fire to die down a bit, you wouldn’t say that the arsonist is “fighting” the fire. Yet that is basically what the Fed is doing with inflation. The Fed has been driving up inflation, and now it’s relenting a bit to allow prices to moderate somewhat.

The way the Fed holds down interest rates is by “quantitative easing,” a euphemism for flooding the banking system with newly created dollars. The Fed has been holding interest rates down to near zero by injecting trillions of new dollars into the banks.

More money chasing the same amount of goods will tend to bid up prices. Federal Reserve bureaucrats are at least economically literate enough to be aware of that, so they know their money pumping is fueling the flames of inflation. And the inflation conflagration is getting dangerous enough to back them into a corner. They feel they have no other choice but to ease up on the pump, even if it means allowing interest rates to rise.

Fed policymakers are highly reluctant to do so, because the main reason they have been holding interest rates down has been to “stimulate” the economy, especially in the face of COVID and the lockdowns. Many investors and economists fear that an economy with less monetary stimulus will crash and fall into a recession.

But what almost nobody understands is what crashes and recessions even are and why they happen. And they have no excuse, because that was clarified way back in 1912 by the great Austrian economist Ludwig von Mises.

As Mises explained, crashes and recessions are made inevitable by monetary stimulus. Money pumping can only stimulate the economy by overextending it.

The extra money sloshing around the banking system lowers the interest rate by boosting investor demand for resources to use in new and expanded production projects. This means more investment opportunities, higher profits, more jobs, and higher wages: i.e., a “stimulated” economy.

New and expanded production projects would be fine and great if they were matched by new and expanded resources to support them—made available by higher savings. That’s what a natural drop in the interest rate would signify. But the infusion of new money only expands production; it does nothing to reduce present consumption and thus increase savings. So it results in an over-commitment of available resources.

It’s the simple logic of scarcity: we have (1) the same finite stock of resources, (2) more production demands for resources, and (3) the same (if not more) consumption demands for resources.

Eventually, something’s gotta give.

The Fed’s money pumping only “stimulates” the economy by deluding investors into behaving as if there are more available resources in the economy than there actually are. At some point, that delusion must run headlong into economic reality.

Generally, that happens when the Fed finally eases up on pumping money into the banking system. With less new money pumping it up, the effective demand of investors for resources collapses back down to a level compatible with consumer demand and the actual rate of saving. Deluded less by monetary stimulus, market actors start reckoning with economic reality. The interest rate spikes, stock prices collapse, and throughout the economy, production projects that looked like profitable winners are revealed to be unaffordable losers (“malinvestments”).

That is what a crash is.

Entrepreneurs then scale back or liquidate the loser projects, reallocating resources (including human resources) to uses that are more compatible with the now clearer economic reality. That reallocation can only happen through a mass change of partners throughout the economy. This means many painful “break-ups” of impractical economic relationships: lay-offs, contract cancellations, bankruptcies, etc.

That is what a recession is.

Those break-ups are prerequisites to the formation of new, more practical economic relationships: new jobs being filled, new contracts being signed, and new businesses being started.

That is what recovery is. The result is a healthier economy. And the only path from an unhealthy economy to a healthier one is through a recession.

That is why Biden and Powell are wrong. A recession is inevitable. It’s also necessary. It was made inevitable and necessary by their own policies: by Biden (as well as President Trump before him) crippling the economy with lockdowns and other destructive policies, and by Powell “stimulating” the crippled economy into a distorted, overextended, and unsustainable condition.

The only way to heal that condition is to let the economy heal itself through a recession. And the sooner that Biden and Powell let that happen, the better.

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This article was published by FEE, Foundation for Economic Education and is reproduced with permission.

A Time for Reckoning

Estimated Reading Time: 6 minutes

Consumer prices are up almost nine percent from where they were a year ago. For the median U.S. household, that’s equivalent to an almost $6,000 pay cut. Politicians have blamed corporate greed, the Ukraine war, and the supply chain because they are keen to get voters to latch on to any explanation as long as it isn’t the correct explanation.

The correct explanation implicates the entire political class.

For four decades, economists have warned, and warned, and warned again that the federal government should not spend money it doesn’t have. But during each of a string of crises, politicians insisted that a “temporary” bout of deficit spending was necessary to get us through to the other side. Deficit spending was needed, politicians said, to deal with the Soviet threat in the 1980s, then the Savings and Loan crisis in the 1990s, then 9/11 in the 2000s, then the housing crisis in the 2010s, then COVID in the 2020s. If they have their way, next up will be more deficit spending in the 2030s to deal with the looming Social Security insolvency crisis. In today’s dollars, politicians added $3 trillion to the debt in the 1980s and again in the 1990s. They added $6 trillion in the 2000s, then almost $10 trillion in the 2010s. According to the Congressional Budget Office, we can expect politicians to add more than $17 trillion in the 2020s. Each generation of voters has complained about the debt, and each generation of politicians has kicked the can down the road, despite knowing that future generations would have to deal with the consequences.

We are that future generation and the inflation we’re seeing today is just one of the consequences.

Today, the federal government collects, from all taxes combined, around $4 trillion per year. But it owes $30 trillion and has committed to paying another $100 trillion to $250 trillion (beyond what it collects in future payroll taxes) to future Social Security and Medicare recipients. For perspective, that’s like a household with a $60,000 income being $450,000 in debt, and then promising to pay for 18 kids to attend four-year private colleges. If that sounds unsustainable, you’re beginning to understand economists’ concerns over the past forty years.

What happened?

Despite all this borrowing, inflation has been very tame for a very long time. What changed is that the debt has become so large that the government is now running out of places on planet Earth to borrow more. American citizens, businesses, and state and local governments lend money to the federal government. So too do foreign citizens, businesses, and governments. Until recently, the largest lender was the Social Security trust fund. Until 2010, Social Security collected more in payroll taxes than it paid out in retirement benefits and loaned the difference to the federal government. But around 2010, the surplus dried up. For the past decade, not only has Social Security had nothing to loan to the government, it’s been needing back money it previously loaned.

As the government has needed to borrow more and more, and the Social Security trust fund has been able to lend less and less, the Federal Reserve has had to take up the slack. But, unlike any other lender, when the Federal Reserve loans money, the money supply increases. And if the money supply increases faster than the economy grows, we get inflation.

The cure for inflation is to contract the money supply, but contracting the money supply raises interest rates. That’s good news for lenders and bad news for borrowers – and the single largest borrower on the planet is the federal government. At $30 trillion, just a one-percentage-point increase in interest rates would cost the federal government an additional $300 billion annually. A two-percentage-point increase in interest rates would cost the federal government almost as much as the entire Department of Defense – every year.

The growth in the federal debt has painted the Federal Reserve into a corner. The Fed must now choose between preserving the purchasing power of the dollar and preserving the financial stability of the federal government. If the Fed contracts the money supply, it keeps inflation down but interest rates go up. If the Fed expands the money supply, it keeps interest rates down but inflation goes up.

But if it’s true that printing money causes inflation, why has it taken so long for the inflation to materialize? The lion’s share of the recent bout of money printing occurred in 2020 when the Fed increased the money supply by a whopping 20 percent. Over just four months, from March to July 2020, the Fed increased the money supply by as much as it had over the prior five years. Yet, inflation remained low through January of 2021. Where was the inflation?

