The US Federal Reserve has turned on a dime, an uncharacteristic about-face for an institution long noted for slow and deliberate shifts in monetary policy. While the Fed’s recent messaging (it hasn’t really done anything yet) is not as creative as I had hoped, at least it has recognised that it has a serious problem.
That problem, of course, is inflation. Like the Fed I worked at in the early 1970s under Arthur Burns, today’s policymakers once again misdiagnosed the initial outbreak. The current upsurge in inflation is not transitory or to be dismissed as an outgrowth of idiosyncratic COVID-19-related developments. It is widespread, persistent, and reinforced by wage pressures stemming from an unprecedentedly sharp tightening of the US labour market. Under these circumstances, the Fed’s continued refusal to change course would have been an epic policy blunder.
But recognising the problem is only the first step toward solving it. And solving it will not be easy.
Consider the math: The inflation rate as measured by the Consumer Price Index reached 7% in December 2021. With the nominal federal funds rate effectively at zero, that translates into a real funds rate (the preferred metric for assessing the efficacy of monetary policy) of -7%.
That is a record low.
Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to -5%. Those two instances bookended the Great Inflation, when, over a five-year-plus period, the CPI rose at an 8.6% average annual rate.
Of course, no one thinks we are facing a sequel. I have been worried about inflation for longer than most, but even I don’t entertain that possibility. Most forecasters expect inflation to moderate over the course of this year. As supply-chain bottlenecks ease and markets become more balanced, that is a reasonable presumption.
But only to a point. The forward-looking Fed still faces a critical tactical question: What federal funds rate should it target to address the most likely inflation rate 12-18 months from now?
No one has a clue, including the Fed and the financial markets. But one thing is certain: With a -7% real federal funds rate putting the Fed in a deep hole, even a swift deceleration in inflation does not rule out an aggressive monetary tightening to re-position the real funds rate such that it is well-aligned with the Fed’s price-stability mandate.
To figure this out, the Fed must hazard an estimate of when the inflation rate will peak and head lower. It is always tough to guess the date – and even harder to figure out what “lower” really means. But the US economy is still running hot, and the labour market, at least as measured by the plunging unemployment rate, is tighter than at any point since January 1970 (on, gulp, the brink of the Great Inflation). Under these circumstances, I would argue that a responsible policymaker would want to err on the side of caution and not bet on a quick, miraculous roundtrip of inflation back to its sub-2% pre-COVID-19 trend.
Again, consider the math: Let’s say the Fed’s projected policy path, as conveyed through its latest “dot plot,” is correct and the central bank takes the nominal federal funds rate from zero to around 1% by the end of 2022. Couple that with a judicious assessment of the disinflation trajectory – not too slow, not too fast – that foresees year-end CPI inflation moving back into the 3-4% zone. That would still leave the real federal funds rate in negative territory at -2% to -3% at the end of this year.
That’s the catch in all this. In the current easing cycle, the Fed first pushed the real federal funds rate below zero in November 2019. That means a likely -2% to -3% rate in December 2022 would mark a 38-month period of extraordinary monetary accommodation, during which the real federal funds rate averaged -3.1%.
Historical perspective is important here. There have been three earlier periods of extraordinary monetary accommodation worth noting: In the aftermath of the dot-com bubble a generation ago, the Fed under Alan Greenspan ran a negative real funds rate averaging -1.1% for 31 consecutive months. Following the 2008 global financial crisis, Ben Bernanke and Janet Yellen teamed up to sustain a -1.9% average real funds rate for a whopping 62 months. And then, as post-crisis sluggishness persisted, Yellen partnered with Jerome Powell for 37 straight months to hold the real funds rate at -0.9%.
Today’s Fed is playing with fire. The -3.1% real federal funds rate of the current über-accommodation is more than double the -1.4% average of those three earlier periods. And yet today’s inflation problem is far more serious, with CPI increases likely to average 5% from March 2021 through December 2022, compared with the 2.1% average that prevailed under the earlier regimes of negative real funds rates.
All this underscores what could well be the riskiest policy bet the Fed has ever made. It has injected record stimulus into the economy during a period when inflation is running at well over twice the pace it did during its three previous experiments with negative real funds rates. I deliberately left out a fourth comparison: the -1.7% real federal funds rate under Burns in the early 1970s. We know how that ended. And I also left out any mention of the Fed’s equally aggressive balance-sheet expansion.
By now, it is passé to warn that the Fed is “behind the curve.” In fact, the Fed is so far behind that it can’t even see the curve. Its dot plots, not only for this year but also for 2023 and 2024, don’t do justice to the extent of monetary tightening that most likely will be required as the Fed scrambles to bring inflation back under control. In the meantime, financial markets are in for a very rude awakening.
