Is the Fed Panicking or Bluffing?

Federal Reserve Board Chair Jerome Powell speaks during his re-nominations hearing of the Senate Banking, Housing, and Urban Affairs Committee on Capitol Hill, in Washington on Jan. 11, 2022. Brendan Smialowski/Pool via Reuters

Commentary

The big takeaway from the annual Federal Reserve Symposium in Jackson Hole, Wyoming—in person this time after two years of staying home and staying safe—was that the Fed is serious about stopping inflation. The message to the media was firm and unified. There will be no stopping this Federal Reserve until the target of 2 percent is reached and stabilized.

Fed Chairman Jerome Powell went so far as to push a single word to summarize what’s about to happen: pain.

Yikes! It isn’t as if the Fed is promising to take away the punch bowl from the party. There is no party, unless you are a sitting member of Congress attached to the sitting majority. The rest of us have been through years of pain. Now, the Fed can only promise more.

This, of course, provoked the bears to make a return to Wall Street. If the central bank really is going full Volcker (circa 1978–1982), rates have a very long way to rise before they even approach being above zero in real terms. Indeed, they have only barely started this fight.

In the simplest terms, we can think of the Fed’s job as an inflation fighter as an analogy to a race with two runners. The federal funds rate needs always to stay ahead of the consumer price index. In that way, interest rates stay above zero in real terms. If that flips in the other direction, it’s a sign that money and credit are too plentiful to maintain stable prices. The only path to reversal is a centrally imposed rate boost that filters through the banking system and restricts all credit markets.

Since World War II, the Fed has mostly been in front of this race, except for a few cases when inflation got out of control. The big change in policy came in 2008, when the Fed experimented with a zero-interest-rate policy. Bracing for disaster, it never really happened. That was for one reason: then-Fed Chairman Ben Bernanke kept the liquidity under wraps by paying more on bank deposits than the market would bear. That’s what accounts for the strange anomalies over the past 12 years.

The Fed grew cocky in these years, and pundits on the outside began to believe in crazy ideas such as that there is never a downside to infinite money printing. Someone must have sprinkled magic dust on the world economy that keeps inflation low even as central banks pursue ridiculously loose policies.

Times have changed! The technocrats in Treasury offices and central banks have finally mastered the craft! That illusion lasted from 2008 until 2020.

The pandemic lockdowns wrecked everything. The Fed went on a wild debt-buying spree that injected a sudden $6.3 trillion directly into the deposit accounts of consumers and producers. In the case of business loans, 90 percent have been forgiven. Now, the Fed is looking at a country awash in money, mountains of paper looking for new sectors to poison.

The chart below gives you a sense of how this race between the Fed and prices is going. The distance between the federal funds rate and the CPI (Consumer Price Index) has never been anywhere near this far apart.

If the Fed is truly serious, it has a very long way to go before it gets ahead of the game. Ronald Reagan’s budget chief in his first presidential term was David Stockman and he watched Volcker’s war from a front-row seat. Now, he is absolutely firm: there is no chance of regaining stable prices until we see federal funds rates that equal or exceed prevailing inflation rates. If that is true, there are awesome implications.

Data: Federal Reserve Economic Data [FRED], St. Louis Fed; Chart: Jeffrey A. Tucker

Let me channel economist Murray Rothbard for a moment. He would observe that in one way, all of this is a masquerade. It’s possible that the Fed will continue to raise rates as a way of dialing back the go-go times inspired by cheap and plentiful money and credit. But the root of the issue is about cause and effect. The Fed, he would say, is not the solution to inflation. It’s the cause. Its tough talk disguises its own culpability in causing the problem in the first place.

How so? The Fed stands ready as the ultimate source of liquidity for the entire government and the whole of the financial system. By its power to buy whatever debt Congress creates, and doing so with its power to electronically print all the resources it needs, it perpetuates an ongoing moral hazard.

Only because of the Fed can Congress get away with its beyond-belief levels of spending. Take that power away and the U.S. government would face the same fiscal restraints of every state government, municipality, or household. All of these institutions can live on credit but the debt they hold is priced with a risk premium that reflects the possibility of default. That isn’t the case with U.S. debt, and the Fed is the reason.

The Fed itself rejects this entire explanation. In his statement, Powell said that his policy is to deploy “higher interest rates” to bring about “slower growth and softer labor market conditions.” Even though this is painful, he says, “these are the unfortunate costs of reducing inflation.”

The implication here is that inflation isn’t the Fed’s fault; it’s the fault of the labor market for being too strong and the fault of output for being unsustainably strong. This understanding of inflation dynamics comes straight from crude Keynesian models that have been rejected for decades by economists. You can hardly find them in any textbook, except perhaps in the appendix on the history of economic thought.

The Fed faces another problem besides just pulling down the inflation indexes. There isn’t just one price but billions, and each sector is moving in chaotic ways. Just as gas and oil prices fell, electricity and utility prices started to soar. In Europe right now, utility bills that have risen 100–200 percent are strangling whole economies.

In fact, it was likely the presence of officials from the European Central Bank in Jackson Hole that contributed to the sense of urgency.

The pricing chaos gets stranger by the day in the United States. As I write, domestic flights from September through November have fallen to levels I’ve not seen in two decades or more. You can fly roundtrip from Dallas to New York for $120 or from New York to Miami for even less. It’s incredible.

How to account for this? Fuel oil prices fell dramatically and that fed price declines. Another main culprit is a big fall in demand for travel by air. The overcrowded planes—airlines learned to fill every seat—plus rampant delays and cancellations have discouraged travelers. The declines in real income also caused consumers to rethink all plans for fall travel. The pricing mechanisms of the airlines are now extremely sensitive to such changes.

Meanwhile, you have surely noticed that food prices have continued in their upward march. If you take out food and energy, we are doing just fine. The only problem is that food and energy are the things that people buy most often and are essential to everything we used to call the good life.

Is the Fed serious? Probably. Just as Dr. Anthony Fauci was determined to control a virus, Powell is determined to control inflation. Their wars on their chosen pathogen tend to be very costly for the rest of us.