Tag Archives: Hard Landing

Demand, Disinflation, and Fed Gradualism

15 Monday Apr 2024

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The Fed’s “higher for longer” path for short-term interest rates lingers on, and so does inflation in excess of the Fed’s 2% target. No one should be surprised that rate cuts aren’t yet on the table, but the markets freaked out a little with the release of the February CPI numbers last week, which were higher than expected. For now, it only means the Fed will remain patient with the degree of monetary restraint already achieved.

Dashed Hopes

As I’ve said before, there was little reason for the market to have expected the Fed to cut rates aggressively this year. Just a couple of months ago, the market expected as many as six quarter-point cuts in the Fed’s target for the federal funds rate. The only rationale for that reaction would have been faster disinflation or the possibility of an economic “hard landing”. A downturn is not out of the question, especially if the Fed feels compelled to raise its rate target again in an effort to stem a resurgence in inflation. Maybe some traders felt the Fed would act politically, cutting rates aggressively as the presidential election approaches. Not yet anyway, and it seems highly unlikely.

There is no assurance that the Fed can succeed in engineering a “soft landing”, i.e., disinflation to its 2% goal without a recession. No one can claim any certainty on that point — it’s too early to call, though the odds have improved somewhat. As Scott Sumner succinctly puts it, a soft landing basically depends on whether the Fed can disinflate gradually enough.

It’s a Demand-Side Inflation

I’d like to focus a little more on Sumner’s perspective on Fed policy because it has important implications for the outlook. Sumner is a so-called market monetarist and a leading proponent of nominal GDP level targeting by the Fed. He takes issue with those ascribing the worst of the pandemic inflation to supply shocks. There’s no question that disruptions occurred on the supply side, but the Fed did more than accommodate those shocks in attempting to minimize their impact on real output and jobs. In fact, it can fairly be said that a Fed / Treasury collaboration managed to execute the biggest “helicopter drop” of money in the history of the world, by far!

That “helicopter drop” consisted of pandemic relief payments, a fiscal maneuver amounting to a gigantic monetary expansion and stimulus to demand. The profligacy has continued on the fiscal side since then, with annual deficits well in excess of $1 trillion and no end in sight. This reflects government demand against which the Fed can’t easily act to countervail, making the job of achieving a soft landing that much more difficult.

The Treasury, however, is finding a more limited appetite among investors for the flood of bonds it must regularly sell to fund the deficit. Recent increases in long-term Treasury rates reflect these large funding needs as well as the “higher-for-longer” outlook for short-term rates, inflation expectations, and of course better perceived investment alternatives.

The Nominal GDP Proof

There should be no controversy that inflation is a demand-side problem. As Summer says, supply shocks tend to reverse themselves over time, and that was largely the case as the pandemic wore on in 2021. Furthermore, advances in both real and nominal GDP have continued since then. The difference between the two is inflation, which again, has remained above the Fed’s target.

So let’s see… output and prices both growing? That combination of gains demonstrates that demand has been the primary driver of inflation for three-plus years. Restrictive monetary policy is the right prescription for taming excessive demand growth and inflation.

Here’s Sumner from early March (emphasis his), where he references flexible average inflation targeting (FAIT), a policy the Fed claims to be following, and nominal GDP level targeting (NGDPLT):

“Over the past 4 years, the PCE price index is up 16.7%. Under FAIT it should have risen by 8.2% (i.e., 2%/year). Thus we’ve had roughly 8.5% excess inflation (a bit less due to compounding.)

Aggregate demand (NGDP) is up by 27.6%. Under FAIT targeting (which is similar to NGDPLT) it should have been up by about 17% (i.e., 4%/year). So we’ve had a bit less than 10.6% extra demand growth.  That explains all of the extra inflation.”

Is Money “Tight”?

The Fed got around to tightening policy in the spring of 2022, but that doesn’t necessarily mean that policy ever advanced to the “tight” stage. Sumner has been vocal in asserting that the Fed’s policy hasn’t looked especially restrictive. Money growth feeds demand and ultimately translates into nominal GDP growth (aggregate demand). The latter is growing too rapidly to bring inflation into line with the 2% target. But wait! Money growth has been moderately negative since the Fed began tightening. How does that square with Sumner’s view?

In fact, the M2 money supply is still approximately 35% greater than at the start of the pandemic. There’s still a lot of M2 sloshing around out there, and the Fed’s portfolio of securities acquired during the pandemic via “quantitative easing” remains quite large ($7.5 trillion). Does this sound like tight money?

Again, Sumner would say that with nominal GDP ripping ahead at 5.7%, the Fed can’t be credibly targeting 2% inflation given an allowance for real GDP growth at trend of around 1.8% (or even somewhat greater than that). It’s an even bigger stretch if M2 velocity (V — turnover) continues to rebound with higher interest rates.

