The Federal Reserve Confronts an Almost Impossible Task: Gary Shilling

The Federal Reserve is planning to tighten credit even as forecasts call for U.S. economic growth to slow and the recent high inflation rates to recede. With just the smallest of missteps, the central bank risks either overkill, or a further loss in credibility.

The incoming economic data has been falling below estimates at a degree not seen since the early days of the pandemic, based on Citigroup Inc.’s Economic Surprise Index. Consumers show few signs of spending their pandemic-related stimulus payments, having saved 71% of their June 2020 checks, even more -- 74% -- of December’s payment and still more, 75%, of the money received in March, according to Federal Reserve Bank of New York surveys. Also, the Fed’s attempts to spur borrowing and spending have been fruitless. Since the fourth quarter of 2019, it has pumped up the money supply as measured by M2 by 34%, but that money lies fallow with the velocity, or turnover, dropping 22% to record lows.

With the end of the extra $300 per week in federal unemployment benefits, real incomes – already eroded by the recent spurt in inflation -- will fall further after dropping 1.7% from January through August on a weekly basis. The highly transmissible delta variant of Covid-19 may further curtail economic activity as many companies including Apple Inc., Inc., Wells Fargo & Co., Chevron Corp., Prudential Financial Inc., and Microsoft Corp. delay opening their offices in full to employees. Payroll jobs rose just 235,000 in August, down from 1.1 million in July and the least since January.

Although inflation rates are dropping more slowly than the Fed may have hoped, they should continue to recede as frictions related to the re-opening of the economy and supply bottlenecks pass. Already, the monthly core Consumer Price Index dropped from 0.9% in June to 0.3% in July and 0.1% in August.

Anticipatory spending is unlikely to be spurred by consumer inflation fears. As usual, one-year inflation expectations reflect the recent past, but over five years, consumers look for 2.9% annual inflation, according to the University of Michigan surveys. That expectation is no doubt too high, as is normal, given the human tendency to overestimate inflation. If prices they pay fall, consumers credit it to their smart shopping, but rising prices are thrust upon them by forces over which they have no control, they complain.

The breakeven rate, the difference between yields on conventional U.S. Treasury securities and Treasury Inflation-Protected Securities, or TIPS, shows that traders expect relatively higher inflation rates in coming years. Still, the implied forecast of 2.5% over the next five years is the same as back in 2007.