Tag Archive for: FederalReserveInflation

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

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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.

*****

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

Even When There Is Inflation, the Fed STILL Fights Falling Prices

Estimated Reading Time: 5 minutes

Under any remotely sound money regime, the aftermath of war and/or pandemic is highly likely to feature a sharp decline in the prices of goods and services on average. Even under unsound money regimes, there are powerful forces operating towards lower prices once the war/pandemic recedes. Strong injections of monetary inflation, however, can overpower them.

The Fed and all the foreign central banks which follow its lead and/or doctrines are apparently of the intention that this time the decline in prices will not take place. Instead, they state the aim of their monetary policies, to be achieved within two years, as a decline of the inflation rate from present near-term highs to 2 percent.

In combatting the powerful “natural rhythm” of prices downwards in the aftermath of pandemic and war we should expect the Fed and foreign central banks to marshal a tremendous amount of monetary power. That will occur beyond an intermission where central banks are ostensibly trying to rein back the monetary inflation which has reached its peak virulence in 2021–22.

Precise measurement of monetary inflation, including its stages, is impossible under the present monetary regime where the supply and demand conditions for monetary base—and the attributes of base money—have been deeply corrupted. In thinking about the next monetary inflation injections, history provides considerable insight.

The aftermaths of supply shocks are full of inflation danger, even though recession intervenes and mitigates this for some time. Monetary inflation has accompanied all the great supply shocks and sometimes preceded them as in the present case of pandemics and war. Here monetary inflation stretches all the way back to 2012/13.

In the aftermath of World War I and the Spanish flu pandemic (1918–19), US consumer prices fell by around 20 percent (from mid-1920 to end-1921). The fall in prices stemmed both from deliberate monetary deflation (starting in late 1919 as the Benjamin Strong–dominated Fed sought to reverse the monetary inflation in the half-year following the armistice) and the easing of supply restraints (with huge gluts developing for many primary commodities).

After World War II there was an almost 5 percent decline in CPI from mid-1948 to the end of 1949, overlapping the recession of November 1948 to October 1949. There was no sudden substantial monetary policy tightening during that time. But the around 30 percent rise of consumer prices during 1946–47 coupled with the constancy in the outstanding supply of high-powered money stock meant this shrunk far in real terms. Accordingly, the overhang of excess money supply dwindled.

Towards the end of the Korean War (1950–53) and into its aftermath consumer prices were relatively flat (mid-1952–55), having risen by almost 12 percent between mid-1950 and the end of 1951. That was despite the McChesney Martin Fed following an inflationary monetary policy as evident first in asset inflation and later in an eruption of consumer price inflation (the second half of the 1950s). In effect, the “natural rhythm” downward of prices as wartime constraints eased and a sustained leap in productivity growth got under way meant that monetary inflation did not produce at first the symptom of consumer price inflation.

Toward understanding the potential strength of price reductions in these examples, we turn to the concept of the “natural rhythm of prices,” already highlighted in the above summary. “Natural rhythm of prices” transcends and goes well beyond the familiar statistical distinction between overall CPI inflation and so-called core inflation (which strips out food and energy). It refers to persistent moves in an upward or downward direction of prices of goods and services which are not attributable to money supply veering persistently ahead of demand (monetary inflation) or below demand (monetary deflation).

Why “natural”? Because the direction of price change as measured in aggregate is in harmony with how real economic changes underway would influence the pricing decisions of individual firms (if indeed there were no offsetting monetary forces thwarting this).

For example, during an economic expansion when productivity growth is surging, firms in competitive sectors would tend to cut prices in line with falling costs as brought about by efficiency gains. Incomes would rise faster in real terms than in nominal terms. Correspondingly the path of demand for money would not shift substantially and remain broadly in line with the slowly growing money supply. Hence, under a sound money regime, declining prices would be consistent with no monetary deflation or inflation.