Wage growth also exceeds a level consistent with the Fed’s target. The chart below shows the gap between price inflation and wage inflation that left real wages well below pre-pandemic levels. Since early 2023, wages have made up part of that decline, but stubborn wage inflation can impede progress against price inflation.

Just Tight Enough?

Despite Sumner’s doubts, there are arguments to be made that Fed policy qualifies as restrictive. Even moderate declines in liquidity can come as a shock to markets grown accustomed to torrents from the money supply firehose. And to the extent that inflation expectations have declined, real interest rates may be higher now than they were in early November. In any case, it’s clear the market was disappointed in the higher-than-expected CPI, and traders were not greatly assuaged by the moderate report on the PPI that followed.

However, the Fed pays closest attention to another price index: the core deflator for personal consumption expenditures (PCE). Inflation by this measure is trending much closer to the Fed’s target (see the second chart below). Still, from the viewpoint of traders, many of whom, not long ago, expected six rate cuts this year, the reality of “higher for longer” is a huge disappointment.

Danger Lurks

As I noted, many believe the odds of a soft landing have improved. However, the now-apparent “stickiness” of inflation and the knowledge that the Fed will standby or possibly hike rates again has rekindled fears that the economy could turn south before the Fed elects to cut its short-term interest rate target. That might surprise Sumner in the absence of more tightening, as his arguments are partly rooted in the continuing strength of aggregate demand and nominal GDP growth.

There’s a fair degree of consensus that the labor market remains strong, which underscores Sumner’s doubts as to the actual tenor of monetary policy. The March employment numbers were deceptive, however. The gain in civilian employment was just shy of 500,000, but that gain was entirely in part-time employment. Full-time employment actually declined slightly. In fact, the same is true over the prior 12 months. And over that period, the number of multiple jobholders increased by more than total employment. Increasing reliance on part-time work and multiple jobs is a sign of stress on household budgets and that firms may be reluctant to commit to full-time hires. From the establishment survey, the gain in nonfarm employment was dominated once again by government and health care. These numbers hardly support the notion that the economy is on solid footing.

There are other signs of stress: credit card delinquencies hit an all-time high in February. High interest rates are taking a toll on households and business borrowers. Retail sales were stronger than expected in March, but excess savings accumulated during the pandemic were nearly depleted as of February, so it’s not clear how long the spending can last. And while the index of leading indicators inched up in February, it was the first gain in two years and the index has shown year/over-year declines over that entire two-year period.

Conclusion

It feels a little hollow for me to list a series of economic red flags, having done so a few times over the past year or so. The risks of a hard landing are there, to be sure. The behavior of the core PCE deflator over the next few months will have much more influence on the Fed policy, as would any dramatic changes in the real economy. The “data dependence” of policy is almost a cliche at this point. The Fed will stand pat for now, and I doubt the Fed will raise its rate target without a dramatic upside surprise on the core deflator. Likewise, any downward rate moves won’t be forthcoming without more softening in the core deflator toward 2% or definitive signs of a recession. So rate cuts aren’t likely for some months to come.

Stubborn Inflation and the Fed’s Approach Trajectory

15 Monday Jan 2024

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When Federal Reserve Chairman Jerome Powell said “higher for longer” last year, it wasn’t about the Grateful Dead concerts he’s attended over the years. No, he meant the Fed might need to raise its short-term interest rate target and/or keep it elevated for an extended period to squeeze inflation out of the economy. As late as December, Powell said that additional rate hikes remain on the table. But short of that, the Fed might keep its current target rate steady until inflation is solidly in-line with its 2% objective. The obvious risk is that tight monetary policy might tip the economy into recession. The market, for its part, is pricing in several rate cuts this year.

Thus far, the release of key economic data for December 2023 has not settled the debate as to whether disinflation has truly paused short of the Fed’s goal. There were inauspicious signs from the labor market in December as well. These data releases don’t rule out a “soft landing”, but they indicate that recession risks are still with us in 2024. The Fed will face a dilemma if the economy weakens but inflation fails to abate, either due to residual stickiness or new supply shocks. The latter are unfolding even now with the shut down of Red Sea shipping.

Bad Employment Report

On the surface, the employment report from the Bureau of Labor Statistics (BLS) was strong relative to expectations, and the media reported it on that superficial level: nonfarm payrolls increased by 216,000 jobs, about 45,000 more than expected; unemployment was unchanged from November at 3.7%.

Unfortunately, the report contained several ominous signs:

1) Employment from the BLS Household Survey declined by 683,000 in December and is essentially flat since July. This discrepancy should be rather unsettling to anyone waving off the possibility of a recession.

