The Fed Girds For Battle
It’s the Fed’s “hold my beer” moment. After more than a year in which Federal Reserve leadership appeared clueless, pollyannish, and indecisive, the Fed is conducting a full-throated messaging campaign to show that it is as serious as cancer about the inflation surge that is scaring the bejesus out of consumers, investors, and economists.
Their public pronouncements in recent weeks go something like this: “Out of a good faith misreading of post-pandemic data we had concluded, mistakenly as it happens, that the inflation wave, which began in 2021, was transitory. But now that we know it is not, we are moving with great speed and resolve to bring the problem to heel. Given the power of our tools, the underlying strength of our economy, and our hard-earned credibility, we are confident we can get the job done quickly, and without inflicting undue harm on the economy. We will continue until inflation gets closer to our 2% target. And so, if you don’t mind, kind sir, please step aside and let us do the job we were created to do. We got this!”
This newly found resolve may assure many that at least the Fed is no longer in denial and has a plan to get us out of this mess. In reality, these open mouth operations are simply a desperate Hail Mary designed to convince us that the Fed can do what it clearly has no stomach or power to do. I would suggest that Fed officials hold onto their beers and drink. They are going to need it.
While most observers have focused on Chairman Jerome Powell’s press conference last week as the clearest insight into the Fed’s thinking, I think more can be gleaned from the extensive conversation two days later in Minneapolis between Christopher Waller, a member of the Federal Reserve Board of Governors (a current voting member of the FOMC) and Neel Kashkari, the President of the Federal Reserve Bank of Minneapolis (and an FOMC alternative member). In particular, Waller offered a very clear assessment of the Fed’s battle plan.
Right off the bat, he confronted mounting criticism that the Fed failed to read the economy accurately over the past 18 months, thereby grossly miscalculating policy, which let the inflation genie out of the bottle. His defense, which essentially boils down to “don’t blame us, no one with mainstream credentials in government, economics, or finance saw this coming,” is both bizarre and inadvertently illuminative. Not only does this ignore the 2021 predictions of former Treasury Secretary Larry Summers, who used to have at least some mainstream credibility, but it completely ignores all those like me who had been shouting from the rooftops that this danger was lurking. Waller’s admission, which shows how deeply embedded Fed leaders are in their own echo chamber, is more of an indictment of the entire economic elite rather than an excuse for their errors.
Waller then admitted that inflation data that was released way back in September 2021 revealed to them that the “transitory story’ that they had been spinning since the beginning of 2021, would no longer hold water. He explained that members of the FOMC were so alarmed that they immediately responded with plans to roll out new messaging that hinted strongly at tighter policy. Say what?
They determined nine months ago that very high inflation had been running rampant for the better part of a year, that it showed no signs of slowing, that the Fed Funds rate (which was then at 0%, and likely 800 basis points below the rate of inflation) was adding fuel to the fire, and the only thing they were prepared to do was to start talking tougher?
The Fed did not implement its first rate hike (25 basis points) until March of this year, fully seven months later! And during that entire time, it continued to expand its balance sheet by hundreds of billions of dollars through quantitative easing rather than immediately stopping the program or, better yet, reversing it. That’s insane. Captain, there is a huge gash in the hull of the ship but rather than try to repair the damage now, let’s think about how we are going to word our next few press releases!
Instead of taking bold steps back in the fourth quarter of last year to get ahead of the curve, or to at least not fall far further behind, the Fed irresponsibly took a slow and muted path. Given its admitted understanding of the conditions nine months ago, its actions seem hard to justify.
Despite these past missteps, Waller claims that the Fed is well-suited to make up for lost time. Emboldened by what he sees as an “historically” strong labor market, Waller believes the current economy can absorb the negative effects of higher interest rates without succumbing to recession. As a result, he predicts the Fed will not be deterred by weaker jobs or economic reports that may emerge in the coming months. In fact, he claims such data would be welcome developments. In his view, the economy needs to lose jobs to be put back into balance. Reduced hiring, he argues, will diminish upward wage pressure, which he sees as the root cause of inflation.
To justify his confidence that higher rates will kill inflation but not the broad economy, Waller took pains to draw a sharp contrast with today’s conditions and those that predominated in the late 1970s/early 1980s, which was the last time the Fed confronted nearly double-digit inflation with bold monetary tightening. Back then, the sharp rise in interest rates brought down inflation AND plunged the country into a recession. But as he views the current economy as benefiting from an “historically strong” labor market, he believes that fate will be avoided.