Turn next to the natural rhythm of prices in the context of the economic journey from the pandemic and/or wartime shortages to resource abundance. The increased scarcity of supplies prompts many businesses to raise their prices. At the same time, the shortage including dislocations goes along with a fall in real incomes. So, overall demand for money might not change significantly (unchanged pace of growth in nominal incomes made up of some decline in real terms and big price rises). If the money supply is on an unchanged low path, then the increase in prices does not signify monetary inflation. Correspondingly there would be no symptoms of asset inflation.

By the same token once peak scarcity has been reached and resources become more plentiful, real incomes rise, prices fall, and the demand for money would still be in line with very slowly growing supply. Falling prices would not indicate monetary malaise but natural rhythm.

In the actual context of the massive fiscal “stimulus” in the US during the pandemic, most households felt much better off even though for society as a whole it was a period of hardship. Real disposable incomes and real demand for money increased; money supply veered far ahead of money demand but not by as much as first appearances might suggest.

Even so, we can say that the increase in underlying prosperity in aftermath of a pandemic and/or war means that the demand for money in real terms is likely to be increasing by more than normal. A fall in prices would be consistent with money demand rising in line with the slowly growing money supply.

Instead, the central scenario is surely that the Fed has flooded the system with so much money (only some of the excess removed during the period of hawkish turn and taking account of cumulative price rises) that the natural downward rhythm of prices will not show up in outward reality. Rather, the Fed will use the relief from symptoms of inflation in the consumer price data to double down on monetary inflation. This would show up at first in a new episode of asset inflation. It will be boom time for government collections of monetary repression tax (this corresponds to interest rates manipulated by the central bank at artificially low levels whilst CPI inflation remains low).

It is not too early for investors or the more general public to concern themselves about the next wave of monetary inflation. Many worry that the Fed may pull back from monetary tightening on the first signs of recession rather than completing the task of bringing inflation back down to 2 percent and keeping it there. That is likely to prove a false version of the problem.

More likely the Fed will keep tightening policy into the first stages of the next recession—that is just par for the course. Inflation may fall below the banner 2 percent. Then the Fed will unleash a powerful monetary stimulus rather than simply allowing the money supply to continue growing at a slow pace with a powerful natural rhythm of prices downwards pulling the economy forward.

The monetary inflation of 2012–22 is dead! Long live the monetary inflation of 2023 onwards!

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

And A Bear Came to Wall Street

Estimated Reading Time: 5 minutes

The last time we provided you with market commentary was in late May.

You might recall, that our position since last summer was that when the Fed took action to constrain inflation, all the markets that had been elevated by easy money policies and zero interest rates would face a challenge.

The market had fallen so far and so hard by our last visit, that we suggested a respite, at least a temporary contra trend rally. We got one from late May into mid-June, but it was feeble and short-lived.

Since then, it has been like being mauled by a Kodiak bear. In 5 of the last 7 sessions, more than 90% of stocks on the NYSE fell. According to Jason Geopfert at SentimentTrader.com, this is the worst bout of selling in the S&P since 1928!

From the May 27 temporary peak, the most widely followed average shed about 11.5 %.

About the only positive thing you can say about this is that such extremes tend to indicate capitulation. Maybe we get the contra trend rally?

On the NYSE, 7531 issues are below their 200-day moving average, one of the most lopsided readings everSo, while the percentage losses are still within the “normal” range as bear markets go, the market internals is breaking records. Weakness has been severe and very widespread.

The Fed has painted itself into a corner.  If it did not fight inflation by reversing policies, markets would lose confidence that they were serious and inflation would run wild. Previous fake attempts to slow down money growth and raise rates had ended at the first sign of pain, and so the Fed had to deliver or their credibility would be shot. 

They started late to the game and many market participants did not take them seriously. Remember when the Fed said they wanted inflation above 2%? What a policy catastrophe!

If they address inflation urgently, it meant most markets that have flourished over the past decade would be in big trouble when the policy is reversed. That was the basis of our macro thesis and that certainly has proven to be the case.

We called this the “investor’s dilemma” because there just are not many good choices when multiple markets have been elevated by easy money to extreme valuations, and then the monetary regime is reversed. Even cash, which is price neutral, is losing almost 9% per year because of the Fed and Biden-instigated inflationary policies. However, losing 9% is better than losing over 20%, and then losing the 9% in addition anyway because stock prices too are quoted in dollars losing value.

