Cure Inflation "By Forcing Long Term Rates Higher"- Zoltan Pozsar
There are two ways to slow inflation. One doesn't work anymore
Housekeeping: Please enjoy the holiday weekend. There will be no weekly report this weekend. Instead, here is an in depth analysis (translation?) of a piece by an economist we respect, and you will likely be hearing alot more from him on MSM soon. Even if he is hard to read.
Happy Easter and Pesach Sameach to those who celebrate
There are two ways to slow inflation: by hiking short-term interest rates or by forcing long-term interest rates higher.- Z. Pozsar
On February 16th Zoltan Pozsar posted his “Global Money Dispatch” starting with the phrase ”We need a Volcker moment. One where the “Vol” in Volcker stands for volatility.
Zerohedge did cover piece on it and we read it several times. From that post:
We bring all this up today because in a startling note from one of the most respected Wall Street strategists, repo market guru and former NY Fed official, Zoltan Pozsar, he not only echoes all of our "tinfoil conspiratorial" thoughts but even goes one step further suggesting that "We need a Volcker moment… a Volcker moment, where Vol stands for “vol” – as in volatility." In other words, Pozsar writes that the Fed needs to crash the market to contain stocks.
The yield curve subsequently went flat, inverted, and uninverted with back end yields going up since then. It is time to reread that post again in context of what just happened.
Zoltan: Volatility Cures Inflation
Pozsar starts in his note out by saying the Fed has one big problem, inflation. He explains the market could actually use a little uncertainty in Fed behavior to help quell said inflation.
Legendary central bankers like Paul Volcker …sparked volatility by starting to target quantities instead of rates, and he didn’t talk too much about what he was doing – he kept the market guessing.
His volatility conclusion is not obvious, but his path to that concept is. Here is an attempt to understand how he came to that conclusion. By volatility we take him to imply the Fed needs to stop telegraphing its moves, keep the market guessing, and encourage self-clearing behavior.
Two Ways To Kill Inflation
“There are two ways to slow inflation: by hiking short-term interest rates or by forcing long-term interest rates higher” he starts out. The first is where the Fed hikes short term rates thereby slowing economic activity as discussed previously.
Since Volcker, the Fed has sought to actually keep long term rates lower by raising short term rates. In doing this they slow the velocity of money, make loaning money unprofitable and thus eventually reduce demand for dollars.
The second way to lower inflation Pozser says, is “by forcing long-term interest rates higher”. The idea behind that is the more expensive it is to borrow, the less money will be borrowed. The spread between real rates and nominal rates at the long end must be closed.
HIKE SHORT TERM AND WATCH LONG TERM
The preferred method for stopping inflation is by raising short term rates. Over the past 30 years, that worked well for the most part in line with the Fed’s dual mandate of price stability and high employment. By raising short term rates they were willing to stomach causing recession recession while slowing inflation. That was because major secular trends were blowing their way.
Back end Rates have to go up to Fall sometimes...
The Fed was comfortable risking recession while fighting inflation because supply chain and production improvements kept the price of goods in a disinflationary trend. He states:
Goods prices were a steady source of disinflation for the past two decades, which gave the Fed precious time and cover to figure out what to do with policy rates to control services inflation.
But that will not work this time he opines. There are a couple things different about the current situation.
Zoltan: Not This Time
First off, Zoltan says, The Fed’s dual mandate has been modified. Secondly, the tail wind of goods disinflation enjoyed by Fed policy-makers is no longer there on which to lean.
DUAL MANDATE CHANGED
Price stability is still their second mandate. But the original mandate of full employment has been slightly altered according to Pozser. Full employment is not enough.
With the Fed’s “updated dual mandate” of inclusive low unemployment and the political imperative of redistribution through firmer wage growth at the bottom of the income distribution.
The Fed is now responsible for full equitable employment. What does that mean? It means that without saying it, they kind of admit that policy has contributed to wealth inequality these past decades and they are now tasked with fixing that somehow. How they will accomplish that in our opinion will be part of the reason we get CBDC for sure, but that is for another time.
The problem with the redistribution of income thing is; it makes tolerating a recession unthinkable while reducing inflation. A recession will destroy those at the bottom even more.
GOODS INFLATION RETURNS
The second problem is Goods Inflation. Goods inflation is now a headwind, not a tailwind. The reason for this can be manifold, and we certainly can’t claim to know exactly why, but taken as a whole, isn’t it obvious? Covid revealed the fragility of supply-chain dependency and lack of redundancy. Pozsar states that while he is no goods inflation expert:
“ he reads the papers enough to sense that with supply chain and distribution bottlenecks everywhere, goods inflation won’t disappear (slow maybe; disappear no). What used to give the Fed cover now exposes it: goods price inflation is a problem now…”
The products we buy are commoditized. The value these days is in the delivery system that has reduced friction between procurement, assembly, and delivery. And the supply of all goods is the problem right now.
So; can the Fed simply raise rates, slow inflation and cause a recession in this new environment? Pozser thinks that would not be an effective approach. We think he is right based purely on observing recent recessionary events. Here’s why.
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