For a clue, notice something strange. From April through August of 2020, the S&P 500 rose 60 percent, more than reversing the plunge it took at the start of the lockdowns. What’s strange is that the S&P 500 was showing a strong recovery during the same period in which the economy was suffering its worst contraction since the Great Depression. Large swaths of the economy were shut down, unemployment peaked at 14 percent – quintuple what it had been just a few months earlier. No one knew how long any of this was going to last, nor what condition we’d be in when it finally did end. Yet, here was the stock market chugging along at a dot-com era pace.

A possible explanation for the missing inflation is that it was hiding in financial markets. If those trillions of dollars the Fed pumped into the money supply landed in financial markets, rather than goods and services markets, then we’d expect to see prices of financial assets rise while prices of goods and services remained steady. Since prices of financial assets aren’t included in inflation calculations, official inflation numbers would remain low despite the massive increase in the money supply. And, if indeed the inflation were hiding in financial markets, then when the covid crisis subsided, that money would start to move out of financial markets and into goods and services markets, causing stock prices to top-out or even fall, while goods and services prices skyrocketed.

And that’s exactly what happened.

In September of 2020, the stock market’s steady upward march faltered, and at the same time, inflation numbers, which were already showing signs of rising, broke out into territory not seen since the 1980s.

A comparison of money growth to prices over the past decade appears to show no link between the money supply and inflation. It appears that it didn’t matter for inflation whether money growth was large or small.

But, if we add together inflation and the growth in the S&P 500 (understanding that the combination is an ad hoc measure), the expected relationship emerges. On average, as the money supply has risen, the sum of inflation and stock price growth has risen also. This suggests that inflation can hide in financial markets, making it appear that increasing the money supply has no deleterious effects.

What comes next?

Defenders of large government will argue that the COVID crisis is simply a hiccup. They will argue that we have a long history of deficit spending combined with low inflation and that, once the supply chain and Ukraine problems are sorted out, we’ll be able to return to business as usual. They’ll argue that we can keep kicking the can down the road.

That’s incorrect. We’ve reached the end of the road, and that end is Social Security. The Social Security board of trustees estimates that Social Security will be insolvent thirteen years from now. At that point, one (or a combination) of three things must happen if Social Security is to continue: (1) payroll taxes must rise by 25 percent; or (2) retiree benefits must be cut by 20 percent; or (3) the Federal Reserve must print an additional $250 billion per year, which, other things equal, would permanently boost inflation even further. 

Social Security’s looming insolvency is a financial fork in the road. One path, increased taxes, leads to more pain for workers. Another path, cutting benefits, leads to more pain for retirees. The third, printing money, leads to more pain for consumers as we all struggle to afford things that were once affordable.

What went wrong?

What went wrong is that we allowed the limited federal government the Founders created to escape its limits. First, politicians discovered that they could win elections by paying off voters with other people’s money. And so modern elections have become contests in which politicians vie with each other to offer “free” stuff to their constituents. “Free” phones, housing, health care, and education are free only to the recipients. Politicians simply force others to pay the bill.

Second, the Supreme Court decided that its job was to “rewrite” the Constitution by reading all manner of things into the document that the plain words on the page didn’t say. Ironically, this began at the same place that the story will ultimately end: Social Security. Politicians and voters wanted Social Security, yet nowhere in Article I, Section 8’s list of federal powers was any mention of establishing a national retirement and disability program. The Supreme Court shot down Social Security. Politicians tried again. The Supreme Court shot it down again. This continued until the Supreme Court finally gave in and concluded that despite the plain words on the page, the Constitution did, after all, empower the federal government to create Social Security. From there, it was simply more of the same to get the CDC, the FDA, the EPA, ATF, and the thousands of federal departments, agencies, programs, and initiatives we have today.

Third, we abandoned the gold standard. Because the quantity of gold is (largely) fixed, when dollars are tied to gold, the quantity of dollars is fixed also. And when the quantity of dollars is fixed, not only can the Fed not wantonly print money, but also the federal government is restrained because the only way it can grow is by taxing the people more. This gives voters an incentive to apply the brakes to runaway government. 

The inflation we feel today is the beginning of the end of a century-long experiment in unlimited government. By kicking the cost of government down the road, generations of politicians have managed to make it look like unlimited government is affordable – possibly even “free.” But we’ve reached the end of the road and found that the people who must ultimately pay for unlimited government is us. Whether through taxes or inflation, pay we will.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.

Don’t Be Fooled: The World’s Central Bankers Still Love Inflation

Estimated Reading Time: 4 minutes

The Bank of Canada on Wednesday increased its policy interest rate (known as the overnight target rate) from 1.0 percent to 1.5 percent. This was the second fifty–basis point increase since April and is the third target rate increase since March of this year. Canada’s target rate had been flat at 0.25 percent for twenty-three months following the bank’s slashing of the target rate beginning in March 2020.

As in the United States and in Europe, price inflation rates in Canada are at multidecade highs, and political pressure on the central bank to be seen as “doing something about inflation” is mounting.

The bank is following much the same playbook as the Federal Reserve when it comes to allowing the target rate to inch upward in response to price inflation. The bank’s official position is that it could resort to very aggressive rate increases in the future in order to hit the 2 percent inflation target.

As in the US, it’s important for central bankers to sound hawkish, even if their actual policy moves are extremely tame.

The World’s Central Banks Are Still Committed to Monetary Inflation

In spite of their lack of any real action, however, Canada’s central bankers are comparatively hawkish when we look at the world’s major central banks. At a still very low target rate of 1.5 percent, Canada’s central bank has set a higher rate than the central banks in the US, the UK, the eurozone, and Japan. Indeed, in the case of the European Central Bank and the Bank of Japan, rising inflation has still not led to an increase in the target rate above zero.

  • Federal Reserve: 1.0 percent
  • European Central Bank: –0.5 percent
  • Bank of England: 1.0 percent
  • Bank of Japan: –0.1 percent

Moreover, the ECB and the BOJ haven’t budged on their subzero target rates in many years. Japan’s rate has been negative since 2016, and the EU’s has been negative since 2014.

banks

The Bank of England recently increased its target rate to 1 percent, which is the highest rate for the BOE since 2009.

In the US, the Federal Reserve has increased the target rate to 1 percent, the highest rate since March 2020.

However, it’s clear that none of these central banks are prepared to depart from the policies of the past twelve years or so, during which ultralow interest rate policy and quantitative easing became perennial policy.

The Federal Reserve has talked tough on inflation but has so far only dared to hike the target rate to 1 percent while inflation is near a forty-year high.

The Bank of England apparently suffers from the same problem, as Andrew Sentence of the UK’s The Times pointed out this week:

There is a serious mismatch between inflation and the level of interest rates in Britain. The rate of consumer prices inflation measured by the CPI is now 9 per cent—four-and-a-half times the official target rate of 2 per cent. The Bank of England is forecasting that CPI inflation will reach double-digit levels by the end of the year…. The older measure—the Retail Prices Index (RPI), which is still widely used—is already showing a double-digit inflation rate (over 11 per cent). Yet the official Bank rate has been raised to just 1 per cent, up a mere 0.9 percentage points on the near-zero rate during the pandemic.

This mismatch is not confined to the UK. In the US, where inflation is currently 8.3 per cent, the official Fed Funds rate is also just 1 per cent. And in the eurozone, where inflation is 8.1 per cent, there has been no interest rate rise at all from the European Central Bank.