However, as we pointed out, he who loses the least is the winner in a bear market.

Markets put in a remarkable performance last year with stocks up 28%. We started 2022 near 4800 on the S&P 500 index. By early January, things started a severe downhill slide and it has continued with little interruption.

As of this writing, the S&P has now dropped 22%, officially in bear territory. Many other indices had already reached that threshold and have gone even further. This is also true of most foreign markets. In short, there has been no place to hide from the claws of the bear.

With rates rising, both stocks and bonds have been put under pressure, undermining the classic 60% stock, 40% bond allocation used by many advisors.

Both stocks and bonds have had the worst start of a year, in half a century so those doggedly determined to hang on to classic portfolio design have been hit hard.

Welcome to Biden economics!

Equity bear markets historically lose about 35%, on average. With losses now around 22%, that suggests we still have more to go. How much is unknowable. We will likely have bounces, but the trend is down.

A famous adage among those that practice technical analysis is that “a trend in force, is a trend in force until proven otherwise.”While very oversold at present, there has been no reversal yet of the bearish trend.

Just remember that an “average” is a mixture of prices, including high and low extremes. Given the extraordinary spending, deficits, market interference, a long period of zero interest rates, and speculation in everything from stocks, bonds, SPACs, NFTs, cryptocurrencies, art, and real estate; we can’t be assured this cycle will be average. Historically markets have a kind of symmetry, that is the more extreme the up cycle, the more extreme the down cycle.

Thus, the honest answer is nobody knows how bad this will get.

Much of the pattern since 1987, has been the Fed “put”. The “put” were both actions and statements made by the Fed that suggested to investors that the Fed had their back. They would cut interest rates and gun money growth to shorten and cushion the severity of stock cycles. But in so doing repeatedly, the Fed trapped itself. Today, rates can’t lowered if they are already zero, and the money supply cant’t be increased  if double-digit inflation is on the loose.

In the past, the exercise of the “put” was a constant interference in the market’s natural response to cleanse itself of excess.

Therefore, with today’s inflationary excesses, the Fed “put” appears inoperable. They now are much like a fire department that rushed to put out every little brush fire, allowing excessive underbrush to build up. Now they show up with a pumper truck empty of water facing a conflagration of their own making.

Stocks are not alone in this mess. Bonds have been remarkably weak with high yield or junk bonds getting pounded badly of late.

Cryptocurrencies have not proven to be anything like a store of value or alternative currency. The best ones such as Bitcoin are down a whopping 70%! And others have turned out to be either a fraud or so poorly constructed they could not function once investors wanted to get out. From a market cap slightly above $3 Trillion just this past October, we are now under $1 Trillion. Yes, $2 Trillion just vanished.

We sense, but cannot prove, that much of the rout in cryptos has spilled over into the stock market of late. There were skeptics, ourselves among them (see the archives for Cryptocurrencies and Financial Speculation). But little could be done to counter the hype. This raises an important question: where were the regulators?

Crypto promoters had an endless stream of sports figures and sexy media stars promoting their claims. The explanations were so complicated that many felt, even if they themselves could not understand the arguments, the complexity itself was proof of the brilliance of the promoters’ claims. You don’t want to admit confusion or doubt, do you? It is better to follow the Kardashians.

At this juncture, we are moving from modest losses in most people’s 401Ks to severe losses. If both stocks and real estate buckle together (and there is increasing evidence they are), families will have to pull back on spending.

Unlike the stagflation of the 1970s, we still have low unemployment and a record number of job openings. But if employment weakens along with the household net worth, consumers will become desperate.

There is already some evidence that the last few months of soaring credit card debt is consumer response to high food and fuel prices. Consumer spending is 70% of GDP. You can’t have the consumer get into trouble and avoid a recession in the real economy.

That is when the bear moves from Wall Street to inflict his depredations on Main Street.

 

When Did The Fed Change Its Tune?

