The Fed‘s “Hawkish Pause” or "Prudent Pause" or Whatever it is, is Not as Clever as it Sounds: With Roots in the Zeal to Finesse a Soft-Landing Without Provoking Recession
The problem with the 21st century mentality to avoid unpleasantness at any price--I don't even think the Fed is immune from--is it has an unfortunate tendency to increase unpleasantness
“There is a path to getting inflation back down to 2 percent without having to see the kind of sharp downturn and large losses of employment that we’ve seen in so many past instances” — Jerome Powell, Federal Reserve Chairman
Intro
While I disagree with the decision last week to pause—let alone a rate cut any time soon before year’s end, which thankfully the Fed signaled, albeit terribly, is not in the offing—I can understand if the Fed felt their rate campaign was thrown for a loop by the financial uncertainty surrounding the debt ceiling spectacle; to recap, whose embarrassing anticlimactic spectacle was poised to send shudders through global financial markets indefinitely, undermine our credit rating at great risk to our global standing as the world’s most trustworthy borrower— a default on our debt obligations narrowly avoided only by way of clinching the most disappointingly mediocre debt deal conceivable, the upshot of which being only to mark the close of yet another pathetic, depressing episode in the cyclical horror show of America’s terminal budgetary incontinence.
Back on the Wagon
Recall my, I suppose unorthodox, position that although I demanded Biden and Mccarthy compromise to make a deal, I considered it destructively useless for the GOP to leverage the debt ceiling, given their abhorrent commitment not to touch mandatory spending at all, unless they could pressure Biden to gut his climate subsidies, and go all out to stop the extreme “Net Zero” agenda; otherwise there wasn’t really any point; whatever discretionary cuts the GOP could secure would be so minuscule, it would hardly be worth any spending cuts or caps. Not in my humble opinion. Not until we reform entitlements, will we be able to rein in the deficit.
As far as Biden and the Democrats were concerned, I was of course mortified but not surprised, that they would consider trying to use the 14th amendment to override Congress, licensing Biden thereby the absolute power to appropriate the powers of the Treasury to borrow, or what Thomas Gregg, on his Substack “Unwoke in Indiana” with great poetic flare, lambasted as, “Biden bonds.” Now after all those histrionic antics with the House Republican “Freedom Caucus” all but a crude pep rally for the US to default on its debt, and the Democratic party coming the closest yet to seriously attempting to impose “Modern Monetary Theory” on us (a risible far-left idea that the deficit is an illusion, and to pay the debt the government can just unilaterally print more money whenever circumstances necessitate, naturally amid the unbounded fiscal stimulus the whole concept of it is supposed to license—I think this theory was behind the “trillion dollar coin” internet joke), we got the most dreadfully inadequate deal in the dishonestly named, “Fiscal Responsibility Act.”
More Like Fiscal Irresponsibility Act
Brian Reidl in The Dispatch— “Loaded With Gimmicks But Still Worth It”—calls it a “choose your own adventure bill,” explaining how this was hardly a win for fiscal responsibility. Reidl, a great fiscal conservative from the Manhattan Institute, remarks the 2024-2029 spending caps after 2025 have no enforcement mechanism, and that certain apparent savings brought about through a maneuvering of the books will actually be cancelled down the line as the money supposed to be saved is just reabsorbed and incorporated into new spending.
On paper, defense spending would rise by $28 billion next year, and nondefense appropriations would fall by $40 billion, to produce the net reduction of $12 billion. However, the White House is claiming that both parties also pledged to later add $10 billion in nondefense spending in 2024 and again in 2025, purportedly “offset” by a $20 billion rescission of IRS funding that was scheduled to be spent almost a decade from now.
This is clearly a budget gimmick. The $10 billion in additional spending in 2024 and 2025 would surely be renewed for all subsequent years and become part of the permanent spending baseline. And Congress is virtually guaranteed to cancel the aggressive future cut in IRS funding that would otherwise cost the jobs of tens of thousands of IRS agents. In other words, both funding cliffs will likely be repealed, and spending will be permanently expanded.
And what about the unspent pandemic aid we thought we could claw back?