2) The number of full-time workers decreased by 1.53 million in December, and the number of part-time workers increased by 762,000 as the holidays approached. Retail employment was not particularly strong however, and the big loss of full-time work stands in contrast to the “strong-report” narrative.

3) The number of multiple jobholders hit a record and increased by 556,000 over the past year. This might indicate trouble for some workers making ends meet.

5) The civilian labor force declined by 676,000. What accounts for the change in status among these former workers or job seekers?

6) From the BLS Establishment Survey, government hiring accounted for 24% of the nonfarm jobs filled in December. Social Services accounted for 10% of the new hiring and health care for 18%, both of which are heavily dependent on government.

7) Nonfarm payrolls were revised downward by a total of 71,000 for October and November. We’ve seen downward revisions for 10 of the past 11 months.

8) In total, initial monthly job reports in 2023 overstated the full-year gain in nonfarm employment after available revisions by 439,000.

Those are big qualifiers on the “stronger than expected” jobs report. Furthermore, I tend to discount new government jobs as a real engine of production possibilities, so the report didn’t offer much assurance about the economy’s momentum. In addition, there are estimates that the payroll gain was due to better weather than the seasonal adjustment factors indicate.

Fictional Payroll Gains?

Still other issues cast doubt on the BLS payroll numbers. First, they are based on a survey of employers that is not complete by the time of each month’s initial report. Second, the survey is heavily skewed toward employees of government and large corporations; the sample of small employers is light by comparison. Third, seasonal adjustments often swamp the unadjusted changes in payrolls.

Finally, the BLS uses a statistical model of business births/deaths to adjust the figures. This is intended to correct for a lag in survey coverage as new businesses are formed and others close. The net effect on the payroll estimate can be positive or negative. Unfortunately, it’s difficult for even the BLS to tell how much the birth/death model affects the headline nonfarm jobs figure in any particular month. Therefore, it’s tough to put much faith in the monthly reports, but we watch them anyway.

Stubborn Inflation

The Consumer Price Index (CPI) for December increased 0.3% over November and 3.4% year-over-year, slightly more than expectations of 0.2% and 3.2%, respectively. The “core” CPI (excluding food and energy prices) rose 3.9% year-over-year, more than the 3.8% expected. The core rate declined on a one-month and year-over-year basis, however, as did the median item in the CPI.

All CPI measures in the chart declined during 2023, though the core and median lagged the headline CPI (green line), which “flattened” somewhat during the last half of the year. So there appears to be some stickiness hindering disinflation in the CPI at this point, but the apparent “stickiness” has been confined to lagging declines in housing costs (also see here).

The Producer Price Index (PPI) reported a day later was thought to be benign. Like the CPI, disinflation in the core PPI has tapered:

In this context, it should be noted that declines in the Fed’s preferred inflation gauge, the PCE deflator, have also undergone something of a pause, and the PCE weights housing costs much less heavily than the CPI.

The CPI and PPI reports don’t offer any reason for the Fed to reduce its target federal funds rate over the next couple of Federal Open Market Committee (FOMC) meetings. There are two more sets of monthly inflation reports before the meeting in late March, so things could change. But again, the Fed has given ample guidance that it might have to leave its target rate at the current level for an extended period.

The Market View

Markets had priced-in six cuts in the Fed funds rate target in 2024 prior to the CPI report, but traders began to discount that possibility in its immediate aftermath. However, members of the FOMC expected an average of three cuts in 2024, with more to come in 2025, whether or not that’s consistent with “higher for longer”. Inflation is hovering somewhat above the Fed’s goal, but getting the rest of the job done might be tough, and indeed, might imply “longer” if not “higher”.

But why did the market ever hold the expectation of six cuts this year? Traders must have anticipated an economic contraction, which would kick the Fed into rapid response mode. The employment report offered no assurance that such a “hard landing” will be avoided. A few more negative signals on the real economy without further progress on prices would provide quite a test of the Fed’s inflation-fighting resolve.

So When Can We Expect That Hard Landing, Hmmm?

13 Wednesday Dec 2023

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The joke’s on me, but my “out” on the question above is “long and variable lags” in the impact of monetary policy, a description that goes back to the work of Milton Friedman. If you call me out on my earlier forebodings of a hard landing or recession, I’ll plead that I repeatedly quoted Friedman on this point as a caveat! That is, the economic impact of a monetary tightening will be lagged by anywhere from 9 to 24 months. So maybe we’re just not there yet.

Of course, maybe I’m wrong and we won’t have to get “there”: the rate of inflation has indeed tapered over the past year. A soft landing now seems like a more realistic possibility. Still, there’s a ways to go, and as Scott Sumner says, when it comes to squeezing inflation out of the system, “It’s the final percentage point that’s the toughest.” One might say the Federal Reserve is hedging its bets, avoiding further increases in its target federal funds rate absent evidence of resurging price pressures.

