Monetary Policy: Why we are NOT in a good place

Inflation expectations are HIGH

We're in the wake of a Federal Reserve meeting that everyone is still buzzing about as we wonder what the Fed plans and how it is going to deal with the upcoming policies of this administration. Speaking of ‘this administration’ Trump has announced that there will be tariffs imposed on Canada and Mexico in the immediate future. Economists are somewhat odds on what this means, but economic theory actually is quite clear about it even though some are trying to muddy the waters. An increase in tariffs is an increase in a very specific kind of tax and it has a one-time effect on the price level through relative prices and does not stoke inflation.

But you are going to hear a lot of different opinions on this in the press. There are many creative ways to spin tariffs through the imagined process of policy to create the perception of inflation risk. But none of this would matter if we had full confidence in the Fed to control inflation. When the Fed started to fight inflation in this cycle it argued it did not have to be so tough, the way it was in the 1980s when inflation had been excessive for a full decade. We were, after Covid, in a period that followed a long stretch of price (low-inflation) stability. But that was then…this is now. The Fed has squandered that advantage… After missing its target for 45 straight months and still showing no sign of eagerness to hit the darn thing (Powell says...we can be patient...and - when he say this- he interestingly, or oddly, is referring to being patient in its plan to continue to CUT RATES as inflation continues to overrun its target even as the momentum for inflation to fall has stalled out) the Fed thinks ‘It is still in a good place!’

Changing relative prices via tariffs does not affect inflation unless the change in relative prices is dealt with in a strange way by the Monetary Authority. So that bends attention back to the Fed and how the Fed is going to respond to the Trump tariffs and to their impact on import prices which could turn out to be broad depending on the exact nature of the tariff or could turn out to be episodic across products.

Core Pce looks stuck well abvoe 2% and is not trending any lowever

Inflation expectations

An additional complication - as I keep pointing out; and people keep denying- is that inflation expectations are really not very anchored. To make this point I look at the ‘mean’ as well as the ‘median’ in the University of Michigan survey for inflation expectations for 5-years ahead; and also at the implicit forecast of inflation in TIPS contracts focusing on the period five-years ahead. Year-ahead inflation is not very interesting because it has a lot to do with energy prices and it's only one year ahead. When we look five-years ahead we get more of a sense of what people really think is going to happen and what monetary policy will do and how much they trust the fiscal and monetary authorities to get things right. And that has much less to do with what will happen mechanically. Yet five-year ahead inflation forecasts no matter where they come from are usually quite poor. However, the argument is that people's expectations affect what they do today; those expectations are important even if they're not correct.

Never at face-value…

When I'm looking at these various metrics one of the things I do not do is to take these numbers at face value! Economists, for example, have been quite disdainful of people and their perceptions of inflation...and yet, oddly, they seem to embrace inflation expectations! Curious, no? If you were to survey people - and you can try this experiment - ask them what they think inflation is without specifying a particular price index don't tell them it's the CPI or the PCE or the PPI just asked them, ‘what do you think inflation is?’ You'll probably be surprised at what a wide array of answers you get from people on this subject. Since people are basically fairly poorly informed about what inflation is, can we be surprised that people also are poor at forecasting what inflation will be 5-years from now? It's also true that the price indexes that are put together by the Bureau of Labor statistics are idiosyncratic and related to a sort of generalized consumer whereas individuals are actually going to experience inflation differently. Economists for example will impute the cost of your rent on a variable basis even if you own your home outright or if you have a fixed rate mortgage meaning that locks in some of the largest costs of homeownership. On the other hand, if you actually are a renter, you may be facing actual literal rate increases every year or two. Individual ‘inflation’ is different.

In fact the BLS does report inflation rates by states! You can look this up and find very different price levels and inflation rates across the US even though the “Fed’ targets one rate. You may also see the same thing if you look at international data for the Euro-Area, for example. Individual EMU members report their own domestic inflation rates, headline, core, and with detailed categories. These naturally differ from the EMU-wide target that the ECB sets. So why should individuals be different?

Inflation expectations are HIGH

To deal with these problems when I look at inflation expectations, I rank the number that is generated as an expectation against the numbers that have been generated over the last, say, 10 or 20 years by that same process. And when we look at inflation expectations this way whether it's the University of Michigan ‘mean’ or ‘median’ or whether it's the ‘embedded number from the TIPS securities’, we find the same thing that currently inflation expectations have been higher than what they are NOW by any of these sources only about 5% of the time! Translation? Simple translation? Inflation expectations are HIGH, not low.