The bill’s $28 billion rescission of unspent COVID funds may also be used to “offset” $28 billion more in additional appropriations. Rescinding funds that are no longer needed is wise, but reprogramming them into new discretionary spending increases net spending in two ways. First, CBO estimates that only $11 billion of those COVID funds would have ever been spent, so translating them into $28 billion of new appropriations would yield a $17 billion net spending increase. Second, like the previous example, any $28 billion in new spending would surely be renewed every year thereafter, long after any offsetting savings have been applied.
Republicans basically got nothing out of this. Neoliberals like me who would consider government spending and runaway deficits the defining political challenge of the 21st century, who urge austerity at once, got nothing out of this. The Democrats in a sense won, because the Republicans didn’t actually cut any spending, let alone the Democrats inflationary agenda— let alone the Inflation Reduction Act I had argued gutting which would be the only thing worth leveraging the debt limit for, given social security was “off the table.” To be clear, given we’re doing nothing about social security (I guess the programs can cut themselves in 2030— I don’t care) if you wanted to use the debt limit to get any progress, then I thought Republicans should at least cut Biden’s climate subsidies—destroying world trade, fracturing our relationships with our allies, making a rapidly militarizing, increasingly fragile China we’re not ready for needlessly bristle, screwing up the power-grid, raising prices, adding to inflation, force-feeding us electric vehicles, raising taxes etc., etc.— as they suggested they would in the pretty awesome “Limit, Save, Grow Act” they proposed, and in the promising speech Kevin McCarthy delivered at the New York Stock Exchange.
I would have actually preferred it if the GOP made no cuts or caps, and assented to Biden’s demagogic table-thumping to just raise the debt limit without negotiating, not if the FRA were to come out of this. The FRA doesn’t make a dent in the 31$ trillion budget. In a few places, it makes room for more spending. It would at least have saved the nation the disgrace of that spectacle had Mccarthy just dodged Biden in that game of chicken right away. The coward Mccarthy is.
Back to the Inflation, Linked to and in Principle Caused by, our Spending Addiction, the Consequences of our Ineptness to Reform which now Blindsided and Hamstrung the Fed, Already in the Middle of Trying to Treat Some of the Effects of our Disease
So if the Fed was blindsided by that gratuitous turbulence, resolved to hit pause on the QT until they knew we wouldn’t skid into the degradation of what would be a slow grating inexorable sort of default, then a pause is excusable. But if they’re under any illusions that they have inflation under control, or because of the risk of triggering recession alone, we should aim to forgo future rate increases—especially since only we’re almost bound for a recession anyway, all things being equal—then they have another thing coming.
While goods inflation has decreased, and overall inflation has decreased several percentage points from a year ago, from nearly 10% to about 4%—if one thinks that because it’s trending down, that means it’s going down, then one underestimates the factors likely to make inflation sticky. Core CPI, the best tool for tracking future inflation, still hovers at 5% percent, as it has for months. Indeed wage inflation went up the day after the Fed announced the rate pause.
Unwarranted Optimism and Leeriness about Financial Stability and Liquidity, Underestimating the Indomitability of the Post-Pandemic Economy
Some of the market analysts at the Financial Times, whose mainly excellent week day newsletter “Unhedged” I read, Katie Martin, Ethan Wu and Robert Armstrong, defend the pause as justified, pointing to promising signs of cooling: first the drop in goods spending, and second the drop in shelter inflation which is apparently a trademark indicator that interest rate hikes, that operate in monetary lags, are finally starting to bite. They say additionally that because of the shock to the banking system, and the sustained series of hikes already administered with special emphasis on the monetary lags factor, the wise thing to do is hit pause through July pending new financial data. The Cato Institute in a newsletter has said the same thing.
