UNLOCKED: "Two Percent Inflation is a fairy tale translating into even worse inflation after the next recovery."
Something's Gotta Give at the Fed
Housekeeping: Questions were asked about the rationale for several recent posts and opinions. Here are the top 3 of those answered in conjunction with a little context.
Question 1: Can the Fed drive the real funds rate high enough and keep it there long enough (to kill inflation) while keeping unemployment under 5% ?
Question 2: Do they have the political will to do it?
No. Not yet.
Given the political pressures of wealth redistribution via the “inclusive” mandate and current administration’s progressive pressures, there is almost no way the Fed has the political will or permission to do that.
This can very likely end in a Nixon/Burns type of Fed diad where socioeconomic pressures, changing attitudes, Geo-political pressures and more conspire to make it impossible for the Fed to do this even if they wanted to.
Question 3: If they do it anyway, can they do so without causing a much bigger recession than we are currently experiencing?
And especially not without goods inflation substantially down; which happens only without: war, sanctions, and East/West animosity.
It is almost impossible to get inflation back down to an acceptable level without causing a worse GDP drop all the while keeping unemployment1 near its recent average even with job openings dropping substantially from current levels.
Which all implies that they might crash the economy, and then reflate it even harder. Hence the title
On Having The Political Will to Do It
Check list from former Fed Chief Dr. Arthur Burns’ lecture on why the Fed did not do the right thing between 1970 and 1978. (lecture PDF at bottom)
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From: The 1979 lecture that Scared Volcker (prem) here is what Arthur Burns, Volcker’s predecessor, said were the reasons why the Fed could not do the right thing. These are Burns’ own reasons for the Fed’s lack of political will during his tenure.
Philosophical and political changes
Desire for a more interventionist govt
Unevenly spread prosperity
Substantial societal tensions
Reflexive embedded societal expectations
Overwhelming goal of full employment
Environmental policies added to the inflation
Entitlements diminished the work ethic
Fed had tools to stop the inflation, but chose not to use them because it had been caught up in the social movements of the day
Fed is beholden to Congress, how could it stand in they way of societal changes that Congress was attempting to enact
Understand what the appropriate level of "full employment” was
Central Banks can’t stop politically driven inflation. They have the tools, but not the will
Inflation was fed by high unemployment, deficits, money creation
What has changed since then? Nothing in our view. Full lecture context of these here
On Causing a Much Bigger Recession If They Do It
TS Lombard on the current predicament and higher normal inflation and/or unemployment needed to rebalance the economic table (emphasis ours):
The notion that inflation magically falls back to 2% without disrupting labour markets is a fairy tale whose belief, when exercised in policy, translates into inflation during the [ next] recovery that follows the coming [current] recession that will be higher than what the economy experienced in the 2010-19 expansion. This is not a policy bias that ends well
Real Fed Funds Rate Must Follow Labor Demand or Sticky Inflation ensues…
What will actually happen at the top level:
Calculations and definitions will be changed, political pleading will commence, bureaucrats will be replaced, lectures will be given to “take our medicine”, tough love lectures, and all the knobs used to keep the economic data in an acceptable range will be twisted to make it seem ok.
What will happen in reality?
But the real economy will get destroyed/reset by economic forces that cannot be massaged away like statistics can be. A generation of small business owners and working class families will see taxes go up while loopholes for the rich evolve and the poor need even more help than in the past.
2% inflation is a fantasy given these parameters. The noninflationary unemployment rate is now well above 3.5%. That relationship was broken through the use of QE2. It was kept on life support from Goldilocks tailwinds and tactics like REPOs, RRP, YCC, Fed “guidance”, with Vol and Gold selling. But the jig is up.
Either inflation normalizes at a significantly higher baseline, unemployment normalizes as being “full employment” closer to 5 or 6%, or we get a torrid stagflationary recession worse3 than the 1970s as the market resets itself on the backs of its citizens while leaders continue to delude themselves that all is well.
There are almost no more knobs for the Fed to turn to reroute the economic flows; And no more safety valves to use for transitory restoration of fantastic economic expectations. One or more of the 3 legs that hold up our economic table has significantly reset.
Inflation has to stabilize higher, unemployment must baseline above 5%, or GDP must go significantly lower (recession worse). Something has to give.
What saves us from this:
The long term will be fine. The US will re-establish itself in manufacturing and also re-domesticate its own supply chains. instead of cars we will lead the world in chip manufacturing.
Short term what makes this analysis wrong is if the war ends, sanctions are lifted, the BRICs do not create an alternative monetary system, and the East and West heal. All of that can happen, and probably will in degrees. But we need the degrees to be big enough to reverse course on growing global division. That we think is too late. Buckle up
When Powell talks about strong wages; he is saying he needs unemployment higher
We intend to describe how in a future post
When Powell talks about the economy being strong the last year; he is saying a recession is here