Tag Archives: Quantitative Tightening

Almost Looks Like the Fed Has a 3% Inflation Target

16 Sunday Nov 2025

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Inflation leveled off below 3% in 2024 and has drifted around the 3% level in 2025. The rate of increase in the core PCE (Personal Consumption Deflator) is the inflation measure of most interest to the Federal Reserve as a policy reference, but advances in the core CPI (Consumer Price Index) have settled at about the same level. The core inflation rates exclude food and energy prices due to the volatility of those components, but even with food and energy, inflation in the PCE and the CPI have been running near 3%.

It’s a 2% Target… Or Is It?

The Fed continues to maintain that its “official” inflation target is 2% for the core PCE. However, the central bank is now easing policy despite inflation running a full percentage point faster than the target. The rationale turns on the Fed’s dual mandate to maintain both “price stability” and full employment, goals that are not always compatible.

Currently, the labor market is showing signs of weakness, so the Fed has elected to ease policy by guiding the federal funds rate downward, and by putting a stop to run-off in its balance sheet holdings of securities. The latter ends a brief period of so-called quantitative tightening.

Just a couple of months ago, the central bank announced a new emphasis on targeting 2% inflation in the long run, with notable differences from the “flexible average inflation targeting” (FAIT) that it claimed to have adopted in 2020. In some respects, the Fed appeared to be giving more primacy to the “2%” definition of price stability than to the full employment mandate. Yet the “new approach” still allows plenty of wiggle room and might not differ much from the approach followed prior to FAIT.

No FAITful Error

Here’s how David Beckworth characterizes the way FAIT ultimately played out. He says that in practice the Fed took:

“… an asymmetric approach to the dual mandate: It would implement makeup policy on misses below the inflation target, and it would respond to shortfalls from maximum employment. These asymmetries, while well- intended, created an inflationary bias that caused FAIT to fail the ‘stress test’ of the 2021–22 inflation surge. This failure caused the Fed to effectively abandon FAIT in early 2022 and become a single-mandate central bank focused on price stability.“

Scott Sumner says the Fed never really really practiced FAIT to begin with. It should have been a symmetric policy, but it wasn’t. During 2021-22, the Fed did not attempt to correct for rising inflation. Instead, it focused on the recessionary effects of Covid and the impingements of Covid-era restrictions on employment.

Clearly, Covid was a shock that monetary policy was ill-suited to address without reinforcing inflation. Furthermore, the pandemic inflation was thought by the Fed to be transitory, but easing policy was a critical error. Stimulating demand via monetary accommodation gave inflation more permanence than the Fed apparently expected.

Lost In the Tea Leaves Again

While a strong commitment to price stability is welcome, it’s not clear that is what’s guiding the Fed’s decisions at the moment. Again, the Fed’s preferred inflation gauge has flattened out at around 3%. However, with uncertainty about tariffs and tariff pass throughs in 2026, the weak dollar, and unrelenting Treasury borrowing, easier monetary conditions could well set the stage for persistent inflation above 3%, despite the official 2% target. That might help explain the failure of longer-term interest rates to decline in the wake of the Fed’s latest quarter-point cut in the federal funds target in October.

Suspicious Minds

Speculation that the Fed is allowing its true inflation target to creep upward is hardly new. Back in June, former New York Fed economist Robert Brusca noted the following:

“A Cleveland Fed survey already has the business community thinking that the REAL target for inflation is 2.5%.”

More recently, Mark Sobel of the Official Monetary and Fiscal Institutions Forum stated that the real target, for now, is probably 3%:

“But could the Fed stealthily and unintentionally end up near 3%? Even apart from above-target inflation in recent years, short- and longer-term structural forces are at play that could usher in slightly higher inflation, notwithstanding Fed speeches on the sanctity of the 2% inflation target.“

Chewing On Data

It’s pretty clear that the Fed has become a skittish about the pace of the real economy, lending more weight to the full employment part of its dual mandate. Employment growth slowed over the past year, partly due to government employee buy-outs and separations of illegal immigrants from their employers. The last official employment report was in early September, however, so the nonfarm payroll data is two months out-of-date:

Private payroll growth from ADP over the past two months has not looked especially encouraging:

Tariffs and weakened profit margins have likely had a contractionary effect, and the six-week government shutdown just ended will shave 0.5% or more off fourth quarter GDP growth. Furthermore, while money (M2) growth has accelerated over the past year, it remains fairly restrained.

