FOMC Recap: What a long strange trip it's been

 

“He looked down and saw his friend, the man with the big yellow orange hat! George was very happy. The man was happy too.”

• Fed pauses as expected, leaving the Fed Funds target range at 5.25% to 5.50% and leaving QT unchanged
• FOMC members median Fed funds projections continues to show another 25bp hike in 2023, while the projected 2024 median Fed funds rate was increased 50bps to 5.1%, effectively removing two rate cuts from their previous 2024 projections
• Powell reiterates the need to stabilize inflation and that there is a "long way to go" to get there
• Indicates data dependence, "need to see more progress before concluding" policy is sufficiently restrictive, "we want to see more than just three months" that inflation and job data support a conclusion one way or the other
  
• Powell acknowledges that the short-run neutral rate may be higher than forecast

Like a monkey named George, I am also curious, curious as to how monetary policy lowers inflation with long and variable lags, whether we can get a soft-landing, or whether, as Bernanke once quipped, expansion don’t die of old age, they get murdered.  Since Jackson Hole much ink has been spilled (Claudia Sahm has had a few good articles recently) over why Americans appear to find themselves unhappy with an economy where the data shows rising growth and cooling inflation.  There is unhappiness with the rise of prices at the pump and in the grocery aisles.  Unhappiness with the state of pay and working conditions; unions feeling like they missed out on the gains after sacrificing during the pandemic, white collar office workers seemingly dissatisfied with commutes to back to the office.  And there is unhappiness with rising borrowing cost.

Over the summer, much was made of the man in the orange hat, Fed Chair, Jerome Powell being spotted at a Dead & Company show in Virginia. In a response to a question posed by representative Wiley Nickel at House Financial Services Committee hearing,  Powell replied “I’ve been a Grateful Dead fan for 50 years.”

As a self-professed Dead fan, I am certain that Powell can appreciate some of the wisdom inherent in the Dead's lyrics about the current state of the economy.  Here are some examples:

“Took my twenty-dollar bill and it vanished in the air…a friend of the devil is a friend of mine”

Many American's are still feeling the sting of inflation when they conduct their everyday affairs, feeling like their money is vanishing in the air.  Others wonder about the politicization of the Fed and "fiscal dominance", worried that the Fed will be forced to engage in financial repression to fund the fiscal agenda.

“I know the rent is in arrears the dog has not been fed in years / It’s even worse than it appears but its alright”

The cost of housing, whether it be the increase in rents or rising mortgage borrowing cost have been a source of pain for many Americans.

“’Cause when life looks like easy street, there is danger at your door”

On a recent episode of Bloomberg's Odd Lots podcast, Bill Gross stated: "We have an economy that's based on asset prices going up," "If they don't go up, there are problems".  I don't envy the Fed's challenge in gauging the impact on financial stability from monetary policy decisions, especially in a world where nonbank financial intermediaries play increasing important roles in the intermediation of credit.  As a reminder, it was only back in March when it seemed we were on the precipice of a larger banking collapse.

“Lately it occurs to me what a long, strange trip it’s been”

And lastly, structural changes in the economy may have been accelerated by the pandemic, with the last 3+ years certainly being "strange".

The standard story is the Fed raises interest rates which feeds through to asset prices, expectations, exchange rates and ultimately drives down demand as households and businesses change their investment and spending decisions. Inherent in the implementation of monetary policy are estimates of the "output gap", the difference between estimated potential output of the economy and the actual output, as well as estimates neutral rate (r-star), and the relationship between the level of unemployment and inflation (NAIRU).  To complicate all of this, the economy can face unanticipated shocks that can impact supply and demand.  A pandemic, a war in Ukraine, unanticipated cuts in oil production, labor strikes, a government shutdown, changes in technology, you get the picture. On top of all of that the Fed also needs to consider the impact of fiscal policy.  Clearly the size of deficits have grown and at present there is no sign that consumers are concerned about future taxation or so called "Ricardian Equivalence".  This makes it hard to see fiscal policy doing much to help reduce demand to cool inflation.  Measuring potential output and therefore the output gap in a dynamic economy seems to be a difficult science.

