Where the Fed is wrong
There seems to be a lot of confusion today regarding inflation, interest rates, and current Federal Reserve policy. A framework for exploring this has many parts: what the Fed (obviously) knows, how it expresses those views through policies like FOMC rates, ZIRP, QE, QT, etc.
There remains the question of where the Fed is really wrong.1
It is the latter that I find fascinating, and where we can identify the reasons why the Federal Reserve and markets seem to be at odds on the future path of rates.
Let’s give the Fed some credit – they know goods inflation peaked months ago – they can look at prices for oil, lumber, used cars, shipping containers, etc. And they certainly understand that FOMC policy has substantial lags of between 6 and 12 months.
What are the main mistakes that are currently driving Fed policy?
• Late: We all understand that the policy of the Central Bank operates with delay. History suggests that the fed recognition of the main economic and market indicators is also excessively lagging. The result is that the Fed always late to the party.
Consider: In the 2010s, the Fed had been in a state of emergency since 2008, when it pushed rates to 0 (zero) until December 2015 (this created many distortions). Then, again in the 2020s, they remained in a post-Covid emergency, despite ample evidence of economic recovery.two
The Fed was slow to act on rising inflation, waiting a full year from the time the CPI exceeded its 2% target to raise rates (see chart above). Today, they seem to be repeating the same mistake, late in acknowledging that inflation peaked in June and property prices have fallen sharply.
• service inflation: What is the impact of the fastest rate increase in history? High federal funds rates are causing high mortgage rates, which in turn is preventing many people from purchasing residential real estate. The net result: potential buyers become renters, driving up apartment prices. Equivalent Rent to Owners is the largest portion of CPI’s Services sector.
The perverse result is that the Fed is making the CPI model show as much higher and more rigid inflation.
• The wealth effect: Jay Powell seems to be targeting asset prices, even though stocks aren’t part of the dual mandate.3
The reason for this is that the Federal Reserve has been institutionally “fully invested” 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 statement, but let’s give you the two biggest ones: Most Americans don’t own stocks; many of whom have modest holdings in IRAs and 401ks that they won’t touch for years. It barely drives spending for 70-80% of consumers.
The second is simply to confuse correlation with causation. The same underlying factors that drive higher stock prices—increasing GDP, employment, and wages—also drive consumer spending and inflation. Therefore, the Fed believes that a rising stock market is what leads to inflation. If you stop to think 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 increases the risk that he will give too much away to economists (see Wealth Effect, above).
It reminds me of Joan Robinson’s wonderful quote: “The purpose of studying economics is not to acquire a set of ready answers to economic questions, but to learn how to avoid being misled by economists.”
One has to wonder how much of the Fed’s current and past policy mistakes can be traced back to this insightful truism.
Keep in mind that I am not part of the Fed haters contingency, nor do I think we should.”End the Federal Reserve” or other similar nonsense.4 I believe the Federal Reserve makes a good faith effort to execute its mission, a job that it sometimes does well and sometimes less well.
I hate unforced errors. Current policy seems to be about to fall into a mistake, one that is so obvious and easy to avoid, but it looks like the FOMC is going to cause a lot of unnecessary pain anyway.
If I were Fed Chairman, I would declare inflation defeated, plant my flag and shout victory, and then go home. The battle has already been won. The greatest risk today is to snatch defeat from the jaws of victory.
See also:
Jerome Powell’s bleak inflation outlook is at odds with markets (WSJ December 14, 2022)
Markets don’t believe the Fed (WSJ December 16, 2022)
Previously:
Rumors about the wealth effect have been greatly exaggerated. (November 16, 2010)
The wealth effect is a malcorrelation fantasy (April 25, 2016)
Behind the Curve, Part V (November 3, 2022)
When your only tool is a hammer (November 1, 2022)
How the Fed causes inflation (model) (October 25, 2022)
Why is the Federal Reserve always late to the party? (October 7, 2022)
__________
1. There is a longer conversation about how the costs of Federal Reserve policy have fallen disproportionately on the poor; this is beyond today’s discussion.
2. After interest rate cuts in March 2020the Fed was held at zero until March 2022. During the same time period, the S&P 500 rose 67.9% (2020) and 28.7% (2021).
3. The Fed’s double mandate: first, keep employment at its maximum, and second, keep prices stable (inflation low) and long-term interest rates moderate. The somewhat impossible task for the Federal Reserve is that during periods of flow, there is an inherent conflict between those two.
4. As I detailed in Bailout Nation, the Federal Reserve has a rich history of being “often wrong, rarely in doubt.” However, I reserve my greatest anger for former teacher, Alan Greenspanwhose disastrous reign not only led to the bubble and the .com crash, but also set the stage for the great financial crisis.