This mismatch is not confined to the UK. In the US, where inflation is currently 8.3 per cent, the official Fed Funds rate is also just 1 per cent. And in the eurozone, where inflation is 8.1 per cent, there has been no interest rate rise at all from the European Central Bank.

In other words, even with these tiny rate increases, we’re seeing in the US and the UK, the Fed and the BOE aren’t as far behind the curve as the ECB, which in late May suggested it has started to consider reining in its easy-money policies. But in typical central bank speak, this means putting in place some small changes many months down the road. Specifically, ECB president Christine Lagarde stated that “based on the current outlook, we are likely to be in a position to exit negative interest rates by the end of the third quarter.”

Translation: “We might do something in five months.”

Anticipating the obvious response to this lack of action, Lagarde also insisted, “We are in a situation that is vastly different from the United States and we are actually perfectly on time and not behind the curve.”

Meanwhile, the Bank of Japan shows no signs of relenting on its dovish policy. In spite of the yen being in the midst of a historic slide compared to the dollar and the euro, BOJ governor Haruhiko Kuroda has made it clear he has no changes in the works.

A Strong Dollar by Default

This is all good for the dollar, and as we’ve seen in recent weeks, talk of a “strong dollar” has returned as other major central banks make their own fiat currencies look even worse than the dollar. The dollar, of course, is being rapidly devalued—but not as much as the yen or the euro.

Unfortunately, this gives the Fed in the US even more breathing room when it comes to getting away with inflationary monetary policy. Moreover, we have even started to hear complaints about this “strong dollar,” as we often hear from exporters, hack economists, and central bankers who think that a weak dollar helps the economy.

Perhaps the biggest danger here may be the adoption of an updated version of the late 1980s Plaza Accords designed to weaken the dollar. If the weak dollar advocates win that fight, we’ll be looking at a continued downward spiral in dollar purchasing power, all justified by the “problem” of a dollar that is too strong compared to other currencies. Weak dollar advocates are already working on it.

In the short term, however, the dollar is very unlikely to be the first domino to fall if the world is headed toward a sovereign debt or currency crisis. A crisis could actually trigger flight to the dollar and away from competing currencies. Ordinary people, however, will continue to face only bad options: continued high price inflation with only moderate wage increases—meaning declining real wages—or a recession that brings down inflation (both price inflation and monetary inflation) but drives up unemployment. Or there could be stagflation, with both a slowing economy and strong price inflation. None of the likely options are good news.

Key Rates

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This article was published by the Mises Institute and is reproduced with permission.

How the United States Conquered Inflation Following the Civil War

Estimated Reading Time: 4 minutes

Americans today are once again the victims of price inflation brought on by runaway government spending and printing of unbacked paper money.

 

According to the most recent polling data, the American public’s approval of Congress stands at a dismal 21 percent. Almost four times as many people disapprove of the job it’s doing.

That’s par for the course in recent decades. It’s the major reason the Washington sausage grinder earns so little praise. To be fair, though, let’s review an occasion when lawmakers got something right. I’m prompted to share this story now because its lessons are especially relevant considering today’s concerns about rising price inflation. The year was 1875.

The Civil War (1861-65) produced disastrous hyperinflation in the Confederacy and considerable currency depreciation of paper greenbacks in the North as well. A decade after Appomattox, Congress still had not made good on its promise to make its paper money redeemable in gold. But in January 1875, alarmed by the rise of pro-inflation agitators (the “Greenbackers,” later to become “silverites”), Congress passed the Specie Payment Resumption Act, which President Ulysses S. Grant later signed into law.

Politicians often break their promises, and this was yet another opportunity to do so. Congress could have declared, “We don’t have the gold necessary to honor our pledge, so we’ll pay gold for greenbacks at 50 cents on the dollar.” But lawmakers chose to be honest for once, and to meet their obligations fully. The Act provided that all paper greenbacks would be redeemable on demand “at par” (100 percent of the earlier promise), beginning on January 1, 1879.

When Rutherford B. Hayes succeeded Grant as President in March 1877, he knew his administration had less than two years to prepare the Treasury and the nation’s banks for redemption. He and his Treasury officials believed the best way to avoid a run on the banks in January 1879 was to shore up the country’s gold reserves. They did so largely by selling bonds to Europeans in exchange for gold.

Redemption Day came amid rumors that people would flood the banks with their paper greenbacks and demand the promised gold, but just the opposite happened. Hardly anybody showed up at bank teller windows asking for the yellow metal. Why? Because the Treasury had accumulated more than enough gold to take care of convertibility, and the public knew it. The lesson? When people have good reason to believe their paper money is “as good as gold,” they prefer the convenience of paper.

Former United States Circuit Judge Randall R. Rader writes,

The year 1879 brought the resumption of the redeemable currency. The consumer price index stabilized at 28 in that year. For more than three decades thereafter (World War I interrupted the price tranquility), the index never rose above 29 or dipped below 25. The index remained at 27 for a decade. Never did it rise or fall more than a single point in a year. The gold standard worked throughout that entire period to keep prices remarkably stable.

Americans today are once again the victims of price inflation brought on by runaway government spending and the printing of unbacked paper money. Does the Specie Payment Resumption Act of 1875 offer a model that could solve the problem? Yes and No.

Certainly, tying the dollar to a precious metal would exert a discipline desperately needed in monetary policy. Putting the Federal Reserve out of business would be a meaningful and positive reform as well; since its inception in 1913, it has given us one Great Depression, a bunch of recessions and a currency worth maybe 1/20th of its 1913 value. The Fed is an inflation factory, stumbling and fumbling from one self-inflicted crisis after another. Gold convertibility, as the 1875 act provided, would signify a restoration of integrity and monetary sanity that we haven’t seen in a hundred years.

But two big, fat elephants ensure that an 1875-like reform would immediately collapse unless they are summarily escorted out of the room. One is dishonest politicians. Washington is overrun with them—people who are interested first and foremost in short-term power and re-election and least of all in the long-term economic health of the country. Many are (pardon my bluntness) economic morons, oblivious to the red ink even as they drown in it.

The other elephant—the presence of which is a confirmation and consequence of the first—is a massive, annual budget deficit.

For half a century from 1865 until World War I, the federal government ran an almost unbroken string of budget surpluses. Today, it produces trillion-dollar deficits without batting an eye, and the President demands trillions more in spending and debt. If he announced today that the dollar would henceforth be backed by gold, the world would laugh, and you and I would rush to the banks with our paper before the gold ran out.

In other words, monetary discipline goes hand in hand with fiscal discipline. A return to sound money is impossible without a simultaneous return to sound budget management. In the face of a monstrous budget deficit and an even more frightening $30 trillion national debt, Congress just voted to ship $40 billion to Ukraine without cutting so much as a penny from anything else.

We have neither a Congress nor a President, and perhaps no public consensus either, that would permit anything remotely resembling the 1875 Specie Payment Resumption Act.

And until we do, the dollar is destined for further depreciation. Just as elections have consequences, so do destructive monetary and fiscal policies.

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This article was published by FEE, Foundation for Economic Education and is reproduced with permission.

 

Inflation: What Causes It, and When Will it Subside?

Estimated Reading Time: 6 minutes

We have been living under the illusion that the relationship between nominal GDP and the quantity of circulating currency is dead. This illusion began in 2008, when the Federal Reserve began expanding the value of its assets without expanding the value of circulating currency. Instead, banks were paid to hold this newly created money on account at the Federal Reserve. The newly created money, thus, did not generate inflation despite expectations among many that high inflation was imminent.