There are also concerns about a “liquidity crunch” in the financial sector. With the banking system under strain, between the deposit flights, unrealized liabilities, combined with the lending constraints posed by higher rates— there is a real (I think exaggerated) risk that the financial system may suddenly go under from an assortment of factors, limiting the supply as well as crimping the flow of money, even deflation coming from China. This is seen as disinflationary by itself, that is leaving aside tight monetary policy. At its worst, market analysts worry the Fed can trigger a brutal recession piling onto it. I’ve read some worried columns in the Wall Street Journal to this effect too. The idea is that since government ignited demand with the pandemic stimuluses (which I do agree is the main culprit, Trump’s $900 million Paycheck Protection Program, and Biden’s $ 1.9 trillion “American Rescue Plan” that will live in infamy), as soon as goods spending goes down, only then will the aggressive monetary policy kick in damagingly, and kill demand altogether plunging the economy into a nasty downturn. But I think a liquidity crunch is unlikely because the Fed’s emergency lending facility backstopping the failed banks will maintain liquidity. Also those depositors put all their money into Money Market Funds backed by government securities, anyway, which also made it so that there was never any real fear of a financial crisis in the first place. Not to mention an ultra tight labor market, soon-to-be stabilized by added immigration, but at the cost of increasing consumer spending, will just entrench liquidity.
Why We Can’t Afford Pausing any Less than Cutting, Not Until Inflation is Reduced to 2%
Moreover, nevertheless legitimate as these concerns are about the financial sector, and important as these observations may prove about disinflationary trends, I think the greater concern for the Fed is entrenched inflation in the long term. Moreover as the Federal funds rate was raised to 5% for the last several months, but core inflation remains unchanged over the last six months, at around 5% that is despite the instability in the banking sector, despite goods spending decreasing.
I think the FT’s market analysts in “Unhedged” are overly optimistic about the downward trend in shelter inflation and goods spending. I wonder if perhaps in their eagerness to determine this inflation is driven mainly by consumer spending, which in a matter of time, is projected to die down, it’s caused them to underrate and overlook factors likely contributing to make inflation sticky, such as the overheated job market, regulatory bottlenecks, supply chain constraints, barely capped government spending ( and remember all the tax breaks and subsidies in the $1.2 trillion Inflation Reduction Act, the 1$ trillion Infrastructure Investment and Jobs Act, and the $500 billion Chips and Science Act—with the inflationary requirements for subsidizing childcare, union protections, government subsidized good wages, and “Buy American” content restrictions—are all still in place, no thanks to certain dumb populist Republicans by the way who were persuaded to vote for this corporate welfare) and not to be underestimated normalizing expectations, and the interaction of all these pressures.
I agree with the editorial board at Bloomberg who in their column “For the Fed Doing Nothing is the Greater Risk,” note the declining goods spending and decreasing rent inflation but argue,
This progress, though, is no assurance of success. The banking turmoil has so far affected only a small fraction of the industry, and alternative lenders are eager to fill any breach — hardly the kind of credit retrenchment required to have much aggregate effect. At 3.7%, the unemployment rate remains near its lowest point since 1970, and below the level that Fed officials consider sustainable without overheating the economy. No wonder some measures of annual wage growth remain as high as6%, and core consumer-price inflation — at 5.3% in May — far exceeds the Fed’s 2% target. If one adjusts for that level of inflation, it’s not even clear that short-term interest rates are high enough to restrict growth.
That leaves one with the valid question, what about the monetary lags? Can’t we still be in for an awful surprise if it turns out the Fed went way further than they needed? Yeah it’s possible, but it’s questionable whether declining shelter inflation for example forebodes recession. Months ago it was said that trucking companies, spending less on supplies, had to mean recession was on its way. Still nothing happened. And used cars and construction.
It was said that once used-car inflation went down or once China opened up, disinflation would come inexorably. Recession too is imminent. Alas, I think that to focus on declining goods spending and shelter inflation is to look at the trees and fail to see the forest of this indomitable economy. I’m not arguing we should expect inflation to go up per se, rather. But at least inflation may prove stickier than one might imagine. Nick Timiraos and Tom Fairless underscore the factor of the structurally indefatigable economy, in the Wall Street Journal, “Why Economies Haven’t Slowed More Since Central Banks Hit the Brakes,”
First, the unusual nature of the pandemic-induced 2020 recession and the ensuing recovery blunted the normal impacts of rate hikes. In 2020 and 2021, the U.S. and other governments provided trillions of dollars in financial assistance to households that were also saving money as the pandemic interrupted normal spending patterns. Meanwhile, central banks’ rock-bottom interest ratesallowed companies and consumers to lock in low borrowing costs.
