Viewpoints: 2023

The Federal Reserve reminds me of a fire chief who moonlights as an arsonist. The Fed aids and abets in the setting of inflationary fires and then runs to extinguish them. In this commentary I will argue that the Fed’s response to the COVID-19 pandemic and the unprovoked invasion of Ukraine by Russia exacerbated and prolonged the inflationary impulses of these events. Furthermore, I will hypothesize that the Fed is going to pursue a more restricitve policy longer than necessary to extinguish the inflationary fire it helped set, the result of which will be a deeper-than-necessary recession. The Fed is not malicious. Rather, it is ignorant. At his semi-annual appearance before the Senate Financial Services Committee on March 7, Fed Chairman Powell stated that the Fed does not know what the level of the “neutral” federal funds is now and that the neutral level is not constant through time. Yet, the Fed persists in conducting its monetary policy by setting the level of the federal funds rate, not knowing whether the level set is above or below the neutral level of federal funds rate.

When it became obvious to all that there was COVID-19 pandemic in March 2020, real production of goods and services in the US and in many other regions of the world collapsed as business shutdowns occurred. This represented a negative supply shock. If nominal aggregate demand remained the same in the face of this negative supply shock, higher prices would result. The changes in the sum of depository institution credit (loans and securities on the books of these institutions) plus the monetary base (the sum of currency in circulation and reserves held at the Fed by depository institutions) are postively correlated with changes in nominal aggregate demand. Let’s call the sum of depository institution credit plus the monetary base “thin-air” credit because both are created, figuarively, out of thin air. By this, I mean that the extension of thin-air credit does not necessitate anyone cutting back on their current spending in order to extend this credit. You can think of the creators of thin-air credit, the Fed and depository institutions, as legal counterfeiters. Plotted in Chart 1 are the annualized percent changes in quarterly observations of thin-air credit (the blue bars) and the annualized percent changes in the quarterly observations of output produced by the business sector (the red bars).

State labor markets in January generally showed some gains from December. 20 states had statistically significant gains in payrolls; California’s job count increase was 96,700 (about double number 2 Texas), and both Arizona and Tennessee saw .7 percent gains. Kansas, Rhode Island, and Wyoming had modest point declines. Over the last 12 months, 47 states had significant increases, with Texas having the highest numerical increase (654,100) and Nevada the highest percentage gain (6.0). the way in both numbers and percentage (650,100 and 5.0, respectively). There were no point declines.

Unemployment rates were little-changed; a few states had statistically significant moves from December, but none larger than .2 percentage points (in either direction). The 2.1 percent rates in both Dakotas were the nation’s lowest, while Nevada’s 5.5 percent was far and away the highest (number two was Oregon). Only 6 states were more than one point away from the national average of 3.4%, and 3 of those (the Dakotas and Delaware) are small.

Puerto Rico’s gained more than 5,000 jobs in January. The overall payroll count on the island is nearing its highest level in more than a decade, while the private-sector is approaching an all-time peak. The unemployment rate (which had not been reported for some months) was unchanged at 6.0 percent, despite a .9 percent gain in the labor force. Revised data show that Puerto Rico’s unemployment rate set a record low of 5.8 percent last June. Data are not released for Puerto Rico on the labor force participation rate or the ratio of employment to population, but considering that the population of Puerto Rico is roughly the as Iowa’s, and its labor force is no more than 70% as large, it is clear that despite good numbers in recent years, there is still a long way to go before the island’s labor market can be seen as comparable to mainland norms.

The Fed looks at bond yields as a gauge of long-term inflation expectations and its overall policy stance. Policymakers believe moderate and stable long bond yields are consistent with well-anchored inflation expectations and an appropriately configured policy stance. Yet, questions surround the current signal from long-bond rates after a decade-plus-long program of debt security purchases (quantitative easing, known as QE) by the Federal Reserve.

Studies have shown that QE has lowered long bond yields by several hundred basis points. But, it needs to be clarified if the anchoring of long-bond interest rates via QE has also changed how the market price of long bonds adjusts to official rate hikes. Whatever the effect is, the Fed is not getting the market response it needs if it believes that higher borrowing costs are the main channel to break the inflation cycle.

The core inflation and long bond yield picture that Fed faces today is something they have not encountered since the mid-1970s. One has to go back to the mid-1970s to find a similar alignment between long bond yields and inflation. The core inflation rate is approximately 200 basis points over the ten-year Treasuries yield, and that alignment has been in place for more than two years.

That alignment raises several issues, all pointing to higher official rates.

First, market rates adjusted for inflation have moved from "super" easy to still easy, indicating that the public's borrowing costs are still not sufficiently high enough to break the inflation cycle. That means the Fed has to hike official rates much more.

Second, an inverted Treasury yield curve with market borrowing costs below the inflation rate has never occurred before. If borrowing costs matter more, as history has shown, curve inversion does not have the same adverse economic consequences. Consequently, the Fed will need to raise official rates well above market expectations creating an even greater curve inversion to get the inflation slowdown its wants.