Strong Growth or Mirage?

Economic growth is still strong. Real GDP in the third quarter grew at an astonishing 5.2% annual rate. A bulge in inventories accounted for about a quarter of the gain, which might lead to some retrenchment in production plans. Government spending also accounted for roughly a quarter, which corresponds to a literal liability as much as a dubious gain in real output. Unfortunately, fiscal policy is working at cross purposes to the current thrust of monetary policy. Profligate spending and burgeoning budget deficits might artificially prop up the economy for a time, but it adds to risks going forward, not to mention uncertainty surrounding the strength and timing in the effects of tight money.

Consumers accounted for almost half of the third quarter growth despite a slim 0.1% increase in real personal disposable income. That reinforces the argument that consumers are depleting their pandemic savings and becoming more deeply indebted heading into the holidays.

The economy continues to produce jobs at a respectable pace. The November employment report was slightly better than expected, but it was buttressed by the return of striking workers, and retail and manufacturing jobs declined. Still, the unemployment rate fell slightly, so the labor market has remained stronger than expected by most economists.

Consumer sentiment had been in the dumps until the University of Michigan report for December, which erased four months of declines. The expectations index is one component of the leading economic indicators, which has been at levels strongly suggesting a recession ahead for well over a year now. See the chart below:

But expectations improved sharply in November, and that included a decline in inflation expectations.

Another component of the LEI is the slope of the yield curve (measured by the difference between the 10-year Treasury bond yield and the federal funds rate). This spread has been a reliable predictor of recessions historically. The 10-year bond yield has declined by over 90 basis points since mid-October, a sign that bond investors think the inflation threat is subsiding. However, that drop steepened the negative slope of the yield curve, meaning that the recession signal has strengthened.

Disinflation, But Still Inflation

Inflation measures have been slowing, and the Fed’s “target” inflation rate of 2% appears within reach. In the Fed’s view, the most important inflation gauge is the personal consumption expenditures deflator excluding food and energy prices (the “core” PCE). The next chart shows the extent to which it has tapered over the past two quarters. While it’s encouraging that inflation has edged closer to the Fed’s target, it does not mean the inflation fight is over. Still, the decision taken at the December meeting of the Fed’s Open Market Committee (FOMC) to leave its interest rate target unchanged is probably wise.

Real wages declined during most of the past three years with the surge in price inflation (see next chart). Some small gains occurred over the past few months, but the earlier declines reinforce the view that consumers need to tighten their belts to maintain savings or avoid excessive debt.

Has Policy Really Been “Tight“?

The prospect of a hard landing presupposes that policy is “tight” and has been tight for some months, but there is disagreement over whether that is, in fact, the case. Scott Sumner, at the link above in the second paragraph, is skeptical that policy is “tight” even now. That’s despite the fact that the Fed hiked its federal funds rate target 11 times between March 2022 and July 2023 (by a total of 5.25%). The Fed waited too long to get started on its upward rate moves, which helps explain the continuing strength of the economy right now.

The real fed funds rate turned positive (arguably) as early as last winter as the rate rose and as expected inflation began to decline. There is also solid evidence that real interest rates on the short-end of the maturity spectrum are higher than “neutral” real rates and have been for well over a year (see chart below). If the Fed leaves its rate target unchanged over the next few months, assuming expected inflation continues to taper, the real rate will rise passively and the Fed’s policy stance will have tightened further.

Another view is that the Fed’s policy became “tight” when the monetary aggregates began to decrease (April 2022 for M2). A few months later the Fed began so-called “quantitative tightening” (QT—selling securities to reduce its balance sheet). Thus far, QT has reversed only a portion of the vast liquidity provided by the Fed during the pandemic. However, markets do grow accustomed to generous ongoing flows of liquidity. Cutting them off creates financial tensions that have real economic effects. No doubt the Fed’s commitment to QT established some credibility that a real policy shift was underway. So it’s probably fair to say that policy became “tight” as this realization took hold, which might place the date demarcating “tight” policy around 15 – 18 months ago.

Back to the Lags

Again, changes in monetary policy have a discernible impact only with a lag. The broad range of timing discussed among monetary experts (again, going back to Milton Friedman) is 9 – 24 months. We’re right in there now, which adds to the conviction among many forecasters that the onset of recession is likely during the first half of 2024. That’s my position, and while the tapering of inflation we’ve witnessed thus far is quite encouraging, it might take sustained monetary restraint before we’re at or below the Fed’s 2% target. That also increases the risk that we’ll ultimately suffer through a hard landing. In fact, there are prominent voices like hedge fund boss Bill Ackman who predict the Fed must begin to cut the funds rate soon to avoid a hard landing. Jamie Diamond, CEO of JP Morgan, says the U.S. is headed for a hard landing in 2024.