Households and businesses continued to spend heavily in recent months. Families tapped their savings, which were replenished by solid income growth. Businesses kept hiring thanks to pandemic-related labor shortages and large profits.
Two industries traditionally sensitive to interest rates—autos and construction—offer examples.
Pandemic-related shortages of semiconductor chips limited the supply of cars for sale, leading eager buyers to pay higher prices for the vehicles available. Although U.S. construction of single-family homes tumbled last year, construction employment grew over the past 12 months. Fueling job growth were supply-chain bottlenecks that extended the time needed to finish homes and a record amount of U.S. apartment construction, which takes longer to complete.
U.S. single-family housing construction has rebounded recently thanks to historically low numbers of homes for sale. Many households refinanced during the pandemic and locked in low mortgage rates—a good reason to stay put. “I didn’t fully anticipate how much the move in interest rates would convince people not to put their houses on the market,” Barkin said.“There are just a lot of embedded pandemic-era forces that are working against this tightening,” Tom Barkin, president of the Federal Reserve Bank of Richmond, told reporters last week.
I would add, the economy is adding tens of thousands of jobs every few weeks. We’re at basically full employment. The job market is tight as hell. Expectations already seem to be becoming entrenched as companies are raising prices to juice profit margins now in advance of future inflation, and though goods spending is trending downward, consumers are still splurging. Middle income households still have a lot in savings, and of course with Biden’s welfare spending low income people are flourishing and spending like hell. Wages are still rising especially in the tight services sector. Yet all this is considered normal dangerously, just because inflation is not as bad as it was, with our bad short-term memories in this day and age. And in my experience working at a supermarket, for what it’s worth, I have noticed my customers are concerned much less today with inflation than they were months ago. Maybe this is all in my head, but more and more of my customers seem to look at the bill, and they’re pleasantly relieved prices aren’t as bad as they expected. “What’s the damage?” “Oh, that’s not bad.” — I hear every day.
Moreover with inflation at 5%, three percentage points above the Fed’s target, it’s not a good sign that people are starting to ignore it. The argument about monetary lags is overrated too. Each time there’s a Federal Open Markets Committee meeting now, we get this uncertainty whether they’re going to cut rates, pause, or raise them. And every time thereafter the Fed issues another rate rise, and Core CPI remains well above target. And the underlying trends don’t seem to make any substantive difference. One is justified to wonder if the Federal Funds Rate is actually high enough to begin with.
Kevin Hassett in National Review, “Throwing Spitballs at Inflation,” argues the Fed should hearken to the “Taylor Rule,” holding the the Fed Funds rate should be raised significantly higher than the rate of inflation. If core inflation is 5% now, then we need a 7% federal funds rate, for example. Sounds reasonable to me. After all these meetings with inflation unchanging, it’s worth considering whether the Fed is using the appropriate short-term interest rate tool. But the best example for charting the appropriate monetary course can only be gleaned from history. Hassett writes,
In the 1970s when Fed policy was as skittish as today’s inflation came in a sequence of waves. In the first quarter of 1970, core PCE inflation posted a twelve-month change of 4.9 percent, just about where we are now. It dropped into the threes for a spell, but then jumped to 11.5 percent in the fourth quarter of 1974. It fluctuated between there and 5 percent or so for the rest of the decade, starting the 1980s in the first quarter at 11.1 percent.
An apologist for the Fed might say there are signs the recession we have all been expecting is about to start. But we learned in the 1970s that haphazard Fed discretionary policy feeds inflation even during recessions. There were four recessions between 1970 and 1982 when Reagan’s supply side stimulus and Volcker’s brutally high interest rates finally got inflation under control.