Estimated Reading Time: 5 minutes

The Federal Reserve is finally taking a tougher stance on inflation. The Federal Open Market Committee (FOMC) raised its federal funds rate target by 50 basis points in May. It will likely raise its target by another 50 basis points when it meets in June—and then again in July. Fed Chair Jerome Powell has acknowledged there “could be some pain involved in restoring price stability,” but nonetheless concludes that “it’s something we have to do.”

To some, the Fed’s recent tightening appears to be too little, too late. The personal consumption expenditures price index (PCEPI), which is the Fed’s preferred measure, has been elevated for more than a year and began accelerating last October. But the Fed left its target rate unchanged until March and did not significantly change course until May. Even then, its move looked modest compared to the prevailing inflation. Bond markets continued to price in more than 2 percent inflation per year over the next ten years.

Why did the Fed wait so long to address the inflation problem? One might argue that Fed officials just didn’t realize inflation was much of a problem until it was far too late. However, this view appears to be inconsistent with most FOMC members’ projections of inflation, which exceeded 2 percent in March 2021 and have been ratcheted up each quarter thereafter. It also appears to be inconsistent with FOMC statements, which suggest Fed officials understood there was an inflation problem by mid-December 2021.

FOMC Statements

The FOMC releases a statement after each meeting to summarize its assessment of the economy and indicate how it will adjust monetary policy, if at all. These statements are carefully worded and do not change much from meeting to meeting. When changes occur, therefore, it provides some indication as to how the thinking of Fed officials has changed. In what follows, we identify significant changes in FOMC statements over the last fourteen months.

March 17, 2021 : “… Inflation continues to run below 2 percent. …”

At the onset of the pandemic, the price level fell below the growth path consistent with the Fed’s 2 percent inflation target. It did not return to that growth path until March 2021. Of course, it takes time to collect and report data. When the FOMC met on March 17, it had PCEPI data for January (released on February 28) and Consumer Price Index (CPI) data for February (released on March 10). Given the available data, it was reasonable to conclude that inflation remained below target—and that’s what the Fed did.

April 28, 2021: “… Inflation has risen, largely reflecting transitory factors. …”

When the FOMC met in late April 2021, it had PCEPI data for February (released March 26) and CPI data for March (released April 13). Based on this new information, the Fed changed its assessment. It acknowledged that inflation had risen, but attributed this to transitory factors. It did not expect inflation to remain elevated.

June 16, 2021: “… Inflation has risen, largely reflecting transitory factors. …”

July 28, 2021: “… Inflation has risen, largely reflecting transitory factors. …”

September 22, 2021: “… Inflation is elevated, largely reflecting transitory factors. …”

The FOMC continued to attribute the high inflation to transitory factors through September 2021. When it met in September, it had PCEPI data for July (released August 27) and CPI data for August (released September 14). Prices were clearly elevated. The July PCEPI data showed prices were 1.4 percentage points higher than the 2-percent growth path projected from January 2020. But the primary cause of higher prices was less clear.

If prices were elevated due to pandemic-related supply constraints, they could be expected to come back down when those constraints eased up. If, instead, they were elevated due to a surge in nominal spending, the Fed would need to take action to bring prices back down (or, see them remain elevated permanently). Fed officials apparently accepted the supply constraint view, maintaining that inflation was largely transitory.

November 3, 2021: “… Inflation is elevated, largely reflecting factors that are expected to be transitory. …”

The FOMC began changing its tune in early November 2021. Whereas it had previously attributed high inflation to “transitory factors,” it now attributed it to “factors that are expected to be transitory.” It was a small admission of doubt from a hitherto confident Fed.

Doubt about the transitory nature of inflation was certainly in order by early November. The FOMC had PCEPI and CPI data for September (released October 29 and 13, respectively), at the time. It knew prices had outpaced FOMC member projections (which had been revised up in both June and September) and were now 2.3 percentage points higher than the 2-percent growth path, despite relaxing supply constraints and strong growth in real output and employment.

December 15, 2021: “… Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. …”

The FOMC statement changed significantly in December 2021. The “transitory” term had been dropped entirely, in line with Chair Powell’s comments on November 30. The statement also acknowledged demand-side factors were contributing to inflation, which implied that prices would not return to normal unless the Fed took action to bring prices back down.