Looking Forward

If new data over the next few months is consistent with a “soft landing” (and it would take much more than a few months to be conclusive), or especially if the data more strongly indicate an incipient recession, the Fed certainly won’t raise its target rate again. The Fed is likely to begin to cut the funds rate sometime next year, and sooner if a recession seems imminent. Otherwise, my guess is the Fed waits at least until well into the second quarter. The average of FOMC member forecasts at the December meeting works out to three quarter-point rate cuts by year-end 2024. When the Fed does cut its target rate, I hope it won’t at the same time abandon QT, the continuing sales of securities from its currently outsized portfolio. Reducing the Fed’s holdings of securities will restrain money growth and give the central bank more flexibility over future policy actions. QT will also put pressure on Congress and the President to reduce budget deficits.

The Perils of Powell: Inflation, Illiquid Banks, Lonnng Lags

01 Saturday Apr 2023

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To the great chagrin of some market watchers, the Federal Reserve Open Market Committee (FOMC) increased its target for the federal funds rate in March by 0.25 points, to range of 4.75 – 5%. This was pretty much in line with plans the FOMC made plain in the fall. The “surprise” was that this increase took place against a backdrop of liquidity shortfalls in the banking system, which also had taken many by surprise. Perhaps a further surprise was that after a few days of reflection, the market didn’t seem to mind the rate hike all that much.

Switchman Sleeping

There’s plenty of blame to go around for bank liquidity problems. Certain banks and their regulators (including the Fed) somehow failed to anticipate that carrying large, unhedged positions in low-rate, long-term bonds might at some point alarm large depositors as interest rates rose. Those banks found themselves way short of funds needed to satisfy justifiably skittish account holders. A couple of banks were closed, but the FDIC agreed to insure all of their depositors. As the lender of last resort, the Fed provided banks with “credit facilities” to ease the liquidity crunch. In a matter of days, the fresh credit expanded the Fed’s balance sheet, offsetting months of “quantitative tightening” that had taken place since last June.

Of course, the Fed is no stranger to dozing at the switch. Historically, the central bank has failed to anticipate changes wrought by its own policy actions. Today’s inflation is a prime example. That kind of difficulty is to be expected given the “long and variable lags” in the effects of monetary policy on the economy. It makes activist policy all the more hazardous, leading to the kinds of “boom and bust” cycles described in Austrian business cycle theory.

Persistent Inflation

When the Fed went forward with the 25 basis point hike in the funds rate target in March, it was greeted with dismay by those still hopeful for a “soft landing”. In the Fed’s defense, one could say the continued effort to tighten policy is an attempt to make up for past sins, namely the Fed’s monetary profligacy during the pandemic.

The Fed’s rationale for this latest rate hike was that inflation remains persistent. Here are four CPI measures from the Cleveland Fed, which show some recent tapering of price pressures. Perhaps “flattening” would be a better description, at least for the median CPI:

Those are 12-month changes, and just in case you’ve heard that month-to-month changes have tapered more sharply, that really wasn’t the case in January and February:

Jason Furman noted in a series of tweets that the prices of services are driving recent inflation, while goods prices have been flat:

A compelling argument is that the shelter component of the CPI is overstating services inflation, and it’s weighted at more than one-third of the overall index. CPI shelter costs are known as “owner’s equivalent rent” (OER), which is based on a survey question of homeowners as to the rents they think they could command, and it is subject to a fairly long lag. Actual rent inflation has slowed sharply since last summer, so the shelter component is likely to relieve pressure on CPI inflation (and the Fed) in coming months. Nevertheless, Furman points out that CPI inflation over the past 3 -4 months was up even when housing is excluded. Substituting a private “new rent” measure of housing costs for OER would bring measured inflation in services closer the Fed’s comfort zone, however.

The Fed’s preferred measure of inflation, the deflator for personal consumption expenditures (PCE), uses a much lower weight on housing costs, though it might also overstate inflation within that component. Here’s another chart from the Cleveland Fed:

Inflation in the Core PCE deflator, which excludes food and energy prices, looks as if it’s “flattened” as well. This persistence is worrisome because inflation is difficult to stop once it becomes embedded in expectations. That’s exactly what the Fed says it’s trying to prevent.

Rate Targets and Money Growth

Targeting the federal funds rate (FFR) is the Fed’s primary operational method of conducting monetary policy. The FFR is the rate at which banks borrow from one another overnight to meet short-term needs for reserves. In order to achieve price stability, the Fed would do better to focus directly on controlling the money supply. Nevertheless, it has successfully engineered a decline in the money supply beginning last April, and recently the money supply posted year-over-year negative growth.