As Powell ponders heeding advice from the Dead, he might want to consider advice from a dead economist who some consider to be the greatest economist America ever produced, Irving Fisher. In Fisher's classic, 'The Money Illusion', he goes to great lengths to discuss the harms of unstable money, boiling it down to three evils: social injustice, social discontent and social inefficiency.  Fisher didn't believe the responsibility to stabilize money was solely the purview of the Fed rather it was shared responsibility between the Federal Government and it's independent central bank.  As it relates to deficits, he noted that “when a government cannot make both ends meet, it pays its bills by manufacturing the money needed” and further that “The government has an added responsibility when its own debts are involved. To borrow billions of dollars and then to depreciate the dollar is not even fair gambling. It is stacking the cards.”  Fisher didn’t absolve the banks or central banks from playing a role in the stability of purchasing power, noting that central banks are “properly expected to provide an “elastic currency” to expand or shrink with the expansion or shrinkage of the business to be done by it.”  While further providing that central banks “can make the money we all use easy or hard to get, and thereby prevent inflation or deflation.” 

It seems the Fed is currently trying to make the money we all use hard to get, so how might this all end? There are three main endings I see espoused by economic pundits (I can't or won't assess the probability of any of these outcomes):

1. "Soft Landing":  which would likely mean we remain with low levels of unemployment while continuing with real growth and low inflation.  The argument for this outcome are best summed up in a recent post by Marcus Nunes as follows: "The difference between now and past occasions, is that the Fed is “adjusting from above”. In other words, monetary policy is tightening, not to take NGDP growth down below its “normal” or stable value, but to bring it down to the stable level!"
   
   
2. "Financial Repression and the Age of Scarcity": the positive supply side forces of global cooperation, favorable demographics and technological productivity gains are reversing while economies will need to invest in areas like their militaries, climate, etc. while facing already high debt burdens.  Rising real rates and higher inflation might be here to stay. While not the only way out, as stated by William White in a recent article "The Case for Pessimism", governments might "try to limit the feedback effects on interest rates and debt service through administrative procedures and capital controls. So called “financial repression,” in which inflation is allowed to rise but interest rates are held down, was used successfully to reduce debt overhang after World War ll."  White isn't alone in this thinking, feel free to take a look at the work of Arslanalp and Eichengreen presented a Jackson Hole.  Both White and Eichengreen point out that financial liberalization and nonbank financial intermediation make carrying out financial repression policies more difficult, but a recent paper by Charles Calomiris discusses how financial repression could be pushed through the banking system by imposing a "high reserve requirements for zero-interest paying reserves".  
   
   
3. "Hard Landing - we've already gone to far - the Fed once again murders an expansion": Look no further than rising bankruptcies, falling commercial real estate prices, slowing of bank credit creation, a slow down in leading indicators, a slowing China, etc.  The U.S. money supply is falling for the first time since 1933.  Holding other variables constant the basic equation of monetarism would say a falling money supply will lead to falling prices, eventually deflation.  The concern for some in a levered economy are that, falling asset prices can lead to unexpected deleveraging which can spiral into a financial crisis.  Related to this concern is that as the increases in interest rates continue to filter through to the economy through rising borrowing cost, this could lead to potential defaults, falling asset prices, and again a spiral as the wealth effect leads to decreased spending, leading to job losses, leading to recession.

I'm certain there are other scenarios or ways to describe these scenarios, but I'm just as certain that I don't know how this plays out or what other shocks to the system will occur in the meantime. In the meantime, some parting thoughts for Powell from the Dead:

 “There is a road, no simple highway / Between the dawn and the dark of night / And if you go, no one may follow / That path is for your steps alone”