What the Fed gets wrong – the big picture

There seems to be a lot of confusion going on today with regards to inflation, interest rates and the ongoing Federal Reserve policy. The framework for exploring this consists of several parts: what the Fed knows (obviously), and how it expresses these opinions through policing such as FOMC rates, ZIRP, QE, QT, and so on.

There remains the question of what the Fed’s fault was actually.¹

This is the last one that I find fascinating and where we can identify the reasons why the Fed and the markets seem different about the future path of rates.

Let’s give the Fed some credit: They know commodity inflation peaked months ago – they can see prices for oil, lumber, used cars, shipping containers, etc., and they certainly understand that FOMC policy has significant delays of anywhere from 6 to 12 months. months.

What are the main mistakes currently driving Fed policy?

• tardi: We all understand that central bank policy is lagging behind. History suggests that the Fed’s recognition of key market and economic indicators is also overdue. The result is that the Fed is always behind the party.

I advise: In the 2010s, the Fed was in a state of emergency from 2008, when it raised rates to 0 (zero) until December 2015 (this created a lot of distortions). Then again in the 1920s, they remained in a post-Covid state of emergency, despite widespread evidence of an economic recovery.²

The Fed delayed acting on rising inflation, waiting a full year from when CPI exceeded its 2% target to raise interest rates (see chart above). Today, they seem to be repeating the same mistake, belatedly realizing that inflation peaked in June and commodity prices fell precipitously.

• Service inflation: What is the impact of the fastest rate increase in history? Higher federal funding rates cause higher mortgage rates which in turn drive many people to buy residential properties. The net result: potential buyers become renters, which drives up apartment prices. Owners Equivalent Rent represents the bulk of the CPI Services sector.

The perverse consequence is that the Fed makes the CPI model show higher and more stable inflation.

• Wealth effect: Jay Powell appears to be targeting asset prices, although stocks are not part of the dual mandate.³

The reason for this is that the Federal Reserve was an institutional “everything” in the wealth effect theory. The thinking here is that a rising stock market makes Americans feel richer, which leads to more spending and higher inflation.

There are many problems with this claim, but let us give you the two biggest ones: Most Americans don’t own stocks; Many of those with modest holdings in IRAs and 401k won’t touch them for years. It hardly drives spending on 70-80% of consumers.

The second is simply confusing correlation with causation. The same fundamental factors that drive stock prices higher—rising GDP, employment, and wages—also drive consumer spending and inflation. Hence the Fed believes that it is the rising stock market that leads to inflation. If you stop to think about it even for a moment, you will see that they are completely wrong about this.

• Jay Powell refers to economists: Powell is a lawyer and investment banker, not an economist. This in itself is not a bad thing. However, it raises the risk that it defers too much to economists (see the wealth effect, above).

It reminds me of Joan Robinson’s wonderful quote: “The purpose of studying economics is not to obtain a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”

One has to wonder how much of the Fed’s current and past policy mistakes trace themselves into this piercing truism.

Please note that I’m not part of the Fed-hating emergency out there, and I don’t think we should.”Terminate the Federal ReserveOr any other nonsense like that.⁴ I think the Fed is making a good faith effort to carry out its mission, a job it does sometimes well and sometimes much less.

I hate unforced errors. The current policies seem to be on the verge of going wrong, which is very obvious and easily avoidable, but it looks like the FOMC is going to cause a lot of unnecessary pain anyway.

If I were Chairman of the Federal Reserve, I would declare inflation defeated, raise my flag and declare victory, then come home. The battle has already been won. The greatest danger today is to snatch defeat from the jaws of victory.

See also:
Jerome Powell’s grim inflation forecasts are at odds with the markets (Wall Street Journal December 14, 2022)

Markets Don’t Believe the Fed (The Wall Street Journal, December 16, 2022)

previously:
Wealth effect rumors greatly exaggerated (November 16, 2010)

The Wealth Effect is a Bad Engagement Fiction (April 25, 2016)

Behind the Curve, Part V (November 3, 2022)

When your only tool is a hammer (November 1, 2022)

How the Fed (Model) Causes Inflation (Oct 25, 2022)

Why is the Fed always late to the party? (October 7, 2022)

__________

1. There is a longer conversation to be had about how the Fed’s policy costs fall disproportionately on the poor; This is beyond today’s discussion.

2. After the interest rate cuts in March 2020, the Federal Reserve remained at zero until March 2022. During the same time period, the S&P 500 rose by 67.9% (2020) and 28.7% (2021).

3. The Fed’s dual mandate: first, to maintain maximum employment, and second, to keep prices stable (inflation low) and long-term interest rates moderate. The Fed’s somewhat impossible task is during periods of volatility, there is an inherent conflict between them.

4. As I detailed in Bailout Nation, the Federal Reserve has a rich history of being “often wrong and rarely questionable.” However, I reserve my greatest indignation for the former maestro, Alan Greenspan, whose disastrous rule not only led to the dot-com bubble and its collapse, but also paved the way for the Great Financial Crisis.