In the long run, inflation is determined by the rate of expansion of circulating currency and growth in real productivity. Real productivity growth is deflationary but tends to be modest and relatively stable. Thus, the growth rate of circulating currency tends to be correlated with the growth rate of total expenditures, as well as inflation.

After the 2008 Financial Crisis, the rate of inflation hovered around 1.7 percent. From the end of that crisis until recently, the velocity of currency trended downward modestly, mirroring the fall in long-term nominal interest rates. Figure 1 conveys this relationship between velocity of currency (right axis) and the nominal interest rate paid on 30-year US Treasuries (left axis).

It is true that an increase in the quantity of money will support a proportional increase in the level of expenditures, as long as the velocity of currency is stable. A more sophisticated expression of this truth holds that the velocity of currency is stable with respect to interest rates. Over the last several decades, the velocity of money currency has tended to follow the downward trend in interest rates. Although the relationship has not been 1-to-1, expansion of the stock of currency has tended to positively impact the level of total expenditures and the price level. For much of this period, the stock of circulating currency grew at a rate of about 7 percent while the rate of growth of nominal GDP was often in the range of between 3 percent and 5 percent.

In accordance with this logic, the FOMC has responded to increasing inflationary pressure by reducing the growth rate of currency in circulation as the level of nominal GDP has broken above the pre-2020 trend. In the meantime, however, the balance sheet continued to expand into the first quarter of 2022. This recent correlation between balance sheet expansion and the annual rate of inflation has led many to believe that the Fed’s current stance is too easy. The balance sheet increased for much of the previous decade without generating significant inflation. Circulating currency serves as reserves that support lending within the financial system. Policymakers and protocols governing monetary policy – for example, the Overnight Reverse Repurchase Agreement Facility – have supported stability in the level of currency in circulation. Stability in the path of NGDP tends to reflect stability in the path of circulating currency. Not coincidentally, the jump in the path of currency in circulation that began in the first quarter of 2020 has been followed by a similar jump in NGDP and in CPI (vertical line indicates start of first quarter of 2020). Those who would like to predict the future path of nominal GDP and of the price level should focus on currency in circulation, not the size of the balance sheet.

Inflation, Balance Sheet Expansion, and Fed Solvency

Claims linking inflation to the size of the balance sheet may stem, in part, from the focus of Fed officials on the size of the balance sheet in recent months. Recent statements by Fed officials reflect that higher inflation readings have made these policymakers increasingly concerned about the size of the balance sheet.

Absent a solvency crisis, however, a larger balance sheet is most likely to be associated with lower interest rates and lower rates of real income growth. This program of balance sheet expansion, called quantitative easing, influences resource allocations by asset class and maturity length. While some might hope that quantitative easing stimulates aggregate demand, there is little empirical evidence or theory to suggest that it does. Since the Federal Reserve began expanding the balance sheet greatly in excess of circulating currency, the rate of real GDP growth has fallen to historic lows. For much of this period, the level of GDP was below its potential path. And as the Fed began balance sheet reductions in 2017, these reductions were accompanied by relatively higher rates of real GDP growth. In the least, it is unlikely that quantitative easing supports expansion of aggregate demand.

Quantitative easing certainly impacts resource allocations. The Fed’s acquisition of subprime mortgages during the 2008 Crisis lowered the risk of financial insolvency for firms that would have been left holding these mortgages. This was intended to help stabilize a housing market that was in meltdown and seems to have helped that market weather the liquidity crisis. Along with purchases of long-term US Treasuries, this policy was also intended to lower interest rates at the upper end of the yield curve. The most noteworthy effect of quantitative easing, then, has been to allocate credit toward particular classes of borrowers.

While balance sheet expansion has not been the cause of inflation over the last decade, this does not mean that the Federal Reserve can expand the balance sheet without limit. Balance sheet expansion absent expansion of circulating currency is not inflationary so long as there is not a mismatch between the assets and liabilities sides of the balance sheet. Assets yield income. On the other hand, much of the liabilities side of the Fed’s balance sheet implies income payments that must be made by the Fed in order to maintain solvency. As long as the income earned by the Federal Reserve exceeds expenditures, the Fed remains solvent.

Expansion of the Federal Reserve’s balance sheet simultaneously increases interest-earning assets and liabilities that require interest payments from the Fed. The Federal Reserve prevents inflation by simultaneously borrowing the funds that it uses to pay for assets purchased. For example, the Federal Reserve may credit interest-bearing deposit accounts or may borrow funds at interest from the overnight lending market in order to offset currency created via its purchase of assets.

Monetary stability requires that the interest payments from the Federal Reserve are provided from the receipts adding to its income rather than from money creation. That is, Federal Reserve profits need to remain positive. Positive profits, defined by income above operating expenses, are remitted to the US Treasury. Negative profits either must be paid by the US Treasury or must be covered by the creation of new money. Negative profits would likely hurt investor confidence.

The assets side of the balance sheet is supposed to constrain the liabilities side. Insolvency occurs when the value of liabilities are not offset by the value of assets. Insolvency could occur, for example, due to rising interest rates. Suppose that investors lose faith in the ability of the Federal Reserve to maintain low and stable inflation. Rising mortgage rates would devalue mortgage-backed securities already held by the Fed that comprise a significant portion of the Fed’s assets. Thus, as interest rates rise, the Federal Reserve will likely need to begin reducing the size of the balance sheet in order to 1) reduce losses on the assets side of its balance sheet and 2) to reduce interest payments that it owes to institutions and investors. As long as the Federal Reserve remains solvent and investors expect that it will remain solvent, a large balance sheet cannot, on its own, be the cause of inflation.

At present, there seems to be little reason to doubt the ability of the Federal Reserve to remain solvent as even doves like Lael Brainard, who was recently confirmed as Vice Chairwoman, are calling for aggressive tightening.

Will Inflation Continue to Rise?

As the year-over-year rate of inflation has increased, many commentators have begun to reflect on the relationship between easy money and inflation. However, few of these commentators have been consistently correct in their evaluation of Fed policy. Most do not differentiate between an increase in the Fed’s balance sheet and expansion of currency in circulation. Over the last year, year-over-year rates of inflation have been rising as a result of the increasing rate of expansion of circulating currency orchestrated by the Federal Reserve during 2020. The good news is that annualized monthly and quarterly rates of inflation have been stable over the last year. The Federal Reserve began moderating this expansion of currency in circulation in the last year as nominal GDP returned to its pre-crisis trend. Nominal GDP has overshot this trend, which is why we have been experiencing relatively high rates of inflation. But there is reason to expect that this overshoot is currently somewhere close to its greatest extent.

If excessive increases in inflation and the growth rate of nominal expenditures are caused by excessive increases in the growth rate of circulating currency, then we should expect inflation to ease in the near future as the rate of expansion of currency in circulation has moderated. 

The swift expansion of circulating currency by the Federal Reserve helped expenditures to bounce back immediately after plunging in the second quarter of 2020. The growth rate of currency in circulation has been back to pre-crisis rates for at least 2 quarters. We should expect inflation and the growth rate of expenditures to follow and inflationary winds to subside as a result.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.