Stephen S. Roach is a faculty member at Yale University and the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate, 2021, published here with permission.
39 Comments
Biggest blunder by Fed was ignoring all data and signal that was shouting from rooftop that inflation is getting out of control and to act and act fast. Though it started to show in December 2020 (After 9 months of money printing) and was very much evident in early 2021 (writing was on the wall). Fed not only denied and ignored but to silence the critics manipulated the word TRANSITORY INFLATION and Powell did this till he was reappointed indicating that he was very much aware of the goofup much earlier but persisted with self interest over economy.
No accountability.
What we are facing today is doing of reserve bank, specially Fed as most governor of reserve banks including rbnz just follow fed to play safe without thinking with attitude that if we were to fall of the cliff so will US and what better excuse that if Bigger economy and country like US can fail, so can we.
All experts and media is raising questions now, after the event, why were they silent when their was a need to raise the voice or were they also too stupid.
They didn't ignore it. They knew exactly what they were doing. They don't care about a bit of inflation if all their rich buddies are getting richer from equities pumping. Problem was, inflation got to a point where the plebs started to become aware of it and complain. Now they have to appear to do something (signal rate rises) and the markets don't like it. Rock and a hard place. My popcorn is ready.
Yep, any day now ... lol
https://markets.businessinsider.com/news/stocks/stock-market-outlook-je…
Successive governments. There was the opportunity in the past to turn things around rather than continuing blowing up debt to enrich asset owners...but no, couldn't do that. I voted for John Key because of his campaigning on productivity and addressing the housing crisis, then it all mysteriously became a good problem to have and no crisis. Same with John Key 2.0 (Ardern) and 3.0 (Luxon - yet more light rhetoric on productivity while investing in housing and practicing NIMBYism).
Carlos you might not of seen this coming but a number of people on here did, people and investors have taken on to much debt,the prices only went sky high because of emergency rates now inflation is high and NZD is tanking the OCR will have to increase anyone who has purchased in last 2-3 years will see their deposit gone and will be in negative equity
Carlos67,
Transitory is a blurry concept. Would 4/5 years qualify, or must it be a lot shorter to qualify?
My money is on inflation being transitory as long as 4/5 years is included in the definition. Why? Well, supply chain issues will have largely been sorted by then. As mortgage rates increase, so too will discretionary income decrease, sucking consumer spending power from the economy. Despite anecdotal evidence, there is actually little hard evidence of rising incomes which might be baked into the system. Rising fuel prices will suck yet more discretionary spending out of the economy.
I remain pessimistic on global growth and there appears to be mounting economic issues in China.
The Fed is so far behind the inflation curve that they can't even see it, and the same applies to the RBNZ. The OCR should be at least at 3% now, and it should go to 4% as soon as possible, if we want to retain any hopes to tame inflation before it's too late.
Not doing so now will simply force the RBNZ to go even higher later on.
Nah, Inflation came to New Zealand earlier than other countries. Unemployment rate was low as well when inflation hits New Zealand. So really, RBNZ should've not had any excuses. But they were using "transitory" and "uncertainty" as excuses to hold off OCR hike last year. They are not doing their job really. Now it's proved that the damages caused by inflation has been much greater than last year's lockdown. Just look at NZD right now.
I think we are at the end of the monetarist experiment.
The enormous run-up in debt/ money was not accompanied by inflation due to out-sourcing to slave-wage economies and the discovery of some large new oil/ resource deposits. (North Sea/ Alaska). Of course technological innovations played a role too.
We are now at the point where there is simply not enough real world resources to go around. The great moderation is over as we smack headlong into diminishing returns and scarcity. (Think Limits to Growth).
The ignorance of physics by our modern high priests (economists) will be for all to see as the money system adjusts back to the real world of energy and "stuff". Inflation is a necessary part of that adjustment perhaps with some large scale defaults thrown in for good measure.
So what are all the real world effects that Joe Bloggs is about to experience ? The last time we went through this I was only about 19 years of age and was totally oblivious to the crash and there has not been high inflation since I was like 8 years old. The price of everything took off in the early 80's including houses. Honestly I cannot see where this is going but one thing is for sure, I'm more exposed financially than I was at 8 years old.
Joe Bloggs will have to work harder for less. May have to sell the boat as he can't afford to fill it up with gas. 2nd hand ute next time, not a new Ranger. Overseas travel will end. Will eat less meat. Not run the heat pump all day. Kids will wear hand-me-downs. Mrs.Bloggs will learn sewing to repair garments rather than replacing. More home cooked meals featuring potatoes. Few meals out. One car household.etc...etc...
