The Fed still intends to withdraw the punch bowl when the party is long over
Federal Reserve Board Chairman Jerome Powell holds a press conference after the Fed raised interest rates by a quarter of a percentage point following a two-day meeting of the Federal Open Market Committee (FOMC) on interest rate policy in Washington, March 22, 2023.
Leah Millis | Reuters
Judging by the Federal Reserve’s most recent statements and actions, the Fed may well take Nike’s immortal advice and plan to “Just do it!”
It seems they still want to take short-term interest rates to their presumed terminal level, now almost universally estimated at 6%, a full percentage point above its most recent target of 4.75- 5%.
A host of leading economists say the fight against inflation is far from over and whether it’s on the Phillips curve or adhering to the Taylor rule, the Fed should go ahead and get some real interest rates above the falling inflation rate to kill post-pandemic price increases once and for all.
Never mind that domestic and global banks remain under duress as the latest concerns over bank solvency put German Bank in the crosshairs on Friday.
As believed in 2007, officials say the banking system is sound and there are few indications of systemic risk from the failures of Silicon Valley Bank, Signature Bank and ongoing unrest in First Republic.
Smaller banks reported $270 billion in commercial real estate loans that will likely come under pressure as the economy weakens, complicating the outlook for credit availability in the months ahead.
The Fed has acknowledged that recent banking problems could lead to tighter credit conditions and make business and consumer loans harder to come by.
This apparently doesn’t bother the Fed since it helps it slow down the economy and put the inflation genie back in the bottle.
It doesn’t matter that a recession, with risks rising daily – look at the yield curve, leading economic indicators, real estate activity and contracting manufacturing – looms in the second half of 2023.
If I was at the Fed, that would bother me.
Inflation is falling rapidly
Global interest rates are plunging and gold has surged in a flight to quality, not a flight to hedge against inflation.
It should be important that Rent.com shows that residential rents have fallen from an 18% year-over-year gain at the start of 2022 to less than 2% year-over-year last month. .
Owner Equivalent Rent, the housing cost proxy used in calculating consumer prices, is 25% of the CPI and 12% of the PCE deflator, the Fed’s preferred inflation gauge.
Housing costs accounted for 70% of the bigger-than-expected rise in the CPI last month, according to old rent data.
Looking further ahead in 2023, rents are likely to put significant downward pressure on inflation, as Fed Chairman Jerome Powell himself admitted at this week’s press conference.
Energy prices, including oil and natural gas, continue to decline, in the case of natural gas, are plunging, driving down consumer energy costs, which will likely lower inflation further , given a weighting of 9% in the CPI.
Goods inflation, again, as Powell admitted, is in disinflationary mode.
Service sector inflation is lagging goods inflation and this is starting to show in airline earnings calls, many of which suggest a slowdown in travel later this year.
Wage inflation also appears to be peaking. Rising wages seem to be the bane of the Fed’s existence, even though much of the wage gains we’ve seen recently are offsetting decades of underpayment across a wide variety of industries.
The Atlanta Fed’s wage tracker shows wage inflation peaking at 6.7% in August of last year, falling to 6.1% last month.
While it is true that the unemployment rate, at 3.6%, is near its lowest level in 50 years, it is also true that the labor force participation rate remains below pre-pandemic levels. and that immigration constraints keep the demand for workers artificially constrained… anything higher interest rates simply cannot set.
It’s not the 1970s
A new paper from former White House economic adviser Peter Orszag, now at Lazard, and fellow economist Robin Brooks argued this week that inflation may well be “transient” as inflation in goods has collapsed and inflation in services may soon follow.
They argue that almost all of the spike in inflation we’ve seen since 2021 was induced by the pandemic and the war in Ukraine, an argument I’ve been making for many months.
I fear, as I have since the beginning of this tightening cycle, that the Fed is using the 1970s as a template for today’s policies.
But past is not always prologue.
That said, history could well repeat itself if the Fed continues to go too far and break more than a few regional banks.
They should prepare to pivot like they have after every political mistake they have made in my 39-year career.
The Fed, unfortunately, does not seem ready for this.
Instead, it seems to be retracing a well-worn pattern of kidnapping not just the Punch Bowl, but also the Hangover Cure, long after the party is over.