Markets Are Yelling Mayday

Estimated Reading Time: 3 minutes

Editors’ Note: As far back as last summer, The Prickly Pear began to warn about 2022 being a “risk-off” year.  Those elements of the economy, including stocks, bonds, cryptocurrencies, and real estate that have been elevated by easy money, will tend to suffer when the easy money is taken away. We are now well into the process as the author explains. However, market action will be uneven, and markets rarely decline without lots of zig-zag interruptions. Recent data suggest the market are for the moment getting very oversold, pessimism is running deep, and under those conditions, a contra trend rally or bounce can be expected. If we are correct that such a rally will ensue fairly soon, this may be the last opportunity for investors to sell into strength to make whatever asset allocations adjustments they and their advisor may feel necessary for their particular circumstances. However, in the somewhat longer term, all markets will have to adjust to a higher interest rate environment, less monetary stimulation, and likely a slowing economy.

 

An aircraft pilot about to crash will repeat the distress signal “Mayday.” Throughout the “May days” of this month so far, financial markets have been sending distress signals that may indicate an imminent crash of their own. The major stock market indices have all been experiencing steep sell-offs since May 4, extending a decline that began around the end of March.

Most analysts attribute the sell-off to inflation fears. Traders aren’t worried about how inflation will directly affect the economy, but how it will influence the decisions of a handful of bureaucrats. They fear that it will lead Federal Reserve officials to tighten the money spigot that is driving the inflation in the first place.

The Fed’s money pumping has driven up prices across the board, but especially the prices of capital goods (the value of which is derived from the value of the future consumption goods they will yield) relative to present consumption goods. That ratio, as Austrian economists explain, is the basis for interest rates. By distorting it with its money pumping, the Fed has artificially lowered interest rates so as to “stimulate” the economy.

This has been the Fed’s standard operating procedure since its founding in 1913, but it has precipitously ramped it up since the advent of Covid in order to prop up an economy staggering under the burden of draconian governmental responses to the disease.

If, as traders fear, the resulting inflation prompts the Fed to ease up on the money pumping, that will allow interest rates to rise by pulling out the props holding up capital prices at artificially high levels relative to present consumption goods. This upheaval in relative prices will translate into severe losses for most businesses, revealing that, lured by the Fed’s artificial stimulus, they had overextended themselves.

This general spike in market losses is what’s known as a “crash” and “recession.”

Wall Street is right to expect it, but it would be wrong to push for policies to forestall it, as it often does. A recession is a tough time, but it’s not a bad thing. The artificially inflated bubble was the bad thing. An economic bust is a necessary and beneficial repair of the economic distortion and damage that occurred during the deceptively pleasant artificial boom. The more you delay this repair, the more distortion and damage will accumulate, and the more painful the later repair will have to be.

The bust we need will be extremely painful because the Fed has been money-pumping at ever-increasing unprecedented levels and without stint since the financial crisis of 2008. But kicking the can down the road even further will only mean an even more painful bust when the Fed finally does relent.

And that’s if we’re lucky. If the Fed never relents, its policy will eventually result in hyperinflation, which can be a civilization-killer.

The market is crying out Mayday. Let it crash. And then let it rebuild and re-ascend sustainably under its own power.

The government got us into this mess, but only the market can get us out. And, as the poets say, the only way out is through.

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This article was published by FEE, Foundation for Economic Education and is reprinted with permission.

Weekend Read: For the Least of These: Against Inflation Economics

Estimated Reading Time: 7 minutes

Just twenty years ago, economists and bureaucrats triumphantly proclaimed the apotheosis of macroeconomic stabilization policy. The “Great Moderation” saw a long spell of full employment, income growth, and low and steady inflation. How we long for those days now!

While labor markets appear healthy, this could quickly change. Meanwhile, inflation has surged: Consumer prices are up more than 8 percent, and producer prices more than 11 percent, from a year ago. We haven’t seen inflation this bad in more than a generation. Wages are rising, too, but not enough to keep up with inflation. American households are getting squeezed. Political unrest is increasing. And continuing global conflict will only make market turmoil worse.

It’s very tempting to return to the policy consensus of yesteryear. But that would be a mistake. While U.S. economic performance was admirable during the late twentieth century, it rested on a Faustian bargain: we accepted the harmful idea that economies needed some inflation—just a little bit—to grease the wheels. As a result, we put far too much power in the hands of unaccountable central bankers. Subjecting monetary policy to bureaucratic whims is one reason we experienced, in barely over a decade, a crippling financial panic and record-breaking inflation.

It’s time to set the record straight. We don’t need inflation to achieve full employment and economic growth. Dollar-depreciation economics just isn’t true. Furthermore, there are strong moral arguments against tolerating inflation. Descriptive economics and prescriptive political economy concur: When it comes to monetary policy, we need to fundamentally change the rules of the game.

Inflation doves claim dollar depreciation has beneficial economic consequences. Inflation increases investment by raising the returns on securities relative to highly liquid forms of wealth, such as cash or checking accounts. Furthermore, because inflation decreases real (purchasing power–adjusted) wages, it makes hiring workers easier. If central bankers keep inflation in the 2 percent range, they can supposedly give the economy a permanent shot in the arm.

Not so fast. Markets don’t work this way. These views rely on a permanently exploitable form of “money illusion,” whereby the public never gets wise to policymakers’ tricks. But even a passing conversation with American citizens reveals they’re well aware of when inflation happens and what it does to their earnings. Nor are they rubes when it comes to their investment choices. When we dig a little deeper, we see the inflation doves make two big errors.

Two Economic Errors of Inflationary Policy

First, inflation doves fail to recognize that investment returns respond to the dollar’s purchasing power. Interest rates on securities such as bonds have two components: the desired rate of return and compensation for inflation over the duration of the asset. When markets expect more inflation, suppliers of capital demand higher returns. Demanders of capital are happy to oblige: paying more in depreciated dollars doesn’t sacrifice real purchasing power. This blunts the effects of inflation on investment.

Its true inflation disincentivizes holding cash and other liquid forms of wealth. But if anything, this is a cost, not a benefit! As a tax on liquidity, inflation causes people to reduce their liquid wealth holdings, because these holdings rarely scale with inflation the way other securities do. Cash, of course, has no yield, so when inflation increases, holders of cash eat the entire dollar erosion. To the extent people try to avoid this stealth tax, society becomes poorer. Having cash and cash substitutes on hand is useful to meet regular transaction demands. Avoiding the inflation tax means people use up other resources, including time, to economize on liquidity. All those resources could have been put to some beneficial purpose in the absence of inflation.

The second error is a special case of the first. It merely happens in labor markets instead of capital markets. Just as investors are sensitive to their purchasing power–adjusted returns, workers are sensitive to their purchasing power–adjusted wages. People aren’t blind. They see prices rising at the car lot, the rental office, the gas pump, and the grocery store. Because we negotiate wages less frequently than other prices, inflation does lower wage values for a little while. But once people get wise and are free to renegotiate, they demand higher dollar wages to compensate for their lost purchasing power. Since employers are enjoying higher dollar incomes, they don’t mind paying higher dollar wages. But the dollar is cheaper than it once was. Net result: neither employers nor employees can afford more goods and services than before.

The persistence of dollar-depreciation economics is best explained by the prejudices of the political class, not the strength of its arguments. Many policymakers, including central bankers, believe the economy would flounder without their constant supervision and intervention. They exaggerate the problems with markets and—much more importantly—the efficacy of technocratic solutions. Yet there’s something more insidious than policy ineffectiveness going on here. If the only problem with inflation were that it didn’t work, it would be, at most, an irritant. This overlooks the moral aspects of inflation, which are grave indeed.