That doesn’t mean money growth has been “optimized” in any sense, but a slowdown in money growth was way overdue after the pandemic money creation binge. You might not like the way the Fed executed the reversal or its operating policy in general, and neither do I, but it did restrain money growth. In that sense, I applaud the Fed for exercising its independence, standing up to the Treasury rather than continuing to monetize yawning federal deficits. That’s encouraging, but at some point the Fed will reverse course and ease policy. We’ll probably hope in vain that the Fed can avoid sending us once again along the path of boom and bust cycles.

In effect, the FFR target is a price control with a dynamic element: the master fiddles with the target whenever economic conditions are deemed to suggest a change. This “controlled” rate has a strong influence on other short-term interest rates. The farther out one goes on the maturity spectrum, however, the weaker is the association between changes in the funds rate and other interest rates. The Fed doesn’t truly “control” those rates of most importance to consumers, corporate borrowers, government borrowers, and investors. It definitely influences those rates, but credit risk, business opportunities, and long-term expectations are often dominant.

The FOMC’s latest rate increase suggests its members don’t expect an immediate downturn in economic activity or a definitive near-term drop in inflation. The Committee may, however, be willing to pause for a period of several meeting cycles (every six weeks) to see whether the “long and variable lags” in the transmission of tighter monetary policy might begin to kick-in. As always, the FOMC’s next step will be “data dependent”, as Chairman Powell likes to say. In the meantime, the economic response to earlier tightening moves is likely to strengthen. Lenders are responding to the earlier rate hikes and reduced lending margins by curtailing credit and attempting to rebuild their own liquidity.

Is It Supply Or Demand?

There’s an ongoing debate about whether monetary policy is appropriate for fighting this episode of inflation. It’s true that monetary policy is ill-suited to addressing supply disruptions, though it can help to stem expectations that might cause supply-side price pressures to feed upon themselves (and prevent them from becoming demand-side pressures). However, profligate fiscal and monetary policy did much to create the current inflation, which is pressure on the demand-side. On that point, David Beckworth leaves little doubt as to where he stands:

“The real world is nominal. And nominal PCE was about $1.6 trillion above trend thru February. Unless one believes in immaculate above-trend spending, this huge surge could 𝙣𝙤𝙩 have happened without support from fiscal and monetary policy.”

In reality, this inflationary episode was borne of a mix of demand and supply-side pressures, and policy either caused or accommodated all of it. Nevertheless, it’s interesting to consider efforts to decompose these forces. This NBER paper attributed about 2/3 of inflation from December 2019 – June 2022 to the demand-side. Given the ongoing tenor of fiscal policy and the typical policy lags, it’s likely that the effects of fiscal and monetary stimulus have persisted well beyond that point. Here is a page from the San Francisco Fed’s site that gives an edge to supply-side factors, as reflected in this breakdown of the Fed’s favorite inflation gauge:

Of course, all of these decompositions are based on assumptions and are, at best, model-based. Nevertheless, to the extent that we still face supply constraints, they would impose limits to the Fed’s ability to manage inflation downward without a “hard landing”.

There’s also no doubt that supply side policies would reduce the kinds of price pressures we’re now experiencing. Regulation and restrictive energy policies under the Biden Administration have eroded productive capacity. These policies could be reversed if political leaders were serious about improving the nation’s economic health.

The Dark Runway Ahead

Will we have a recession? And when? There are no definite signs of an approaching downturn in the real economy just yet. Inventories of goods did account for more than half of the fourth quarter gain in GDP, which may now be discouraging production. There are layoffs in some critical industries such as tech, but we’ll have to see whether there is new evidence of overall weakness in next Friday’s employment report. Real wages have been a little down to flat over the past year, while consumer debt is climbing and real retail sales have trended slightly downward since last spring. Many firms will experience higher debt servicing costs going forward. So it’s not clear that the onset of recession is close at hand, but the odds are good that we’ll see a downturn as the year wears on, especially with credit increasingly scarce in the wake of the liquidity pinch at banks. But no one knows for sure, including the Fed.

“Hard Landing” Is Often Cost of Fixing Inflationary Policy Mistakes

05 Wednesday Oct 2022

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The debate over the Federal Reserve’s policy stance has undergone an interesting but understandable shift, though I disagree with the “new” sentiment. For the better part of this year, the consensus was that the Fed waited too long and was too dovish about tightening monetary policy, and I agree. Inflation ran at rates far in excess of the Fed’s target, but the necessary correction was delayed and weak at the start. This violated the necessary symmetry of a legitimate inflation-targeting regime under which the Fed claims to operate, and it fostered demand-side pressure on prices while risking embedded expectations of higher prices. The Fed was said to be “behind the curve”.