I have presented various graphs to demonstrate this some of them in my weekly letter or some of them on my ‘substack’ or even my Linked-In account. To some extent the demonstration might be hard for people to understand because it's a format and framework they're not used to seeing. But if you were to survey people and ask them if inflation were high or low or moderate the ranking format is exactly the right format to use because it's going to tell you exactly that. It will also give you a rather precise statement like inflation has been higher 10% of the time or 12% of the time or 50% of the time however that can easily be translated into high, or low, or moderate.

The Fed is in a worse place…OMG! Here it comes again!

So my concern is that inflation expectations are not as controlled as they were the last time that Trump was president and he put tariffs in place. And while people are looking at tariffs and saying well you know tariffs really are not inflationary - at least this is the economist view of things- and they weren't last time when Trump imposed tariffs, we may be in for a shock when we see prices rising even if it's only a one time increase in an environment where the Federal Reserve has no longer pinned inflation expectations at a low point. If people are skeptical about how well the Fed is controlling inflation and has controlled inflation - and right now relative to its target inflation has been over targeted for 45 months in a row- that can't be a good thing - they are less likely to take an increase in prices and brush it off and assume price increases are going to be temporary and prices will go back down. In fact, now since we have had a recent burst in inflation people are more likely to say Oh my God here it comes again.

The soft-landing gambit was an entrée to disaster

If you have been reading this letter you are aware that I have been critical about the Fed’s searching for a soft-landing. Pursuit of a soft-landing has been responsible for inflation being over its target for 45 months in a row because the Fed never took the steps it needed to take in order to get inflation back down inside of its target. Even now, Mr. Powell says the Fed is in no hurry. Well after missing your target for 45 months why would you be in a hurry? Perhaps the Fed should be in a hurry because the longer this goes on without getting inflation back into target the less credibility its target has… But, when I ask people about this former Federal Reserve officials, economists, they all take the point of view that no the Fed is fine the Fed has credibility. I don’t get it. This is denial – a form of California dreaming- but we will get to that. The Fed has succeeded in bringing inflation down from a very high pace, but it has not achieved what they sometimes called the final mile of getting inflation down to target.

And if you recall the things that I've written about the soft-landing and inflation this is exactly the problem that I have chronicled. Soft-landings do not return inflation to their pre-soft-landing level. We saw this in the mid-1960s when the Fed raised rates avoided a recession but left inflation higher in the late 60s than it had been in the early 60s and then of course we had the recession of 1969-1970 and that left inflation even higher and then we had the severe recession 1973-1975 and although inflation ramped up into that at a high rate at the end of that recession - which could not in any terms be called a soft-landing - nonetheless inflation was at an even higher level! Inflation continued to build into the 1980s until Paul Volcker came on the scene and administered the necessary medicine.

Do you really want to follow that path and have to once again take that necessary medicine with budget deficits already a huge proportion of GDP so that extremely high interest rates would have a crushing impact on deficits and government finances?

Today’s ‘good place’ may be tomorrow’s rock and a hard place

I think the answer clearly is no. And so I think a policy right now to keep interest rates as low as they possibly can be kept is a bad strategy; it is bad risk management. I think the Fed SHOULD want to make sure that it contains inflation here not that it thinks that it's in a good place and it can act if it needs to act. Because if inflation kicks up we know very often it kicks up sharply and the Fed winds up having to take a protracted action. One of the reasons COVID or post COVID inflation was so hard on the economy is that it started with the federal funds rate below the inflation rate. The Fed had a long run with interest rate increases just to get them to a neutral position where interest rates were even with inflation. And that became even harder because the Fed delayed for so long and when the Fed finally took interest rates up to chase the inflation rate, the Fed had a long, long, way to go.

In this cycle that is not the issue because the Fed does have interest rates above the rate of inflation. Interest rates are above the trailing rate of inflation, interest rates are above the level of ‘expected inflation,’ interest rates are better positioned than they were during the COVID. At least for now. That, however, is only part of the story because real interest rates are not particularly high and if inflation begins to take off real interest rates will lose ground they'll become even lower and the Fed will have to boost them even higher in order to get control of things and that's going to be a problem as we saw last time when sharp nominal rate increases created problems in the banking sector. Look back at where interest rates have been… those are the interest rates that are on the investments that banks are holding. If the Fed has to boost the federal funds rate significantly above those levels the assets on bank balance sheet are going to go into a loss position and bank capital is going to be in trouble and we're going to have another banking problem on our hands. This is another reason why Fed policy needs to be preemptive and needs to control inflation now. The best way to solve a banking crisis is to avoid it.

