Tag Archives: Liquidity

A Monetary Cease-Fire As Inflation Retreats, For Now

20 Tuesday Jun 2023

Posted by in Inflation, Monetary Policy

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The inflation news was good last week, with both the consumer and producer price indices (CPI and PPI) for May coming in below expectations. The increase in the core CPI, which excludes food and energy prices, was the same as in April. As this series of tweets attempts to demonstrate, teasing out potential distortions from the shelter component of the CPI shows a fairly broad softening. That might be heartening to the Federal Reserve, though at 4.0%, the increase in the CPI from a year ago remains too high, as does the core rate at 5.3%. Later in the month we’ll see how much the Fed’s preferred inflation gauge, the PCE deflator, exceeds the 2% target.

Inflation has certainly tapered since last June, when the CPI had its largest monthly increase of this cycle. After that, the index leveled off to a plateau lasting through December. But the big run-up in the CPI a year ago had the effect of depressing the year-over-year increase just reported, and it will tend to depress next month’s inflation report as well. After this June’s CPI (to be reported in July), the flat base from a year earlier might have a tendency to produce rising year-over-year inflation numbers over the rest of this year. Also, the composition of inflation has shifted away from goods prices and into services, where markets aren’t as interest-rate sensitive. Therefore, the price pressure in services might have more persistence.

So it’s way too early to say that the Fed has successfully brought inflation under control, and they know it. But last week, for the first time in 10 meetings, the Fed’s chief policy-making arm (the Federal Open Market Committee, or FOMC) did not increase its target for the federal funds rate, leaving it at 5% for now. This “pause” in the Fed’s rate hikes might have more to do with internal politics than anything else, as new Vice Chairman Philip Jefferson spoke publicly about the “pause” several days before the meeting. That statement might not have been welcome to other members of the FOMC. Nevertheless, at least the pause buys some time for the “long and variable lags” of earlier monetary tightening to play out.

There are strong indications that the FOMC expects additional rate hikes to be necessary in order to squeeze inflation down to the 2% target. The “median member” of the Committee expects the target FF rate to increase by an additional 50 basis points by the end of 2023. At a minimum, it seems they felt compelled to signal that later rate hikes might be necessary after having their hand forced by Jefferson. That “expectation” might have been part of a “political bargain” struck at the meeting.

In addition, the Fed’s stated intent is to continue drawing down its massive securities portfolio, an act otherwise known as “quantitative tightening” (QT). That process was effectively interrupted by lending to banks in the wake of this spring’s bank failures. And now, a danger cited by some analysts is that a wave of Treasury borrowing following the increase in the debt ceiling, along with QT, could at some point lead to a shortage of bank reserves. That could force the Fed to “pause” QT, essentially allowing more of the new Treasury debt to be monetized. This isn’t an imminent concern, but perhaps next year it could present a test of the Fed’s inflation-fighting resolve.

It’s certainly too early to declare that the Fed has engineered a “soft landing”, avoiding recession while successfully reigning-in inflation. The still-inverted yield curve is the classic signal that credit markets “expect” a recession. Here is the New York Federal Reserve Bank’s recession probability indicator, which is at its highest level in over 40 years:

There are other signs of weakness: the index of leading economic indicators has moved down for the last 13 months, real retail sales are down from 13 months ago, and real average weekly earnings have been trending down since January, 2021. A real threat is the weakness in commercial real estate, which could renew pressure on regional banks. Credit is increasingly tight, and that is bound to take a toll on the real economy before long.

The labor market presents its own set of puzzles. The ratio of job vacancies to job seekers has declined, but it is still rather high. Multiple job holders have increased, which might be a sign of stress. Some have speculated that employers are “hoarding” labor, hedging against the advent of an ultimate rebound in the economy, when finding new workers might be a challenge.

Despite some high-profile layoffs in tech and financial services, job gains have held up well thus far. Of course, the labor market typically lags turns in the real economy. We’ve seen declining labor productivity, consistent with changes in real earnings. This is probably a sign that while job growth remains strong, we are witnessing a shift in the composition of jobs from highly-skilled and highly-paid workers to lower-paid workers.

A further qualification is that many of the most highly-qualified job applicants are already employed, and are not part of the pool of idle workers. It’s also true that jobless claims, while not at alarming levels, have been trending higher.

It’s important to remember that the Fed’s policy stance over the past year is intended to reduce liquidity and ultimately excess demand for goods and services. In typical boom-and-bust fashion, the tightening was a reversal from the easy-money policy pursued by the Fed from 2020 – early 2022, even in the face of rising inflation. The money supply has been declining for just over a year now, but the declines have been far short of the massive expansion that took place during the pandemic. There is still quite a lot of liquidity in the system.

That liquidity helps explain the stock market’s recovery in the face of ongoing doubts about the economy. While the market is still well short of the highs reached in early 2022, recent gains have been impressive.

Some would argue that the forward view driving stock prices reflects an expectation of a mild recession and an inevitable rebound in the economy, no doubt accompanied by eventual cuts in the Fed’s interest rate target. But even stipulating that’s the case, the timing of a stock rally on those terms seems a little premature. Or maybe not! It wouldn’t be the first time incoming data revealed a recession had been underway that no one knew was happening in real time. Are we actually coming out of shallow woods?