If economics is a science, political economy is an art. When we participate in public discourse, we’re not having a narrow economic conversation. We’re having a broad political-economic conversation. Value-free economics ends where value-laden policy proposals begin. And when we look at the values implicit in inflationary policy schemes, we see much that should offend us. To paraphrase the great Chicago political economist Frank Knight, we must grab the bull by the tail and stare the situation square in the face.

Inflationary Policy Fails Conventional Normative Tests

If, as we’ve argued, the positive economic analysis of low-inflation-as-shot-in-the-arm for the economy does not hold, what does that imply for normative judgment and prescription?

There are some who are unable to avoid inflation. As we noted, cash has no yield. Those who rely heavily on cash, such as the unbanked, are hurt the most by a depreciating currency. Who are these people? According to a 2019 Federal Deposit Insurance Corporation report, “Younger households, less-educated households, and Black, Hispanic, and American Indian or Alaska Native households were more likely to use [nonbank financial] transaction services, as were lower-income households and households with volatile income.”

Simply put: the poor with low credit, and especially minorities among them. Not only do their cash holdings suffer under an inflationary regime, but their relative lack of formal education—itself likely a reflection of broader social injustices—means they have less leverage with which to negotiate for better wages to compensate for eroded real incomes.

There is virtually no normative framework that justifies a policy regime that burdens the poor and marginalized. Since there’s no clear upside to inflation, its regressive effects are prima facie unjustifiable. Consider two of the most prevalent political-philosophical paradigms:

Rawlsian justice-as-fairness would say that from the “original position” behind the “veil of ignorance,” no reasonable person would favor an institutional arrangement that disproportionately hurts those at the bottom of our economy as does inflationary monetary policy. If one were to enter into this economy not knowing in what socioeconomic position one would start, no one would favor a system in which those at the margins of our society are handicapped against upward mobility by monetary policy. Yet this is precisely the barrier current policy places in their way.

Similarly, if the supposed benefit to investment is illusory, as detailed above, Pareto optimality would also come down in favor of monetary stability. Since market bargaining eliminates the supposed beneficial effects of inflation on investment and employment, the poor would gain and nobody else would lose if we could transition to a non-inflationary regime. Our current monetary framework is not Pareto optimal: by rejecting inflationary monetary policy, we could benefit one or more groups of people—in this case, the poor—without hurting others.

Yet both of these examples, while normative, are not quite moral. They are instrumental arguments, rather than intrinsic arguments, and thus neglect an important dimension of normativity. Morality has to do with what is best because it is good for its own sake. It is concerned with what is and contributes to the “good life” for human beings qua persons. Several interrelated moral perspectives add additional weight to our critique.

The personalist tradition, adopting Immanuel Kant’s second formulation of his categorical imperative, insists that persons, as rational beings, must never be treated as means to an end but always as ends in themselves with inherent dignity and worth. Imposing the costs of inflation upon the savings and incomes of the poor for the sake of an ephemeral—or worse, imaginary—economic stimulant effectively uses one group of people for the ends of another. The cash holdings of the poor may not be much, but those savings should be theirs to use as they choose, without being stealth-taxed by a misguided inflationary policy with no justification for the common good.

Speaking of the common good, the Catholic tradition of social thought defines it as “the sum of those conditions of social life which allow social groups and their individual members relatively thorough and ready access to their own fulfillment.” Certainly, the capital and income needed for one’s livelihood fall within these categories. Furthermore, we cannot simply look out for our own interests, but through the principle of solidarity, “every social group must take account of the needs and legitimate aspirations of other groups, and even of the general welfare of the entire human family.” Thus, morally speaking, the inherent dignity of each human person not only serves as the foundation of individual rights but of our responsibilities to one another. Inflationary policy injures, rather than serves, the common good, and by the principle of solidarity people cannot overlook the harm done to others, even if it does not directly harm them.

There is a relation here to Kant, whose principle incidentally has ancient Christian antecedents and has been integrated into broader personalist social thought by figures such as the nineteenth-century Orthodox Christian philosopher Vladimir Soloviev or Pope John Paul II, among others. As Soloviev put it, “Pity which we feel towards a fellow-being acquires another significance when we see in that being the image and likeness of God. We then recognize the unconditional worth of that person; we recognize that he is an end in himself for God, and still more must be so for us.”

So, too, on this personalist moral basis we must regard inflationary policy not merely as mistaken but, in a sense, inhumane. Indeed, this personalist ethic formed the anthropological foundation of the German economist Wilhelm Röpke’s Humane Economy: “I see in man the likeness of God; I am profoundly convinced that it is an appalling sin to reduce man to a means.” And Röpke, too, criticized inflationary policy along the same lines we have above, writing, “no great perspicacity is needed to recognize the close kinship between lack of respect for property and indifference to the value of money.” To the extent the poor often must rely on cash as a store of value, the two coincide. Inflationary policy lacks basic respect for the property of the poor.

Of course, public policy is always imperfect—morality is not reducible to law. But neither may law violate morality. Rather, as Thomas Aquinas argued, civil law must be based upon, while also striving to approximate, the natural moral law in the particular circumstances of our political life together. Likewise, our monetary policy ought to contribute to the common good, rather than detract from it as it does now.

A more responsible monetary regime isn’t about scoring partisan points, nor is it reducible to economic soundness. Good money does require good economics, but this isn’t sufficient. Rather, monetary stability is a matter of striving for a more humane economy, especially for the poor. Like all economic institutions, monetary institutions should enable all persons to flourish. As inflation ravages the U.S. economy, it’s clear our monetary policy—and the unaccountable technocratic-bureaucratic class that implements it—fails this basic test.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.

The Renewed Politicization of the Federal Reserve

Estimated Reading Time: 4 minutes

Economic research shows that monetary policy works best when conducted by an independent central bank. After Fed chairs in the 1960s and ‘70s caved to pressure from American Presidents, those who followed sought, at least to some degree, to reestablish the Fed’s independence. Until now, that is.

Since 2019, the Fed has politicized its activities in virtually every way: through its monetary policy goals, the use of its enhanced balance sheet, its regulatory actions, and its emergency lending activities. Each of these changes has pushed the Fed further from being an effective and independent central bank toward becoming a purely political institution, which prevents it from choosing the best policies for Americans and the US economy.

Monetary Policy: “Inclusive” Employment and (Flexible) Average Inflation Targeting

Fed officials, including current Chair Jerome Powell, have acknowledged that monetary policy is a broad tool that cannot be used to address the problems of racial and income inequality. Despite this admission, however, the Fed has injected the issue of inequality into its monetary policy goals.

In August of 2020, the Fed rewrote its statement of goals and strategy to emphasize employment ahead of inflation. The new language described the maximum employment goal as “a broad-based and inclusive goal that is not directly measurable.” Chair Powell cited racial differences in unemployment rates as a motivation for the change. This shifted the Fed’s goal from focusing on the best outcome for most Americans to a purely discretionary target, which the Fed admits is impossible to measure.

At the same time, the new objectives stated that the Fed would target a rate of two percent inflation averaged over time, giving Fed officials greater ability to deviate from the prescribed rate of two percent annual inflation. Moreover, Fed officials have since revealed that they only intend to seek an average of two percent when it has previously been below target. When inflation is above target, in contrast, the Fed will allow it to remain so and will not bring it down enough to return to the previous price-level trend.