Punch Bowl Resentment

The past few weeks have seen equity markets tank amid rising interest rates and growing fears of recession. This brought forth a chorus of panicked analysts. Bloomberg has a pretty good take on the shift. Hopes from some economists for a “soft landing” notwithstanding, no one should have imagined that tighter monetary policy would be without risk of an economic downturn. At least the Fed has committed to a more aggressive policy with respect to price stability, which is one of its key mandates. To be clear, however, it would be better if we could always avoid “hard landings”, but the best way to do that is to minimize over-stimulation by following stable policy rules.

Price Trends

Some of the new criticism of the Fed’s tightening is related to a perceived change in inflation signals, and there is obvious logic to that point of view. But have prices really peaked or started to reverse? Economist Jeremy Siegel thinks signs point to lower inflation and believes the Fed is being too aggressive. He cites a series of recent inflation indicators that have been lower in the past month. Certainly a number of commodity prices are generally lower than in the spring, but commodity indices remain well above their year-ago levels and there are new worries about the direction of oil prices, given OPEC’s decision this week to cut production.

Central trends in consumer prices show that there is a threat of inflation that may be fairly resistant to economic weakness and Fed actions, as the following chart demonstrates:

Overall CPI growth stopped accelerating after June, and it wasn’t just moderation in oil prices that held it back (and that moderation might soon reverse). Growth of the Core CPI, which excludes food and energy prices, stopped accelerating a bit earlier, but growth in the CPI and the Core CPI are still running above 8% and 6%, respectively. More worrisome is the continued upward trend in more central measures of CPI growth. Growth in the median component of the CPI continues to accelerate, as has the so-called “Trimmed CPI”, which excludes the most extreme sets of high and low growth components. The response of those central measures lagged behind the overall CPI, but it means there is still inflationary momentum in the economy. There is a substantial risk that expectations of a more permanent inflation are becoming embedded in expectations, and therefore in price and wage setting, including long-term contracts.

The Fed pays more attention to a measure of prices called the Personal Consumption Expenditures (PCE) deflator. Unlike the CPI, the PCE deflator accounts for changes in the composition of a typical “basket” of goods and services. In particular, the Fed focuses most closely on the Core PCE deflator, which excludes food and energy prices. Inflation in the PCE deflator is lower than the CPI, in large part because consumers actively substitute away from products with larger price increases. However, the recent story is similar for these two indices:

Both overall PCE inflation and Core PCE inflation stopped accelerating a few months ago, but growth in the median PCE component has continued to increase. This central measure of inflation still has upward momentum. Again, this raises the prospect that inflationary forces remain strong, and that higher and more widespread expected inflation might make the trend more difficult for the Fed to rein in.

That leaves the Fed little choice if it hopes to bring inflation back down to its target level. It’s really a only a choice of whether to do it faster or slower. One big qualification is that the Fed can’t do much about supply shortfalls, which have been a source of price pressure since the start of the rebound from the pandemic. However, demand pressures have been present since the acceleration in price growth began in earnest in early 2021. At this point, it appears that they are driving the larger part of inflation.

The following chart shows share decompositions for growth in both the “headline” PCE deflator and the Core PCE deflator. Actual inflation rates are NOT shown in these charts. Focus only on the bolder colored bars. (The lighter bars represent estimates having less precision.) Red represents “supply-side” factors contributing to changes in the PCE deflator, while blue summarizes “demand-side” factors. This division is based on a number of assumptions (methodological source at the link), but there is no question that demand has contributed strongly to price pressures. At least that gives a sense about how much of the inflation can be addressed by actions the Fed might take.

I mentioned the role of expectations in laying the groundwork for more permanent inflation. Expected inflation not only becomes embedded in pricing decisions: it also leads to accelerated buying. So expectations of inflation become a self-fulfilling prophesy that manifests on both the supply side and the demand-side. Firms are planning to raise prices in 2023 because input prices are expected to continue rising. In terms of the charts above, however, I suspect this phenomenon is likely to appear in the “ambiguous” category, as it’s not clear that the counting method can discern the impacts of expectations.

What’s a Central Bank To Do?

Has the Fed become too hawkish as inflation accelerated this year while proving to be more persistent than expected? One way to look at that question is to ask whether real interest rates are still conducive to excessive rate-sensitive demand. With PCE inflation running at 6 – 7% and Treasury yields below 4%, real returns are still negative. That’s hardly seems like a prescription for taming inflation, or “hawkish”. Rate increases, however, are not the most reliable guide to the tenor of monetary policy. As both John Cochrane and Scott Sumner point out, interest rate increases are NOT always accompanied by slower money growth or slowing inflation!