And the monetary base has been pretty flat for most of 2025:

We’ll see where these aggregates go from here. The extended “restraint” might now be of some concern to the Fed, given recent doubts about employment and economic growth. Still, in October, Fed Chairman Jerome Powell said that another quarter-point cut in the federal funds rate target in December was not a foregone conclusion. That statement seems to have worried equity investors while offering little solace to bond investors.

Aborted Landing

If (and as long as) the Fed gives primacy or greater weight in its policy deliberations to employment than inflation, it might as well have adopted an inflation target of 3% or more. The additional erosion in purchasing power wrought by that leniency is bad enough, but the effect of monetary policy on the real side of the economy is more poorly understood than its effect on nominal variables. The Fed’s shift in priorities is both unreliable on the real side and dangerous in terms of price stability. These concerns are even more salient given the upcoming appointment (in May) of a new Fed Chairman by President Trump, who seems eager for easy money.

Indecorously Jaw-Boning an Unhurried Fed

21 Saturday Jun 2025

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President Trump engaged in one of his favorite pastimes on June 18 while the Federal Reserve Open Market Committee (FOMC) was concluding its meeting on the direction of monetary policy. He publicly called Fed Chairman Jerome Powell “stupid” for not having cut rates already, and later said the Fed’s board was “complicit”.

“”I don’t know why the Board doesn’t override this Total and Complete Moron!“

Trump also tagged Powell with one of his trademark appellations: “Too Late”. Yep, that’s how Trump says he refers to Powell.

Later that day, the Fed once again announced that it had decided to leave unchanged its target range for the interest rate on federal funds. Powell described the overall tenor of current Fed policy as mildly restrictive, but FOMC members still “expect” (loosely speaking) two quarter-point cuts in the funds rate by year end.

Of course, Powell and the FOMC really were far too late in recognizing that inflation was more than transitory in 2021-22. Now, with inflation measures tapering but still higher than the Fed’s 2% target, Trump says “Too Late” Powell and the Fed are again behind the curve. Of course, because the central bank is outside the President’s direct control, it makes a convenient scapegoat for whatever might ail the Trump economy, and Trump frets that unnecessarily high rates will cost the U.S. Treasury hundreds of billions in interest on new and refinanced federal debt.

The President has no appreciation for the value of an independent central bank, as opposed to one captive to the fiscal whims of Presidents and Congress. Despite his frequent criticism of inflationary sins of the past, Trump doesn’t understand the dangers of a central bank that could be bullied into inflating away government debt.

The day after the Fed’s meeting, Trump said rates should be cut immediately by a huge 2.5%! As the Donald might say, no one’s ever seen anything like it!

Trump, however, is delusional to think the Fed can engineer reductions in the spectrum of interest rates by aggressively slashing its fed funds target. The Fed does not control long-term interest rates, nor is that part of the Fed’s formal mandate. In fact, an aggressively large reduction in the fed funds rate is likely to backfire, feeding expectations of higher inflation and a selloff in credit markets.

Let me reiterate: the Fed does not control long-term interest rates. Short-term rates are more heavily influenced by the Fed’s rate actions, and by expectations of Fed policy, but the Fed is likewise influenced by those very expectations. In fact, the Fed often follows market rates rather than leading them. In any case, a general truth is that long-term interest rates go where market forces direct them, not where the Fed might try to push them.

Today the Fed is attempting to walk a line between precipitating divergent and potentially negative outcomes. It wants to see clear evidence that inflation is settling down at roughly the 2% target. Also, the Fed is wary that Trump’s tariffs might generate a near-term spike in prices. Under those circumstances, prematurely easing policy could rekindle more permanent inflationary pressures. It seems clear that the Fed currently judges inflation as the dominant risk.

At the same time, the real economy shows mixed signals. Clear signs of a downturn would likely prompt the Fed to cut its fed funds target sooner. After the latest meeting, the Fed announced that it had reduced its own forecast for real GDP growth in 2025 to just 1.4%. Recent employment gains have been moderate, but jobless claims are trending up. The unemployment rate is low, but the labor force has declined over the past few months, which incidentally might be putting upward pressure on wages.

Policy uncertainty was a major theme in the Fed’s June rate decision. Tariffs loom large and would be a threat to continued growth if producers, facing weak demand, were unable to pass the cost of tariffs through to customers, undermining their profit margins. Prospects for passage of the budget reconciliation bill create more uncertainty, providing another rationale to stand pat without cutting the funds rate.