Taken together, these two changes relax the traditional constraints on the Fed’s ability to engage in overly-expansionary monetary policy. When warned that the policy is too loose, they can point to their expanded employment goal to justify the policy. Then, when inflation rises above two percent, they can claim that it is temporary and will not affect the average rate of inflation in the future.

The irony is that such an approach would likely produce exactly the opposite of what is intended. To the extent that emphasizing maximum employment (in the broader sense) and ignoring temporary periods of above-average inflation results in overly-expansionary monetary policy, it risks recessionary corrections and even lower employment than would have occurred had the Fed stuck with its previous policy.

In early 2021, for example, Chairman Powell testified that the Fed planned to keep its interest rate targets near zero until the economy reached maximum employment, a policy it maintained throughout 2021 despite record inflation. Powell now says the US labor market is “unsustainably hot,” but the Fed has taken only minimal action to calm the labor market or bring down inflation. Many commentators are already expressing concerns about a looming recession.

Balance Sheet Activities: Fiscal Accommodation

Through the use of large-scale asset purchases (LSAPs), also known as quantitative easing (QE), the Fed has massively expanded its balance sheet from less than $1 trillion in 2008 to almost $9 trillion today. While the federal government increased fiscal spending by $5 trillion in response to the Coronavirus pandemic, the Fed bought up more than $3.4 trillion in Treasury securities since 2019, effectively monetizing a large portion of the fiscal deficit.

While some economists applauded the Fed’s fiscal accommodation, debt monetization is not a prudent action of a responsible central bank. Those that engage in such activities encourage profligate spending by their fiscal authorities, which often ends up in fiscal default. Such massive purchases of Treasury securities were enabled by the Fed’s enlarged balance sheet and would not have been possible in the pre-2008 system.

Emergency lending: Everyone Gets a bailout!

One traditional function of central banks is that they act as emergency lenders in times of financial crises. Although the Fed’s 2008 emergency lending deviated from the rules of the classical lender of last resort, former Fed Chairs Bernanke and Yellen respected the limits of the Fed’s authority as understood by economists and stated in the Federal Reserve Act.

Not so for Jerome Powell. Despite the fact that 2019 was not a case of “unusual and exigent” circumstances in terms of bank failures or shortages of financial liquidity, the Fed initiated a variety of emergency lending facilities beyond those of the 2008 crisis. The Fed lent to non-financial companies and state and local governments, which former Fed chairs said it should never do.

These actions disturb the efficient allocation of capital in the financial system and further heighten the Fed’s political profile.

Regulation: Climate and Industrial Policies

Bank regulators have increasingly used their regulatory powers to discourage banks from supporting politically unpopular industries, such as oil and gas, firearms, and medical marijuana. These punitive measures often take the form of discretionary enforcement actions, which lack the transparency and immutability of rules passed through the regulatory process.

Fed regulators have now turned their sights to climate change and the supposed threat it poses to US banks. The Fed subjects banks to “climate stress tests” and has joined international central banks’ Network for Greening the Financial System (NGFS), whose stated goal is to “support the transition toward a sustainable economy.” While these changes are ostensibly made in the name of limiting banks’ risk exposure, their result in practice will be to harm the US economy by preventing banks from lending for specific purposes such as the production of energy and fossil fuels.

The Fed’s Politics Threatens Its Independence

Fed officials have gone beyond policy discretion into overt political activism. President of the Minneapolis Federal Reserve Bank Neel Kashkari has been reprimanded by Senator Pat Toomey for his recent political actions. In 2020, former New York Fed President Bill Dudley argued that “Fed officials should consider how their decisions will affect the political outcome” by potentially withholding monetary accommodation in order to prevent the re-election of President Donald Trump. Such actions reveal these officials to be political opportunists rather than independent central bankers.

Independent central banks tend to deliver better monetary policy. But independence can only be maintained by focusing on the narrow goals assigned by Congress. By straying from its mandate, Fed officials have chosen to base their decisions on politics rather than on sound economics.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.

Prices Continue to Rise, Exceeding Fed Projections

Estimated Reading Time: 2 minutes

New data from the Bureau of Economic Analysis shows that prices continue to rise at breakneck speed—and much faster than the Federal Reserve has projected. The Personal Consumption Expenditures Price Index (PCEPI), which is the Fed’s preferred measure, grew at a continuously compounding annual rate of 6.3 percent from March 2021 to March 2022, up from 6.1 percent in the previous month.

Prices have grown 4.0 percent per year since January 2020, just prior to the pandemic. If the Fed had instead delivered 2-percent inflation over this period, prices would be 4.6 percentage points lower today.

Figure 1. Price Level and 2-percent Growth Path

The surge in prices has caught most households off-guard. Perhaps more surprisingly, it has caught Fed officials off-guard, as well. Federal Open Market Committee members have consistently under projected inflation since December 2020. The median FOMC member projections for inflation, which the Fed reports in its quarterly Summary of Economic Projections, are presented in Table 1. In December 2020, the median FOMC member projected inflation would be just 1.9 percent in 2022. The projection climbed to 2.6 percent by December 2021. In March 2022, when the Fed released its most recent Summary of Economic Projections, the median FOMC member projected prices would grow 4.3 percent this year.

Median Inflation Projection

Projection Date 2021 2022 2023 2024 Longer run
December 2020 1.8 1.9 2.0 2.0
March 2021 2.4 2.0 2.1 2.0
June 2021 3.4 2.1 2.2 2.0
September 2021 4.2 2.2 2.2 2.1 2.0
December 2021 5.3 2.6 2.3 2.1 2.0
March 2022 4.3 2.7 2.3 2.0
Table 1. Median FOMC Member Projections for Inflation

Yet, even the most recent revision appears to be insufficient. Forecasts of the price level based on FOMC member projections, which Morgan Timman and I produce for our Monthly Inflation Report, are presented in Figure 2 along with the price level. Prices are currently 0.8 percentage points higher than they would be if they were in line with the median FOMC member projection made in March. They are currently on track to grow 7.1 percent this year.

Figure 2. Price Level and Forecasts Based On FOMC Member Projections

Although Fed officials have revised up their projections for inflation considerably, they have not meaningfully changed their course of policy from what was announced last December. It is now clear that those plans were made with very optimistic projections of inflation in mind. Those projections have since been shown to significantly underestimate the extent of the problem. If the Fed were committed to bringing down inflation over the same time horizon, it would have no choice but to increase the speed or intensity of its plan to tighten. That it has not done so reveals that it is unlikely to bring inflation down as quickly as it previously suggested. Indeed, its most recent projections reflect this. The Fed now projects inflation at 2.7 percent in 2023 and 2.3 percent in 2024, up from the 2.3 and 2.1 percent projections made back in December.

The Fed seems resolved to see inflation climb further. I expect FOMC members will revise their projections of inflation again in June. They should revise their course of action, to bring inflation down as planned, instead.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.

Endgame For the Fed: Is Checkmate Coming?

Estimated Reading Time: 6 minutes

For more than 40 years, the Federal Reserve has fostered, encouraged, and otherwise helped to create the most reckless credit expansion in the nation’s history. Total credit market debt of all varieties — federal, state, local, household, financial and nonfinancial – has ballooned from 330 percent of gross domestic product in 1960 to over 900 percent of gross domestic product in 2021. Adjusting for the size of the economy and for inflation, we now have three times as much credit and debt as we had in 1960.