Somewhat surprisingly, given the clear change in the FOMC statement, the Fed did not take action to bring prices back down. It left its federal funds rate target unchanged in December and January. It made a modest 25-basis-point hike in March and then left its target there until May. In April, The Economist magazine asked whether the Fed could pull off an ”immaculate disinflation.” The Fed recognized prices were too high. But it was not doing anything to bring prices back down beyond hoping they would decline on their own.

January 26, 2022: “… Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation. …”

March 16, 2022: “… Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures. …”

May 4, 2022: “… Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures …”

In the January, March, and May 2022 statements, the FOMC continued to acknowledge that demand-side factors were contributing to inflation. It added “energy prices” and “broader price pressures” as contributors in March, reflecting the Russian invasion of Ukraine (and corresponding supply disturbances). But, otherwise, its statement was largely unchanged.

Conclusion

Monetary policy is difficult in real-time. Data is collected and released with a lag. Policy decisions have delayed effects. It is difficult to know what and how much to do in the moment.

The FOMC statements suggest that, by December 15, 2021, Fed officials understood inflation was at least partly the result of demand-side factors and, hence, needed to be brought down to some extent with contractionary monetary policy. And, yet, the Fed largely failed to act until May 2022.

One might excuse Fed officials for being late to recognize the inflation problem. Reasonable people can disagree about when the Fed should have known inflation was too high. But there is no excuse for the considerable delay before acting once the problem had been recognized. Perhaps a December 2021 rate hike would have spooked markets, as the Fed had just revised its view and had not had time to conduct forward guidance. But the Fed had opportunities in January and March. And it could have called a special meeting in February or April. Instead, it waited until May.

The Fed could have—and should have—taken prompt action to bring down inflation. It didn’t. Now inflation is much higher—and much harder to deal with—than it otherwise would have been.

*****

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.

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.

The Democrat Playbook: How To Look Like You Are Fighting Inflation Without Really Trying

Estimated Reading Time: 5 minutes

“Inflation is 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.”  Professor Milton Friedman

 

You want to bring down inflation? Let’s make sure the wealthiest corporations pay their fair share.  President Joe Biden

Inflation is the relationship between the quantity of money in circulation and the supply of goods and services.

Government and central banks can create money but they can’t create oil, copper, food, housing, hip surgeries, or Tootsie Rolls.  But government can create conditions that stifle the production of these things through taxation, regulation, import restrictions, and arbitrary credit restrictions.

The basic rule in dealing with inflation, if you are a Democrat, is to blame everyone, and everything, for the price spiral.  Never look at your own insane monetary and fiscal policy.  Then, start tinkering with the economy to show that you care.

Republicans have played the game as well, with wage and price controls by Nixon and WIN buttons (Whip Inflation Now) promoted by President Ford. But Democrats are better at the game.

Being old enough to remember the inflation of the 1960-1980 period, the tried-and-true response is to blame greedy corporations. From that follows the imposition of “windfall profits” taxes. Of course, inflation was only 1 ½% under Donald Trump, so corporations must have undergone tremendous change very quickly, with greedy people taking them over, just to frustrate Biden. That includes, of course, many of the “woke” corporations run by Progressives. They raise their prices as well.

Price controls are also part of the toolbox. Democrats know what the “just” and “honest” price should be, and thus they will attempt to fix prices to what they believe is the correct level.

The problem with price-fixing is well established since attempts go back to the Code of Hammurabi in Mesopotamia.

They were tried by Greeks and Romans, especially under Diocletian.

The Church (allied with the government) tried price fixing based on “the just” price during the Middle Ages.

Almost all Socialist governments do the same, to some degree or another. Things like the Medicare Codes, which fix the price for specific procedures, are a good example. So is rent control in Democrat-controlled cities like New York.

If you establish a price above what the market determines through free exchange, based on real supply and demand data, it will create surpluses.

If you fix prices below the real cost of production, based on free exchange and real supply and demand, you will create shortages.  This is the most common outcome.

