The Fed is too late to remove the punchbowl | Financial Times

Wednesday, February 2, 2022 10:41 PM

Always remember, it can be worse tomorrow.—Soda Jerk, Witness to Murder

Dear Friends + Interlocutors,

Financial guru of the Financial Times, Martin Wolf, bluntly informs us that the Fed has blown it. The Fed has acted too late to remove the punchbowl. What he doesn’t spell out is what the consequences may be. All I see is a bunch of charts I can’t relate to. So what?

In 2008 in response to the blowup on Wall Street, the Fed flooded the markets with liquidity. One might say over-flooded. In response to the 2020 Covid pandemic, the Fed did the same, leading the world. The stock market skyrocketed. The Fed is reluctant to remove the punchbowl.

Who wants to be held responsible for a Wall Street crash and a world-wide recession or depression? What is Martin Wolf thinking? Let the party continue. The Fed’s job mandate is to keep Wall Street drunk. I guess I should stop joking. Washington is full of responsible people.


The Fed is too late to remove the punchbowl

By Martin Wolf, Tuesday February 1st, 2022, The Financial Times

Policy is still aggressively loose, even though the recovery and surge in inflation have long been clear

On November 22, US president Joe Biden renominated Jay Powell as chairman of the Federal Reserve. Eight days later, Powell told Congress that it was “probably a good time to retire that word and try to explain more clearly what we mean”. The magic word he was about to retire was “transitory”. That incantation had permitted the Fed to persist with an extremely expansionary monetary policy during a strong recovery accompanied by soaring inflation. A cynic might think there was something more than accidental about the timing of the word’s retirement. I could not possibly comment. Let us hope instead that the shift is not too late.

US consumption is back on the pre-Covid trend unlike last time. Chart showing US real consumption expenditure vs pre-crisis trends (Q4 2007=100)

In 1955, chairman William McChesney Martin remarked that the Fed “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up”. It was sound advice, as the monetary turmoil of some two decades later demonstrated. Losing control over inflation is politically and economically damaging: restoring control usually requires a deep recession. Yet the Fed has been running this risk lately, because it has not even started to remove a highly alcoholic punch bowl.

Whether inflation is indeed transitory is not mainly determined by what is going on in markets for specific products. It depends more on the environment in which such shocks emerge. The risk is that in a highly supportive policy environment, such as today’s, a price shock can too easily ripple across the economy as workers and other producers struggle to recoup their losses.

The recovery of fixed investment has been particularly strong. Chart showing Components of US real GDP (Q4 2007=100), consisting of Residential investment, Fixed investment and Consumption

So we must start from the state of the economy. The Institute for International Finance notes that US real consumption has by now fully returned to its pre-pandemic trend. This never happened after the 2008 financial crisis. Business and residential investment is also extremely robust. The recovery is stronger than in the other big high-income countries. The main reason for this rude health, argues the IIF, has been fiscal stimulus. (See charts.)

The labour market has also substantially healed and, on some measures, is hot. In a recent piece for the Peterson Institute for International Economics, Jason Furman and Wilson Powell show that the prime-age non-employment rate, unemployment rate, number of unemployed people per vacancy and quit rate are all stronger than the 2001-2018 average. The last two are at record levels. As Jay Powell himself noted in his press conference last week, “labour market conditions are consistent with maximum employment in the sense of the highest level of employment that is consistent with price stability”. In other words, the Fed has already fulfilled its jobs mandate.

Data on US labour markets are confusing but show tightness. Chart showing measures of US labour market tightness (standard deviations from the mean) for the Quits rate, Unemployed per job opening, Unemployment rate, and Prime-age non-employment rate

The strong labour market is also showing up in a rapid rise in nominal earnings, with total compensation for civilian workers above the pre-pandemic trend. Yet real compensation was 3.6 per cent below trend in December 2021. This was because annual consumer price inflation reached 7 per cent, the highest rate for four decades. Even core inflation (with volatile items such as energy and food stripped out) reached 5.5 per cent. Moreover, contrary to the belief that this is due to just a few items, the IIF shows that inflation is running at over 2 per cent on over 70 per cent of the weighted index. This price surge is no limited phenomenon.

US nominal employment costs are rising strongly. Chart showing US nominal employment cost index, total compensation for all civilian workers (Dec 2019=100)

The rate of price increases on the scarcest items will slow and many prices will even fall. But that will not be enough. One reason is that affected businesses and workers will seek to recoup their losses, risking an inflationary spiral. Another is that policy is still aggressively loose, given the ongoing asset purchases and a Fed funds rate of 0.25 per cent. Whatever the supply disruptions, a central bank still has to calibrate policy to demand. Yet the Fed continues to ladle out the punch, even though the party is turning into an orgy.

Given, in addition, the “long and variable lags” in the relationship between monetary policy, the economy and inflation, described by Milton Friedman, it is hard to believe the Fed is anywhere near where it needs to be today. The Fed itself agrees: tightening is on the way. But the question is whether it can still contain an inflationary spiral and keep expectations stable without having to inflict a recession. That is going to be extremely hard to pull off. Policymakers just do not know enough about the post-pandemic economy to calibrate the needed policy changes, especially as they are clearly too late.

Meanwhile high inflation is lowering real employment costs. Chart showing US real employment cost index, total compensation for all civilian workers (Dec 2019=100)

In this context, the Fed board’s December forecasts are bewildering. The median view is that core consumer price inflation will fall to 2.7 per cent this year and 2.3 per cent in 2023, as the unemployment rate stabilises at 3.5 per cent. Meanwhile, the forecast is for the Fed funds rate to be between 0.6 and 0.9 per cent this year, and 1.4 per cent and 1.9 per cent in 2023 (if we leave out the three highest and lowest). These forecasts are, we must note, below the Fed’s own estimate of the neutral rate of interest, which is 2.5 per cent. Moreover, the assumed real interest rates are also negative. Perhaps board members believe that aggressive asset sales will deliver the needed tightening via higher long-term rates. Alternatively, they have to believe that the economy and inflation will stabilise smoothly even though monetary policy stays expansionary throughout.

Inflation is over 2 per cent on 70 per cent of the indices by weight. Chart showing combined weight of items in US price indices with annual inflation above two percent (% weight)

This would be immaculate stabilisation. It is conceivable that the policy settings chosen during the worst of the Covid crisis still make sense today. It is conceivable too that the forecast tightening will deliver robust growth and smooth disinflation. Both are less unlikely than that the moon is made of green cheese. But likely? Not so much.

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