To summarize, inflation is down but not out. The Fed might continue its pause on rate hikes through one more meeting in late July, but there will be additional rate increases if inflation remains persistent or edges up from present levels, or if the economy shows unexpected signs of strength. I’d like to be wrong about the prospects of a recession, but a downturn is likely over the next 12 months. I’ve been saying that a recession is ahead for the past eight months or so, which reminds me that even a broken clock is right twice a day. In any case, the stock market seems to expect something mild. However misplaced, hopes for a soft landing seem very much alive.

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

01 Saturday Apr 2023

Posted by in Inflation, Monetary Policy

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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.

The Federal Reserve and Coronatative Easing

09 Monday Mar 2020

Posted by in Monetary Policy, Pandemic

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Laughs erupted all around when the Federal Reserve reduced its overnight lending rate by 50 basis points last week: LIKE THAT’LL CURE THE CORANAVIRUS! HAHAHA! It’s easy to see why it seemed funny to people, even those who think the threat posed by Covid-19 is overblown. But it should seem less silly with each passing day. That’s not to say I think we’re headed for disaster. My own views are aligned with this piece by Michael Fumento: it will run its course before too long, and “viruses hate warm weather“. Nevertheless, the virus is already having a variety of economic effects that made the Fed’s action prudent.

Of course, the Fed did not cut its rate to cure the virus. The rate move was intended to deal with some of the economic effects of a pandemic. The spread of the virus has been concentrated in a few countries thus far: China, Iran, Italy, and South Korea. Fairly rapid growth is expected in the number of cases in the U.S. and the rest of the world over the next few weeks, especially now with the long-awaited distribution of test kits. But already in the U.S., we see shortages of supplies hitting certain industries, as shipments from overseas have petered. And now efforts to control the spread of the virus will involve more telecommuting, cancellation of public events, less travel, less dining out, fewer shopping trips, missed work, hospitalizations, and possibly widespread quarantines.

The upshot is at least a temporary slowdown in economic activity and concomitant difficulties for many private businesses. We’ve been in the midst of a “flight to safety”, as investors incorporate these expectations into stock prices and interest rates. Firms in certain industries will need cash to pay bills during a period of moribund demand, and consumers will need cash during possible layoffs. All of this suggests a need for liquidity, but even worse, it raises the specter of a solvency crisis.

The Fed’s power can attempt to fill the shortfall in liquidity, but insolvency is a different story. That, unfortunately, might mean either business failures or bailouts. Large firms and some small ones might have solid business continuation plans to help get them through a crisis, at least one of short to moderate duration, but many businesses are at risk. President Trump is proposing certain fiscal and regulatory actions, such as a reduction in the payroll tax, wage payment assistance, and some form of mandatory paid leave for certain workers. Measures might be crafted so as to target particular industries hit hard by the virus.

I do not object to these pre-emptive measures, even as an ardent proponent of small government, because the virus is an externality abetted by multiplicative network effects, something that government has a legitimate role in addressing. There are probably other economic policy actions worth considering. Some have suggested a review of laws restricting access to retirement funds to supplement inadequate amounts of precautionary savings.

Last week’s Fed’s rate move can be viewed as pre-emptive in the sense that it was intended to assure adequate liquidity to the financial sector and payment system to facilitate adjustment to drastic changes in risk appetites. It might also provide some relief to goods suppliers who find themselves short of cash, but their ability to benefit depends on their relationships to lenders, and lenders will be extremely cautious about extending additional credit as long as conditions appear to be deteriorating.

In an even stronger sense, the Fed’s action last week was purely reactive. Scott Sumner first raised an important point about ten days before the rate cut: if the Fed fails to reduce its overnight lending target, it represents a de facto tightening of U.S. monetary policy, which would be a colossal mistake in a high-risk economic and social environment:

“When there’s a disruption to manufacturing supply chains, that tends to reduce business investment, puts downward pressure on demand for credit. That will tend to reduce equilibrium interest rates. In addition, with the coronavirus, there’s also a lot of uncertainty in the global economy. And when there’s uncertainty, there’s sort of a rush for safe assets, people buy treasury bonds, that puts downward pressure on interest rates. So you have this downward pressure on global interest rates. Now while this is occurring, if the Fed holds constant its policy rate, it targets the, say fed funds rate at a little over 1.5 percent. While the equilibrium rates are falling, then essentially the Fed will be making monetary policy tighter.

… what I’m saying is, if the Fed actually wants to maintain a stable monetary policy, they may have to move their policy interest rate up and down with market conditions to keep the effective stance of monetary policy stable. So again, it’s not trying to solve the supply side problem, it’s trying to prevent it from spilling over and also impacting aggregate demand.”

The Fed must react appropriately to market rates to maintain the tenor of its policy, as it does not have the ability to control market rates. Its powers are limited, but it does have a responsibility to provide liquidity and to avoid instability in conducting monetary policy. Fiscal actions, on the other hand, might prove crucial to restoring economic confidence, but ultimately controlling the spread of the virus must be addressed at local levels and within individual institutions. While I am strongly averse to intrusions on individual liberty and I desperately hope it won’t be necessary, extraordinary measures like whole-city quarantines might ultimately be required. In that context, this post on the effectiveness of “non-pharmaceutical interventions” such as school closures, bans on public gatherings, and quarantines during the flu pandemic of 1918-19 is fascinating.