A spinoff of shortages is long wait periods (waiting in the queue) or rationing, which is simply an attempt to equalize the misery of shortages.

An interesting book written during the last great inflation period was Forty Centuries of Wage and Price Controls by Robert Schuettinger and Eamonn Butler. The conclusion of the book, after exhaustive historical examples, is wage and price controls have never worked anywhere, at any time in history.

The reason they never work is that they never address the underlying causes of inflation, which is excessive government spending funded by monetary creation.

Price fixing inevitably leads to expansive and usually authoritarian government. For example, let’s suppose the government decides a particular item, let’s say milk, is vitally important to the population. So, they fix the price to stop public outrage.

To be even partially effective, you then must proceed to fix the price of dairy cattle, milking machines, barns, hay, farmland, farm labor, processing, transportation, and dozens of other price inputs that create what you see as the “price” of milk.

The price of anything is simply the sum of hundreds of prices of the applicable inputs. You can’t control one, without trying to control the others. Hence, attempts to control inflation through price control creates a gigantic and intrusive government that destroys the free market and its wealth-producing capacity. That is why Venezuela can sit on the largest reserve of oil per capita in the world, and be impoverished with oil over $100 a barrel.

The softer version of price controls is jawboning or attacking corporations for what the government has caused.

So, blaming corporations, taxing them heavily, and excoriating them in public (jawboning) should be expected.

Windfall profit taxes are likely as are price controls.

We may also see rationing.

Jawboning is an attempt to deflect blame onto someone else, typically business owners. Sometimes this gets very ugly when particular religious or ethnic groups are cited as exploiting inflation. Sometimes it has been Jews, sometimes ethnic Chinese,  Koreans in some neighborhoods, and sometimes kulaks.

Then, there is usually an attack on “hoarders”.

Hoarding is a rational response to expected shortages. Governments are against hoarding and prefer rationing. If you try to get supplies that you need, you are to be condemned as a hoarder. If your costs go up, you will be accused of exploitation and price gouging if you pass those costs along. If you correctly anticipate inflation and profit from it, you will be called a speculator. In all these cases, the government simply blames individuals and corporations for responding to something the government itself caused.

Finally, there is what could be called ‘the switch”.

This is a variation on the old theme of passing out public money to buy votes. Here is how it works: Take money from the public through taxation. Take money from the public secretly through currency debasement. Then hand money back to the public to help them deal with the excessive price inflation the money printing caused.

It is almost a perfect circle. Give the money back to the public that you took from them, to acculturate the public to taking government money and make them politically dependent on politicians.

A good example has actually been proposed. Drive up the cost of fuel by harassing and regulating oil producers, forcing the Green agenda, and printing excessive money. Then ride to the rescue by sending the public a check so they can deal with the high fuel costs. Since the government is running huge deficits anyway, simply print the money you will pass out to the public. The belief is the public will be too stupid to understand the game.

A variation of this scheme was the stimulus checks. Shut the economy down using Covid restrictions, causing great pain. Relieve some of that pain by sending checks to those harmed, hopefully, to make them grateful and dependent.

Thus, the way not to fight inflation is to harass and harangue businesses and housewives, print excessive money to pass out to the public to help with inflation, impose wage and price controls, blame corporations, and impose “windfall” profit taxes.

As to what to do to really fight inflation, the following steps are necessary. If inflation is too much money chasing too few goods, one needs to decrease the amount of money and increase the supply of goods.

Slow dramatically the growth of government spending and the growth of the money supply.

Increase the supply of goods by deregulating and rewarding production. Avoid at all cost wage and price controls, rationing, and windfall profit taxes. Foster vigorous competition, knocking down legal and regulatory barriers that block new producers from entering the market.

In short, do the opposite of what Democrats propose.

If the program is both credible and consistent, consumer hoarding will stop as the public learns there is no rational reason for doing it. When supplies of goods and services are reliable, and if prices moderate, there is no reason to buy before prices climb even further. It takes time to break the back of inflationary psychology. However, if the underlying cause, too much money and too few goods is addressed, the inflation will subside.

 

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.