Towards Getting a Grip on the Money Supply
I was pleased to see after I was nearly finished writing this piece, that is to say, as I go to press, the title of this week’s Economist was, “The Trouble with Sticky Inflation.” Noting some of the pressures likely to keep inflation high, or at least above the 2% target, they describe the bind that central banks are in. Amid signs of tenuous financial stability, having reduced inflation in America at least to an arguably tolerable 4% slash 5%, is it worth it to keep raising interest rates if the next hike or two could send the economy into potentially a hard disinflationary downturn?
Short answer: Yeah.
Since the beginning of the monetary tightening campaign, the Fed has idealized a soft landing, quelling inflation without causing recession or unemployment. The conceit that this is feasible and desirable is at the heart of Jerome Powell’s thinking, however he signals that they’re taking inflation above all, first and foremost very seriously, and they’re willing to do whatever it takes. Perhaps in this sense Powell’s stance on inflation is analogous to Joe Biden’s approach to Ukraine. Biden wants to give Ukraine the arms not to triumph but only not to be defeated, while Powell wants to reduce inflation without hurting anybody. Biden is fearful of what Putin might consider escalation, causing him to deploy a tactical nuke. Powell is afraid of triggering a baleful recession, or any recession, as the price of hitting an arbitrary disinflationary target.
I think when interpreting the Fed’s statements, the most important thing to bear in mind is how badly this Fed wants to avoid inflicting a recession, although to maintain the facade of institutional integrity to do their job and restore price stability. If this assessment is apt, then we can expect them to raise rates a little bit and then pause them in succession. Indeed after hitting pause last weekend, we’re probably already beginning to see this lamentable pattern unfold, where inflation would remain above target and the Fed would undermine its credibility with confused signals. Similar to their mixed signals at the FOMC meeting following SVB. But there was no signaling yet that better reveals the Fed’s angst than Powell’s quivering last weekend.
One must understand he is highly reticent to keep raising rates to get inflation to 2 percent, if he has to kill a strong, resilient growing economy that, not least because of headline inflation declining, people are hardly complaining about. And factor a robust economy in with the political pressure of the New Deal pretensions of the current administration, perpetually bragging about the jobs, jobs jobs—JOBS— whose constant inflationary additions he presides over as a Keynesian end in itself.
Melissa Sue Garritts Getty Images
Although the institution of the Fed is supposed to control the money supply without regard for the political convenience of the executive, they are only human, and thus not immune to political pressures to please and not hurt anyone. Therefore, like everyone especially in the digital age, with their low self-esteem desperate for validation from the collective, perhaps the Fed is incapable of doing the politically unpalatable thing and, in contrast, doing what’s necessary to hit a target of stability, at the risk of causing 5 million people to go out of work. This is the greater danger that the Fed just eases off target rather than that they do too much. As the Economist explains, consigning this robust economy to live with higher rates, because they’re too worried about causing unemployment, would be destabilizing for the stock market.
“opportunistic disinflation” espoused by some Fed governors of the 1980s. Rather than inducing recessions to bring inflation down, they sought to do so passively from cycle to cycle. Yet today’s markets are not prepared for such tactics. The pricing of inflation-linked treasuries, for example, is consistent with average inflation expectations of 2.1% over the next five years, and 2.3 % in the five years thereafter. A world of higher sustained inflation would therefore involve an epochal shift for financial markets. Unfortunately, it would be volatile, wrong-foot investors and pit winners against losers.
One source of volatility could stem from the damage to central banks’ reputations. In the decades since the 1980s they have trumpeted their commitment to targets. Yet over the past two years they have failed to anticipate the persistence of inflation. Should they then pay lip service to their unmet targets, they might no longer be taken at their word. In time they could lose the ability to guide the expectations of businesses and their workers. Those expectations could become unmoored and cause lurches in prices, inducing inflation to spiral.
Volatile inflation would hurt companies, and their shares, by making it harder for them to manage their costs and set prices. It would hurt virtually every asset class by raising the likelihood that central banks would have to rush to adjust rates after an unexpected flare-up. That could bring large swings in real yields, prompting investors to demand a discount in compensation for the uncertainty, forcing asset prices down.