But Waller is looking at the rear-view mirror. He assumes that the economy that arose during the last decade of almost zero percent interest rates and historically stimulative fiscal policy will persist after those props are removed. But now, as rates increase and stimulus is removed, the economy must contract and change. We are already seeing such a change in the more speculative end of the economy. That’s where the problems are usually first manifest.
In case you hadn’t noticed, the wheels are coming off the technology and the cryptocurrency sectors. The technology-heavy Nasdaq composite index is down more than 25% thus far this year. The ARK Innovation ETF, which tracks the highest-flying growth-oriented technology, and “new economy” stocks is down 56%. E-commerce bellwethers such as Netflix and Shopify are down even more. The carnage in the crypto space is also spectacular. Although bitcoin is down about 60% from its high, that’s the good news. Lesser known cryptos are down 70% or 80%. Some have been nearly wiped out completely, even those “stable” coins that were supposed to be pegged to the dollar. The pain extends to the businesses that worked in the crypto space. Financial firm Microstrategies, which borrowed to invest in bitcoin, is down 60% year to date while Coinbase, the crypto trading platform, is down 72%. (Bear in mind that all the losses listed above are just this calendar year. If you started measuring from the November 2021 highs, the losses are significantly greater.)
Recall that the Recession of 2001 and 2002 largely resulted from the implosion of the dotcom bubble when the pain in Silicon Valley rippled through the broader economy. But this time the outsized gains were even bigger and less tethered to reality. Many tech firms have already announced large scale layoffs. Hundreds of thousands of highly paid workers may suddenly find themselves looking for jobs. Falling stock prices may also encourage recent retirees, who may have been coaxed out of the labor force by oversized stock market gains, or millennials who’ve been trading meme stocks and crypto currencies on Robinhood for a living, to join former Netflix, Twitter and Peloton employees in looking for work. Boom will go bust, and the unemployment rate may rise much quicker than Fed models suggest.
Waller also, somewhat bizarrely, believes that the Fed’s job will now be made easier by higher credibility than it had in the late 1970s when Paul Volcker went to war against high inflation. His theory holds that the Fed’s routine failures to confront inflation for much of the 1970s had diminished its credibility, making Volcker’s task that much harder. But by raising rates to nearly 20% in 1980, Volcker restored the credibility, which, in Waller’s view, the Fed holds to this day. He argues that since the Fed has already demonstrated it can do the job, the people are assured it can do it again. This is laughable.
Firstly, the Fed has largely “won” the battle against inflation in recent years by lying about it. The CPI has been changed and weakened so many times since 1980 that the index barely resembles the one used by Volcker. Secondly, the Fed has been routinely backing off from tough choices since the Great Recession of 2008. The taper tantrum of 2013, its painfully slow decisions to lift rates from zero in 2015, the rapid pivot away from tightening to easing in December of 2018, all speak to its jitters in the face of turmoil. Thirdly, the Fed’s repeated failures to recognize dangerous bubbles in the stock and real estate markets and its pathetic predictions about the mortgage problems in 2007 being “contained” to subprime, or inflation in 2021 being “transitory,” all add to the vaudevillian nature of its economic insight.
If Powell and Waller believe, despite all its recent failures, that the Fed can draw on a 40-year-old mystique generated by a man who passed away more than two years ago, they are in for a very rude awakening.
Left out of the discussion between Kashkari and Waller about the differences between the 1970s and today is how much more leverage we must contend with today and how much higher stock, bond and real estate prices are in relation to the overall economy. Back in 1980 those asset prices had been falling or stagnant for the better part of a decade. Consequently, there weren’t that many gains left to lose. Now stocks, bonds, and real estate are still not far off from record highs. The bursting of those bubbles, which could result from higher interest rates, will be much more recessionary than what happened in 1980.
So, interest rate increases in 2022 and 2023 may be high enough to burst the debt bubble and plunge the economy into another financial crisis, but they will not be nearly high enough to kill inflation. If the Fed has to reverse course to stimulate an economy in recession, while inflation remains well above its 2% target, the dollar will likely collapse, sending commodity prices and the costs of imported goods upward.
As Fed officials tell us how they are ready for battle and that they have the enemy in their sights, I can’t help thinking about “Baghdad Bob,” the hapless spokesman for Saddam Hussein who boldly pronounced in live interviews how the U.S. invasion was failing even as American tanks lumbered into the scene behind him. We can laugh at their predicament. But we won’t laugh long.