Again, Jerome Powell says that Fed policy is “modestly restrictive” at present. In fact, estimates of the “policy neutral” Fed funds rate are in the vicinity of 2.75%, well below the current target range of 4.25-4.50. However, the money supply (M2) has drifted up over the past year and by May was up 4.4% from a year earlier. That would be consistent with 2% inflation and better than 2% real growth, the latter being higher than the FOMC’s expectation.

Another consideration is that the Fed has nearly ended its quantitative tightening (QT) program, having recently trimmed the passive runoff of maturing securities in its portfolio to just $5 billion per month. This leads to less downward pressure on bank reserves and less upward pressure on the fed funds rate. In other words, policy has already shifted toward greater support for money growth. But out of caution, the Fed wants to defer reductions in the funds rate to avoid undermining the central bank’s inflation-fighting credibility.

Jerome Powell and the FOMC probably could not care less about Trump’s exhortations to reduce interest rates. For one thing, it is beyond the Fed’s power to force down rates that could spur housing and other economic activity. And Trump should be grateful: such a reckless attempt would risk great harm to markets and the economy, not to mention Trump’s economic agenda. Better to wait until near-term inflation risks and policy uncertainty clear up.

Trump can jawbone as aggressively as he wants. He cannot fire Powell, though he keeps saying he “should”. However, no matter what actions the Fed takes, he will almost certainly not reappoint Powell to lead the Fed when Powell’s term expires next May. Sadly, Trump will try to appoint a replacement he can rely upon to do his bidding. Let’s hope the Senate stands in his way to preserve Fed independence.

The Fed Tiptoes Through Lags and an Endless Fiscal Thicket

04 Wednesday Sep 2024

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The late, great Milton Friedman said monetary policy has “long and variable lags” in its effect on the economy. Easy money might not spark an inflation in goods prices for two years or more, though the typical lag is thought to be more like 15-20 months. Tight money seems to have similar lags in its effects. Debates surround the division and timing of these effects between inflation and real GDP, and too many remain convinced that a reliable tradeoff exists between inflation and unemployment.

With that preface, where do we stand today? The Fed executed a veritable helicopter drop of cash during the pandemic, in concert with support payments by the Treasury, with predictable inflationary results. It was also, in part, an accommodation to supply-side pressures. Then the tightening of policy began in the spring of 2022. How will the timing and strength of these shifting policies ultimately play out, as well as the impact of expectations regarding future policy moves?

Help On the Way?

Federal Reserve Chairman Jerome Powell and the Fed’s Open Market Committee (FOMC) are now poised to ease policy after three-plus years of a tighter policy stance. The FOMC is widely expected to cut its short-term interest rate target by a quarter point at the next FOMC on September 17-18. There is an outside chance that the Fed will cut the target by a half point, depending on the strength of new data to be released over the next couple of weeks. In particular, this Friday’s employment report looms large.

What sometimes goes unacknowledged is that the Fed will be following market rates downward, not leading them. The chart below shows the steep drop in the one-year Treasury yield over the past couple of months. Other rates have declined as well. Granted, longer rates are determined in large part by expectations of future short-term rates over which the Fed has more control.

And yet the softening of market rates may well be a signal of weaker economic activity. There is certainly concern among investors that a failure by the Fed to ease policy might jeopardize the much hoped-for “soft landing”. The lagged effects of the Fed’s tighter policy stance may drag on, with damage to the real economy and the labor market. Indeed, some assert that a recession remains a strong possibility (and see here), and the manufacturing sector has been in a state of contraction for five months.

On the other hand, the Fed has fallen short of its 2% inflation goal. The core PCE deflator, the Fed’s preferred inflation gauge, was up 2.6% for the year ending in July. Some observers fear that easing policy prematurely will lead to a new acceleration of inflation.

Powell Gives the Nod

Nevertheless, markets were relieved when Jerome Powell, in his recent speech in Jackson Hole, Wyoming, indicated his determination that a shift in policy was appropriate. From Bloomberg:

“Federal Reserve Chair Jerome Powell said ‘the time has come’ for the central bank to start cutting interest rates.