The new regime could wrong-foot investors in other ways, too. Were central banks more lax, it would initially flatter the prices of short-term bonds and push down their yields. In time, as the system adjusted to higher inflation, nominal rates would rise to keep real interest rates constant; in anticipation, the price of long-term bonds would fall. Investors could rush into commodities, an inflation hedge. Yet a stampede into the tiny market for futures, which are easier to trade than physical barrels of oil, would risk a bubble.
Higher inflation would also create new winners and losers. Most obviously, inflation involves an arbitrary transfer of wealth from lenders to borrowers, as the real value of debt falls. Heavily indebted borrowers, including governments around the world, may feel like rejoicing. But as bond investors realised they were being stiffed, they could punish recklessness with higher borrowing costs, including in rich countries.
Indeed one great danger is for the credibility of central banks, and how if the Fed’s word is no longer seen as reliable, what it will do for investors who have come to rely on it. But there is another more obvious danger with hitting the monetary brakes at 4% or 5% inflation, which is that it will leave the economy more exposed to future inflationary shocks. Whether it’s the fiscal stimulus Bidenomics, for example, hurls out of helicopters onto aggregate demand, OPEC raising oil prices, the effects of rebuilding supply chains and diversifying from China, a labor shortage that’s not going away, declining immigration because of increased restrictions provoked by dishonorable unease about mass migration—if we leave inflation at 4% all it takes is for one or another of these things to push inflation back up to 7% or higher. Furthermore the critics of tighter macroeconomic policy underestimate that the economy since the pandemic has been radically transformed structurally, all in ways that make the markets more sensitive to unexpected supply-side shocks, which should necessitate higher rates, especially after a decade of zero rates, and all the problems that quantitative easing led to. As Kenneth Rogoff argues in his pensive Foreign Affairs article, “The Age of Inflation”
The 2020s are shaping up to be the most difficult era in central banking since the 1970s, when the global economy was contending with both the Arab oil embargo and the collapse of the postwar Bretton Woods system of fixed exchange rates. Today, large-scale global shocks such as war, pandemic, and drought seem to be coming one after another or even at the same time. Meanwhile, the forces of globalization that for much of the past 20 years have helped sustain long-term growth have instead turned into headwinds, both because China is rapidly aging and because of growing geopolitical frictions between China and the United States. None of these changes is good for productivity and growth, but they are all contributing to higher inflation now and will into the future.
Doing the Right Thing is not Supposed to be Easy
No less than Martin Wolf, a great neoliberal, writes in the Financial Times, “at this stage in the inflationary process, the central bank needs to show moral fibre.”
I couldn’t have said it better myself. He was writing about Britain whose inflation is considerably worse than ours, but I think it’s commonsense that going all out for 2%, no matter what, and risking recession is a better trade off: than maintaining full employment in exchange for a fragile economy, more sensitive to shocks; even worse sacrificing the Fed’s credibility and screwing up the stock market. Come on, what’s a few million unemployed compared to indefinite inflation perhaps for years and the erosion of the central bank’s integrity?
I don’t know why it’s so hard for our leaders to do the politically unpalatable but necessary thing these days. I don’t know why it’s so hard not to be popular. In these grotesquely lonely times where nobody seems willing to stand alone, whether in politics or society at large, my Thatcherite sensibility craving some pure-minded integrity and commitment—something fixed, something hard, something stable, something original—has found a kindred spirit in the institution of the central bank as a bastion of principle, in addition to the conservative majority Supreme Court. I have become an avid support of this tightening campaign, frightening Wall Street who keep pricing in rate cuts, and disgruntling Joe Biden.
Powell has implied recently that we may (hopefully) be in for two more rate rises before the end of the year. Good. Come on Powell god damn it. Stay the course. Be undeterred by public opinion. To hell with soft landings. To hell with some uniquely exposed midsize banks. It’s not your job to maintain employment or less swoop in to guarantee the deposits of dumb crypto-speculators. It’s not your job to make life easier for people. For us, them, you, me or anyone. And in fact, policies to that effect did the terrible damage it’s your institutional role to prevent and get us out of.
New data will be coming out this week. I expect it to underline the urgency to get a grip on the money supply, to stave off a looming future of stubborn mid-level inflation.
— Jay