Basically that's how we lived in the 1970's, and my grand parents thought we were extravagant because we didn't grow our own veg.
If you think Joe Bloggs currently owns two cars (including a new ranger), a boat, owns a heat pump (let alone runs it all day) and takes overseas holidays I think you are a bit out of touch with how everyday New Zealanders are living.
I'm late thirties, and your description of how people lived in the seventies is how most people I know live now - if they are lucky and could even afford kids and a house (and these are for the most part educated people with relatively high incomes). It's not hard to guess why.
Pretty sure the average standard of living and peoples expectations have gone up considerably since the 1970's. The way we lived back then is not the way people live now sorry. We were lucky to have an old car and electronics stuff was non existent and we had a black and white TV, dinners out were fish and chips and overseas travel was zero, there is no way that's considered "Average" living these days.
It's interesting to me that some people fail to understand the concept of relative disadvantage. Sure, lots of people didn't have cars in earlier decades. But because lots of people didn't, you weren't at a massive disadvantage if you didn't - for example, factories near where I used to live used to send their own vans round to pick up workers. Public transport used to be way better. Same with phones - sure, no one had cellphones. But because no one had them, you weren't at disadvantage if you didn't (and there were public payphones, which there aren't now).
It depends on what you care about. I think people's expectations about what an average salary will get them in terms of being able to buy a house, have 2-3 kids, and have the luxury of one parent stay home and look after those kids for a decent amount of time gave dropped considerably.
But really, you're comparing an era when the important stuff was cheap and the unimportant stuff was pricey to the current opposite situation.
Being able to afford a bit of junk while being unable to afford the important stuff is not a higher standard of living for many of our younger folk now. Colour TV, a digital device, cheap food based on cheap labour etc...whoopdeedoo...
PPT Rescues S&P From Worst-Ever Start To A Year; Rate-Hike Odds Tumble
At its lows today, the S&P 500 had never - ever since 1920 - started a year as badly as 2022...
That's quite a record to break, and has sparked the hope in many that this kind of tumble in stocks will force The Fed's hand to pivot back to its traditional role of levitating stocks (we saw a sudden and big bounce intraday today which reminded us the gold ol' days of the PPT)... Nasdaq was down 5% before its exploded higher back into the green and Russell 2000 ripped from down 3% to up almost 3%...
J.C, I know this is your favourite hobbyhorse, but the ‘widow maker’ trade that is betting against the Bank of Japan in the JGB market applies in respect of the central bank of any monetary sovereign. In that context, the bond ‘vigilantes’ are an anachronism from the days of fixed currencies.
The inflation of today is dependent on the oil price remaining high, supply issues continuing due to the pandemic, fiscal stimulus continuing and the ability to import cheap labour into high income countries not resuming.
An increase in the federal funds rate coupled with the withdrawal of liquidity to banks will first have the effect of causing price falls in speculative assets like shares and crypto. Continuing increases in the Fed rate will see company profits fall and new labour hires fall. Real Estate prices will be sticky for a year or so after which they will go down or up depending on the new situation.
The effects of this will be to see economic activity decrease, the oil price fall and for 'the great retirement' go into reverse as older people realise that they aren't going to have as much as they thought they would have to support themselves for the next 30 years.
Supply issues will become less of an issue when there are fewer goods being bought. If the omicron wave passes in the next 3 months in the world with no new variants emerging, supply issues won't be an issue in the inflation equation.
It doesn't look like there will be anymore fiscal stimulus in the US in the next 3 months and the Chinese will be too slow and cautious with their own stimulus (needed now that they have popped their own credit bubble) to have any worldwide effect. So until Republican politicians wake up to the absolute need for stimulus there will be very little and it won't be a factor in the inflation story.
The wild card is Covid. If Omicron wipes out Delta and allows international travel and the import of cheaper labour into high income countries then say goodbye to wage inflation pressures. Locally you could say goodbye to $10 billion worth of overseas discretionary spending currently boxed up in NZ and supporting the local economy.
I think the Fed is tightening into a recession. I think that at a certain point it will either have to stop and reverse part of the course or face the implosion of the world economy. Too many of the factors actually supporting the current inflation rate I don't see continuing.
When you take away all the stimulative factors that we've seen in the last couple of years, mostly done because of Covid then there is only the underlying deflationary trend. Deflation is good for solid asset price values like US treasuries, land and staples/essentials businesses.
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