“Powell’s comments cemented expectations for a rate cut at the central bank’s next gathering in September. The Fed chief said the cooling of the labor market is ‘unmistakable,’ adding, ‘We do not seek or welcome further cooling in labor market conditions.’ Powell also said his confidence has grown that inflation is on a ‘sustainable path’ back to the Fed’s goal of 2%.“

The “sustainable path back to … 2%” might imply a view inside Fed that policy will remain somewhat restrictive even after a quarter or half-point rate cut in September. Or perhaps the “sustainable path” has to do with the aforementioned lags, which might continue to be operative regardless of any immediate change in policy. The feasibility of a “soft landing” depends on whether policy is indeed still restrictive or on how benign those lagged effects turn out to be. But if we take the lags seriously, an easing of policy wouldn’t have real economic force for perhaps 15 months. Still, the market puts great hope in the salutary effects of a move by the Fed to ease policy.

Big Balance Sheet

It can be argued that the Fed already took a step toward easing policy in May when it reduced the rate at which it was allowing runoff in its portfolio of Treasury and mortgage-backed securities. Prior to that, it had been redeeming $95 billion of maturing securities a month. The new runoff amount is $60 billion per month. Unless neutralized in other ways, the runoff has a contractionary effect on bank reserves and the money supply. It is known as “quantitative tightening” (QT). but then the May announcement was a de facto easing in the degree of QT.

Thus far, the total reduction in the Fed’s portfolio has amounted to only $1.7 trillion from the original high-water mark of $8.9 trillion. Here is a chart showing the recent evolution in the size of the Fed’s securities holdings.

The Fed’s current balance sheet of $7.2 trillion is gigantic by historical standards. It’s reasonable to ask why the Fed considers what we have now to be a more “normalized” portfolio, and whether its size (and correspondingly, the money supply) represents potential “dry tinder” for future inflation. It remains to be seen whether the Fed will further pare the rate of portfolio runoff in the months ahead.

Money growth had been running negative for roughly a year and a half, but it edged closer to zero in late 2023 before accelerating to a slow, positive rate a few months into 2024. The timing didn’t exactly correspond to the Fed’s slowing of portfolio runoff. Nevertheless, the Fed’s strong preference is to supply the banking system with “ample reserves”, and reserves drive money growth. Thus, the Fed’s reaction to conditions in the market for reserves was a factor allowing money growth to accelerate.

A Cut Too Soon?

A rate cut later this month will make reserves still more ample and support additional money growth. And again, this will be an effort to mediate the negative impact of earlier policy tightness, but the effect of this move on the economy will be subject to similar lags.

A danger is that the Fed might be easing too soon, so that inflation will fail to taper to the 2% goal and possibly accelerate again. And perhaps policy was not quite as tight as it needed to be to achieve the 2% goal. Now, new supply bottlenecks are cropping up, including a near shutdown of shipping through the Suez Canal and a potential strike by east coast dockworkers.

Fiscal Incontinence

An even greater threat now, and in the years ahead, is the massive pressure placed on the economy and the Fed by excessive federal spending and Treasury borrowing. The growth of federal debt over the 12 months ending in July was almost 10%. Total federal debt stands at about $35 trillion. According to the Congressional Budget Office (CBO) projections, federal debt held by the public will be almost $28 trillion by the end of 2024 (the rest the public debt is held by the Fed or federal agencies). The CBO also projects that the federal budget deficit will average almost $1.7 trillion annually through 2027 before rising to $2.6 trillion by 2034. That would bring federal debt held by the public to more than $48 trillion.

Inflation is receding ever so slowly for now, but it’s unclear that investors will remain comfortable that growth in the public debt can be paid down by future surpluses. If not, the only way its real value can be reduced is through higher prices. Most observers believe such an inflation requires that the Fed monetize federal debt (buy it from the public with printed money). Tighter credit markets will increase pressure on the Fed to do so, but the growing debt burden is likely to exert upward pressure on the prices of goods with or without accommodation by the Fed.

Hard, Soft, Or Aborted Landing?

Some economists are convinced that the Fed has successfully engineered a “soft landing”. I might have to eat some crow…. I felt that a “hard landing” was inevitable from the start of this tightening phase. Even now I would not discount the possibility of a recession late this year or in early 2025. And perhaps we’ll get no “landing” at all. The Fed’s expected policy shift together with the fiscal outlook could presage not just a failure to get inflation down to the Fed’s 2% target, but a subsequent resurgence in price inflation.

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.

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.

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

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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.