In many ways, credit can be a wonderful thing. It can enable a worker of meager financial means to acquire a motor vehicle that will allow him to take a job otherwise inaccessible to him via public transportation. It can enable a young married couple to buy a house and to build equity in that house over the 30-year term of the mortgage or deed of trust. Credit can enable an entrepreneur to buy a business and to do a better job of running the business than the previous owner was able to do.

The expansion of credit on a nationwide scale is expansionary in economic terms because virtually no one borrows money to put it under a mattress. People borrow money to spend it, whether on goods and services or on investment assets. The spending of borrowed money on goods and services buoys the real economy, creating demand for a product that would not otherwise exist. It also buoys investments, such as stocks, bonds, and real estate. For example, real estate rises in price because of the availability and price of credit. If you doubt this, ask yourself this question: if it were totally impossible to borrow money to buy a house if you could buy a house only by paying the full purchase price in cash, how much would houses sell for? The answer is obvious, isn’t it? They would sell for far, far less than they sell for today.

Although taking on more debt puts money into a borrower’s pocket, debt service — paying interest and principal — takes money out of that borrower’s pocket. That means less money the borrower has to buy goods and services or invest. Overall economic effects on the nation, though, are determined not on an individual borrower basis but on the basis of all the borrowers and lenders — on a nationwide basis, in other words. As long as credit and debt are expanding on a nationwide basis, expansionary economic policies remain in effect. The economy remains robust, unemployment rates remain low, and for the stock and bond markets it’s “party on, Garth.”

But what happens if, for whatever reason, credit and debt (the mirror side of credit) begin to decline on a nationwide basis? Should that occur, the amount of money flowing into goods and services into the purchase of goods and services would decline, as would the amount of money flowing into investment assets. In economic terms, this is contractionary. Because the amount of credit and debt outstanding is in the trillions, if the magnitude of the contraction in total credit outstanding were sufficiently severe, the resulting economic contraction could quickly turn into an economic depression far exceeding anything this country or any other country has ever experienced. Society would unravel.

The Fed has striven mightily to prevent this from ever occurring. The Fed’s response to economic developments in 1987, 200-2002 and 2007-2009 has been the same: “flood the market with liquidity.” Do whatever needs to be done to keep total credit from contracting, because that will spell disaster. If credit does indeed contract in large amounts, the Fed will be exposed as having run the greatest Ponzi Game in history. The truly massive amount of debt it has created — measured not in the billions but in the tens of trillions — will be the fuel for a giant crash. As Warren Buffet famously said, it’s not until the tide goes out that you learn who has been swimming naked. It’s no accident that Ponzi games such as Enron and Madoff Securities are not exposed until the stock market crashes.

The Fed’s tools to prevent a devastating credit contraction and crash — flooding the market with liquidity — don’t work to curb rising inflation. Flooding the market with liquidity would only make inflation worse. The Fed’s tool to combat inflation is to raise interest rates — to raise debt service requirements. That is where the Fed is now. Consumer price inflation is bubbling along at an 8.5 percent rate (the highest in 40 years). Producer prices are galloping at an even higher rate: more than 11 percent. When inflation was 7.6 percent in 1978, the Fed pushed the federal funds rate to 8.5 percent. And now, with inflation higher than it was in 1978, where is the federal funds rate? At 9 percent? No. At 8 percent? No. At 7 percent? No. It is at 0.33 percent!

The Fed is hugely behind the curve. The most recent rise was a paltry one-quarter of one percent. The Fed is clearly terrified at the prospect of raising interest rates, otherwise, the rate increase would have been at least one full percentage point or more. The Fed is demonstrating by its actions that it is not serious about fighting inflation. It is gambling that inflation will subside of its own accord, with little help from the Fed.

If over the next six months to one year, inflation does indeed subside, with the federal funds rate rising to perhaps 1 percent or 1.5 percent, the Fed will be shown to have made the correct decision. But no one has a crystal ball in that regard.  If the inflation rate keeps advancing, and we have double-digit consumer price inflation six months or one year from now, the Fed’s hand will be forced. Serious interest rate increases will be required. In that scenario, the probability that the Fed will err, either on the upside (raising interest rates too high and creating a market panic and resulting crash) or on the downside (runaway, Weimar-style inflation as a result of tepid interest rate boosting) hugely increases.

The historical precedents here are strongly against the Fed. The market can panic more quickly than the Fed can counter the decline by lowering interest rates and engaging in “quantitative easing.” Note that 2000-2002 was a more serious downturn than 1987 and that 2007-2009 was more serious than 2000-2002. The trend is clear. The next downturn likely will be far worse than 2007-2009 if the Fed errs in the direction of raising interest rates too far or too fast. The reason for this is that declines are generally roughly proportional to the amount of total credit market debt outstanding.

To date, the equities markets have come back after each drubbing, but if a decline goes far enough, that pattern may not necessarily repeat. Instead, we may end up in a Japanese/Nikkei scenario where equity prices in 2050 or 2060 are lower than they are today. Note that the Nikkei is lower now in 2022 than it was 33 years earlier in 1989. In Great Britain, following the disastrous South Sea Bubble, equities went into a more than 50-year bear market.

The historical precedents are not any better if the Fed errs on the downside and allows inflation to really get out of control. Inflation has a way of accelerating, as the Weimar experience shows. (The source of the data that follows is “The Great Disorder” by Professor Gerald D. Feldman, a 900-plus page tome that will tell you more about Weimar Germany than you ever wanted to know). In August 1914, the dollar exchange rate of the paper mark in Berlin was 4.21— one U.S. dollar would buy 4.21 marks. At the time of the Armistice in November 1918, it was 7.43. Things became steadily worse after that. By January 1922, one U.S. dollar would buy 191.81 paper marks. Relatively speaking, though, that had been a walk in the park compared to the complete and utter disaster —- resulting in the total destruction of the mark, and I do mean total —that unfolded beginning in August 1922 and finishing up a mere 16 months later in December 1923.

In August 1922, one dollar bought 1,134.56 paper marks. By June 1923, one dollar was buying 109,966 marks. Was that the end of it? No, things got worse, much, much worse. Two months later, in August 1923, one dollar would buy 4.6 million marks. One month after that, in September 1923, a dollar would get you almost 99 million marks. In October 1923, the exchange rate was 25 billion paper marks for one U.S. dollar. By December 1923, one dollar would get you 4.2 trillion marks.

One conclusion that may be drawn is that it took only about five years for inflation to destroy the mark. Another is that when things really get out of control, as they did for Germany beginning in August 1922, the end is nigh, as little as 16 months away.

In conclusion, the Fed is now sailing between Scylla and Charybdis, between the monster of a stock market crash and resulting depression on one hand and the whirlpool of runaway inflation on the other. Despite an 8.5 percent inflation rate, the U.S. dollar has remained strong. Across the Pacific in Tojo-land (Japan), the Japanese yen has been rapidly depreciating. Japan is even farther along the economic-profligacy scale than the U.S. is. The ratio of debt to GDP is far higher. The Japanese economy has been aptly described as “a bug in search of a windshield.” Keep an eye on Japan: it may provide an important clue of what finally happens when monstrous credit and debt expansion over decades (especially sovereign debt) goes off the high board.