The Trolley Car Problem – The Fed's Predicament
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This is part one of a two-part series. Part two will appear next week.
An unstoppable trolley car is barreling down the track. As the switchman, you stand at the junction where the track branches and you must choose which path the trolley will follow. Unfortunately, people are tied to both tracks, making the decision incredibly difficult.
The trolley car problem is a well-known ethical question that forces one to choose between two poor consequences. For the Fed, it is whether to allow inflation to fester or to force the economy into a recession.
The Fed and many other central banks face a trolley car problem, albeit lives are not on the line. With inflation running hot and economic activity faltering, years of questionable monetary policy force central bankers to make tough decisions. Such tricky decisions were last made when policymakers were in school or just starting their careers.
Given the extreme debt accumulation of the last 40 years and the heightened speculative nature of financial markets, their choices may be the most important monetary policy actions in our lifetimes. These decisions will have outsized effects on the investment environment for some time.
Rubber band theory
Let's move from ethics to physics and introduce a second theory: the rubber band effect. When you stretch a rubber band, it builds up energy. The longer the stretch, the more energy it builds. When the rubber band can't be stretched anymore, energy releases forcefully in the opposite direction.
For the last 40 years, developed nations have fostered an unsustainable debt growth cycle. Debt was increasingly encouraged as the primary fuel for economic growth and prosperity. As the cycle wore on, debt became less productive. In a steadily increasing number of cases, the growth of the borrowed money could not support the borrowers' ability to pay interest or repay the principal on the debt.
Instead of letting the rubber band release its pent-up energy, policymakers chose to keep stretching the debt cycle. They consistently chose a more aggressive monetary policy over letting irresponsible debtors go bankrupt. Meager and even negative interest rates along with quantitative easing (QE) fostered growing amounts of unproductive debt and allowed marginal borrowers to remain solvent.
The handiwork of the central bankers was possible because there were few consequences for their actions. That changed in 2021.
This two-part article tells the tale of three central banks, their grossly stretched debt cycles, and the trolley car problems they now face.
The Three Musketeers
The Federal Reserve, European Central Bank (ECB), and the Bank of Japan (BOJ) are confronting significant inflation, weakening economic growth, and bear markets in their stock markets. Despite similar challenges, they are taking vastly different approaches.
Central banks fight high inflation by increasing interest rates and reducing their bond holdings (QT). The objective is to stifle demand for goods and slow economic activity. Conversely, weakening economic activity is met with lower interest rates and bond purchases (QE) to encourage borrowing and spending.
But what has worked so well in the past is awkward today. Inflation is on the rise, and economic growth is rapidly slowing. Central banks can fight inflation or try to bolster the economy, but not both.
Making matters more demanding, they must also consider the fallout of their decisions on their respective currencies and capital markets. Adding to the pressure, they must remain highly mindful of the overstretched debt cycle.
The diagram below by Lily Lebowitz helps us visualize the Fed’s trolley car problem. Jerome Powell can tackle inflation but risk a recession and lower stock prices. Or he can try to avoid a recession and risk persistently high inflation.
Comparing central banks
Jerome Powell – Federal Reserve
At his June 15, 2022, FOMC policy press conference, Jerome Powell made it evident the Fed will aggressively use its tools to their fullest extent to reduce inflation back to 2%. He was also clear unemployment may rise as a result. He said the following:
- We at the Fed understand the hardship high inflation is causing. We are strongly committed to bringing inflation back down, and we are moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.
- If you don't have price stability, the economy's really not going to work the way it's supposed to and it won't work for people, their wages will be eaten up. So we want to get the job done.
- So, a 4.1 percent unemployment rate (current 3.6%) with inflation well on its way to 2 percent, I think that would be, I think that would be a successful outcome. So, we're not looking to have a higher unemployment rate, but I would say that I would certainly look at that as a successful outcome
- We don't seek to put people out of work, of course, we never think too many people are working and fewer people need to have jobs, but we also think that you really cannot have the kind of labor market we want without price stability.
The Fed's misunderstanding
The Fed is singularly focused on breaking inflation's back. The problem making its task very difficult is that it grossly underestimated the persistent nature of inflation.
"We understand better how little we understand inflation" – Jerome Powell 6/29/2022
Throughout 2021, speculative activities flourished, economic activity was brisk, and inflation rose. Many, including me, said the Fed must quickly pull back on the monetary policy reins. Despite stimulus-driven demand and significant supply line problems, the Fed kept interest rates at zero and bought $120 billion in bonds per month.
The price for its blunder is higher and more persistent inflation. As a result, economic activity stagnated, asset prices fell, and consumer/business confidence eroded rapidly.
The Fed's mandate
The graph below shows the Fed's predicament. The red dot is the Fed's objective as mandated by Congress. While exact levels of unemployment and inflation are not quantified, the Fed considers them to be a 4.1% unemployment rate and 2.0% core inflation rate. The other dots show each monthly intersection of unemployment and core prices since 2000.
For the last 20 years, as shown by the blue dots, the Fed was often tasked with reducing unemployment and frequently wanted more inflation. Other than a brief instance or two, the Fed never worried about high inflation.
Per CNBC 2019: "In order to move rates up, I would want to see inflation that's persistent and that's significant," Powell said at a news conference in Washington. "A significant move up in inflation that's also persistent before raising rates to address inflation concerns: That's my view."
The Fed's dilemma
As the yellow dots highlight, the Fed must now tackle the highest inflation in 40 years while the unemployment rate is slightly below target. Based on Powell's recent comments, he is willing to increase unemployment to bring inflation back to its target.
First quarter GDP was negative 1.6%. Based on the Atlanta Fed's GDPNow forecast, second quarter GDP growth may also be negative.
U.S. stock markets are in bear market territory as investors watch the Fed tighten policy despite faltering economic growth. This is new ground for most investors. Over the last 20+ years, they grew accustomed to a Fed that reliably eased at the first hint of economic weakness. The new paradigm is causing investors to lose confidence. Making matters more onerous for the Fed, bond yields have risen rapidly, adding to economic pressures and financial stability.
The rubber band keeps stretching
As a result of the pandemic and continued debt growth in the post-financial crisis era, the economy is saddled with twice as much government debt as a percentage of GDP than in 2008. Corporate debt to GDP is also at record highs. The economy and livelihood of many borrowers are now much more reliant on low-interest rates. Unlike 2008, when lower interest rates and QE saved many struggling borrowers, QE and reducing interest rates are not viable as inflation is raging.
The Fed is opting to send the trolley car on the recession track to temper inflation. This harsh decision doesn't bode well for the economy or financial markets.
But there is hope.
The Fed has been accommodative in the past when financial stability and economic problems arose. As such, will the financial markets and the economy cry uncle loud enough to get the Fed to change its policy?
It is possible the Fed partially relaxes the rubber band with limited economic and market costs. However, that scenario depends on inflation. If inflation declines enough, the Fed may be able to revert to an easy monetary policy and keep the extended debt cycle intact.
If inflation must be tamed, though, the Fed may continue to travel down the trolley track that sacrifices the economy and financial markets. That is the scenario that snaps the debt cycle rubber band and scares me.
"Until we see tangible evidence of a decline in inflation back to target, nobody should count on central bankers to reverse course." – Brett Freeze
Summary part one
I end part one with a quote from President John F Kennedy:
There are risks and costs to action. But they are far less than the long-range risks of comfortable inaction.
As I detail above and will discuss further in part two, there are significant risks to the actions the Fed is taking, and other central bankers are contemplating. However, as Kennedy said, doing nothing, which has been the status quo, presents even greater risks.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
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