However, Cochrane has demonstrated elsewhere that it’s possible the Fed was on the right track with its earlier dovish response, and that price pressures might abate without aggressive action. I’m skeptical to say the least, and continuing fiscal profligacy won’t help in that regard.

The Policy Instrument That Matters

Ultimately, the best indicator that policy has tightened is the dramatic slowdown (and declines) in the growth of the monetary aggregates. The three charts below show five years of year-over-year growth in two monetary measures: the monetary base (bank reserves plus currency in circulation), and M2 (checking, saving, money market accounts plus currency).

Growth of these aggregates slowed sharply in 2021 after the Fed’s aggressive moves to ease liquidity during the first year of the pandemic. The monetary base and M2 growth have slowed much more in 2022 as the realization took hold that inflation was not transitory, as had been hoped. Changes in the growth of the money stock takes time to influence economic activity and inflation, but perhaps the effects have already begun, or probably will in earnest during the first half of 2023.

The Protuberant Balance Sheet

Since June, the Fed has also taken steps to reduce the size of its bloated balance sheet. In other words, it is allowing its large holdings of U.S. Treasuries and Agency Mortgage-Backed Securities to shrink. These securities were acquired during rounds of so-called quantitative easing (QE), which were a major contributor to the money growth in 2020 that left us where we are today. The securities holdings were about $8.5 trillion in May and now stand at roughly $8.2 trillion. Allowing the portfolio to run-off reduces bank reserves and liquidity. The process was accelerated in September, but there is increasing tension among analysts that this quantitative tightening will cause disruptions in financial markets and ultimately the real economy, There is no question that reducing the size of the balance sheet is contractionary, but that is another necessary step toward reducing the rate of inflation.

The Federal Spigot

The federal government is not making the Fed’s job any easier. The energy shortages now afflicting markets are largely the fault of misguided federal policy restricting supplies, with an assist from Russian aggression. Importantly, however, heavy borrowing by the U.S. Treasury continues with no end in sight. This puts even more pressure on financial markets, especially when such ongoing profligacy leaves little question that the debt won’t ever be repaid out of future budget surpluses. The only way the government’s long-term budget constraint can be preserved is if the real value of that debt is bid downward. That’s where the so-called inflation tax comes in, and however implicit, it is indeed a tax on the public.

Don’t Dismiss the Real Costs of Inflation

Inflation is a costly process, especially when it erodes real wages. It takes its greatest toll on the poor. It penalizes holders of nominal assets, like cash, savings accounts, and non-indexed debt. It creates a high degree of uncertainty in interpreting price signals, which ordinarily carry information to which resource flows respond. That means it confounds the efficient allocation of resources, costing all of us in our roles as consumers and producers. The longer it continues, the more it erodes our economy’s ability to enhance well being, not to mention the instability it creates in the political environment.

Imminent Recession?

So far there are only limited signs of a recession. Granted, real GDP declined in both the first and second quarters of this year, but many reject that standard as overly broad for calling a recession. Moreover, consumer spending held up fairly well. Employment statistics have remained solid, though we’ll get an update on those this Friday. Nevertheless, payroll gains have held up and the unemployment rate edged up to a still-low 3.7% in August.

Those are backward-looking signs, however. The financial markets have been signaling recession via the inverted yield curve, which is a pretty reliable guide. The weak stock market has taken a bite out of wealth, which is likely to mean weaker demand for goods. In addition to energy-supply shocks, the strong dollar makes many internationally-traded commodities very costly overseas, which places the global economy at risk. Moreover, consumers have run-down their savings to some extent, corporate earnings estimates have been trimmed, and the housing market has weakened considerably with higher mortgage rates. Another recent sign of weakness was a soft report on manufacturing growth in September.

Deliver the Medicine

The Fed must remain on course. At least it has pretensions of regaining credibility for its inflation targeting regime, and ultimately it must act in a symmetric way when inflation overshoots its target, and it has. It’s not clear how far the Fed will have to go to squeeze demand-side inflation down to a modest level. It should also be noted that as long as supply-side pressures remain, it might be impossible for the Fed to engineer a reduction of inflation to as low as its 2% target. Therefore, it must always bear supply factors in mind to avoid over-contraction.

As to raising the short-term interest rates the Fed controls, we can hope we’re well beyond the halfway point. Reductions in the Fed’s balance sheet will continue in an effort to tighten liquidity and to provide more long-term flexibility in conducting operations, and until bank reserves threaten to fall below the Fed’s so-called “ample reserves” criterion, which is intended to give banks the wherewithal to absorb small shocks. Signs that inflationary pressures are abating is a minimum requirement for laying off the brakes. Clear signs of recession would also lead to more gradual moves or possibly a reversal. But again, demand-side inflation is not likely to ease very much without at least a mild recession.