Another problem is the problem of the zero bound…

Let me repeat… another problem is the problem of the zero bound.

California dreamin’

This is not a typo. No one is talking about this in the same way that no one was talking about wildfires in California before wildfires occurred. But, after the fact, we were told all of the risk characteristics that were there that so clearly were responsible for this conflagration. California was set up for the perfect storm and yet it was totally unprepared even though it is chock full of climate change believers and it knew that it had all of this flammable underbrush… and it had very dry conditions… and yet there's no evidence that California had taken any special action to try to prevent fires. It did not fill the reservoirs, and they'd let go dry because they needed to have a cap on them…It would have made a lot more sense to not use that for drinking water and fill it with water in case you needed it to fight fires!! Duh!

So in that spirit I'm thinking of the zero bound now before we are there.

The point is this: if the Federal Reserve is going to play with interest rates at this level when the economy doesn't need them cut when the economy is still running well when the economy still has a lot of liquidity from all of the government spending if the Fed cuts interest rates now to keep growth going, what happens when interest rates are lower and the economy starts to run out of gas? The Fed is going to have to cut of interest rates even deeper and the zero bound beckons.

Two problems

So you see there are two problems with interest rates right now one is there is a risk that the Fed is not raising them enough to keep inflation at bay the other is that the Fed is interested in cutting them too sharply, an action that will prolong growth reduce rates prematurely and leave them in a poor position to cushion the economy if/when growth gets weak. And in the latter situation, if the economy gets weak ,and the Fed takes a strong action to try to arrest weakness, before you know it, interest rates are going to be back down against the lower bound and the Fed is going to be in the soup having to run balance sheet policy for stimulus – a policy we know is rather inefficient.

Interest rates - if anything- are TOO LOW

In my world there is no excuse for interest rates being as low as they are given the performance of the economy. The Fed should not be cutting rates, it should not be planning to cut rates, and the Fed should be telling us how determined it is to get inflation into target sooner rather than later, rather than to assume it's in a ‘good place’ to deal with whatever happens. If the economy were to weaken interest rates are high enough that the Fed could cut rates to help the economy. But if the Fed just reduces interest rates because it thinks they're too high and gets them to a position to keep stimulating and pushing growth ahead when the economy doesn't need it, when we finally need interest rates lower, we won't have enough firepower there to do anything without getting ourselves into trouble.

California lesson…not learned?

California should be a lesson for us. Monetary policy is nothing like wildfires. But wildfires are a good example of how they came about and how California refused to plan even though there were things occurring in their economy that they could see. Now it's true that the Santa Ana winds were horrific, and it may be that if California were better prepared and that if it had more water and if the fire hydrants hadn't gone dry, it wouldn't have made a great deal of difference. However, people would have felt a lot better about their government than about its preparedness and about their willingness to trust them in the future. Trust is important. Right now we talk about trust I think the Fed has lost a lot of it. I'm concerned about the way the Fed deals with the current risk in the economy. I'm concerned about how blase the Fed is about the current state of inflation. And I'm concerned about how the Fed looks at interest rates and about its plan to get them even lower.

Give it up on the soft-landing already

The Fed should not be expending any more political capital to try to achieve its fabled soft-landing seeking it has put us into this precarious position while the Fed has avoided much of an increase in the unemployment rate it has strung the inflation rate out above its target for such a long time that has eroded its confidence and raised inflation expectations. This leaves it in the worst place to deal with any inflation should it arise. However, I think the Federal Reserve is positioning itself to blame any rise in inflation on the Trump administration and on its tariffs, its fiscal policy, and its efforts to deport illegal and dangerous migrants. These actions are likely to have some impact on the price level, however, if people were confident that the Federal Reserve had created a situation of price stability, concern that any temporary price increase would turn on to inflation would be substantially damped.

But, in this environment, after having delayed when we had a real inflation, and allowing inflation to run over target for 45 months in a row, it's hard for me to think that markets are going to trust the Federal Reserve at all. And this will come at a time when our government is already greatly divided and where Democrats and Republicans are simply looking for opportunities to get at one another and to savage one another's policies

Despite what the Fed says we are not in a good place. END