Third, the most significant risk to investors is if remnants of QE have permanently broken the links between long-term market borrowing rates and official rates. That would open the door to official rates moving to levels not seen in several decades. The risk of this scenario is low, but not zero, as the Fed has never faced an inflation cycle with QE in place.

Quantitative easing (QE) is the "albatross" of the current stance of monetary policy. Quantitative easing was a monetary tool created during the Great Financial Recession. Operating at the "zero" bound of official rates, the Fed found a new channel (QE) to provide monetary stimulus and liquidity to the economy and financial markets. QE was a new way of making money as the Fed bought bonds directly from the financial markets in exchange for cash, increasing the broad money supply.

The first quantitative easing program ran from 2009 to 2014. During that period, the Fed's balance sheet exploded to over $4 trillion from about $500 billion before the Great Financial Recession. The Fed started the second QE program when the pandemic hit. That boosted the Fed balance sheet to $8.8 trillion, more than twice the size after the first program.

Several studies have concluded that the first QE program was the equivalent of several hundred basis points of additional official rate cuts. The second program was as big or bigger in scale, providing monetary stimulus worth several hundred points of Fed easing.

Since QE never existed before, no one understands how this new tool would impact the effectiveness of monetary policy when policymakers tighten policy. But it should be symmetrical. That means as long as the scale of QE remains exceptionally large (Fed balance sheet still well over $8 trillion), it will probably take much bigger hikes, and to higher levels, in official rates for the stance of monetary policy to be as restrictive as when QE was not in place. (Note: If there are no negative consequences of QE it would then go down as the greatest invention in history)

How else can anyone explain the exceptional strength of the labor markets and historic low unemployment rate, accelerating bank lending, resilience in the equity and bond markets, and high inflation rates after nearly 500 basis points of official rate hikes, the most significant increase for a single year since the early 1980s without linking it to QE?

Remnants of QE are preventing the Fed from accomplishing its goal of reversing the inflation cycle. Risk assets should remain well-bid as long as the Fed fails to recognize the problem. But what happens when the Fed says they were wrong again?

The Federal Reserve Bank of Philadelphia’s state coincident indexes in December were somewhat mixed. The indexes in 16 states were down from November, thought the largest decline was Minnesota’s fairly modest .41 percent. Of more concern was 16 states showing declines at the three-month horizon percent, and two more unchanged. Three states (Minnesota, Maine, and Vermont) had declines larger than .5 percent. On the upside, only seven had gains of more than 1 percent, which is less than what has recently been the case (Texas was the only one of the 4 largest states in this group). Over the past 12 months the count of states seeing gains of 5 percent or more was reduced to 9 (including California, Florida, and Texas) while 4 states (Arizona, Montana, Mississippi, and Oklahoma) had increases under 2 percent.

The independently estimated national figures of growth over the last 3 (.81 percent) and 12 (4.12 percent) were plausibly in line with the state results.

State labor markets in December were essentially unchanged from November. West Virginia was the only state to report a statistically significant change in payrolls (a 1.4 percent drop). Texas had the largest (not statistically significant) increase: 29,500. Over the last 12 months, 42 states had significant increases, with Texas leading the way in both numbers and percentage (650,100 and 5.0, respectively). There were no point declines.

Unemployment rates rose significantly in 7 states and dropped in 5. Nevada’s .3 percentage point increase and Maryland’s .3 percent point decline were the largest moves. Utah’s 2.2 percent was the lowest rate, and Nevada’s 5.2 percent was the highest. The Dakota’s were the only other states with unemployment under 2.5 percent. Illinois and DC both had 4.7 percetn unemployment rates. In sum, 46 states had unemployment rates no more than 1 percentage point different than the national average of 3.5 percent.

Puerto Rico’s job count edged down 1,500. Yet again there was insufficient information to compute the (seasonally-adjusted) unemployment rate on the island.

The inverted Treasury yield curve has raised concern over the risk of recession in 2023, and for a good reason. An inverted yield curve has occurred before the past eight recessions. Yet, something is awry. Banks are not restricting credit as they typically would with an inverted yield curve, and businesses and consumers are borrowing at banks at the fastest rate in fifteen years. What's up?

The thinking behind the inverted yield curve is that banks slow and eventually stop lending when bank funding costs exceed what banks can earn by lending. Yet, bank credit has been accelerating throughout 2022. The latest data for November shows bank lending to businesses, real estate, and consumers rising 11.8% over the comparable period one year earlier. That's the fastest annual growth since 2007.

Why are banks lending so much with an inverted yield curve? Banks' total costs of funds are not determined solely by the rate of federal funds. Customer deposits account for half of the funding costs for many big banks. And with customer deposit earning (or costing) less than 70 basis points, the bank's all-in funding costs remain relatively low. So it's still profitable to lend nowadays.

That raises questions about the recessionary signal from an inverted yield curve because, in previous periods of inverted yield curves, bank lending slowed sharply, often contracting (see chart). Can the inverted yield curve signal be trusted if bank credit is accelerating, not slowing, or contracting as in previous periods? I would think not.

Also, why are businesses and consumers still borrowing briskly after the Fed substantially raised official rates? Because the federal funds rate is not crushingly high, at least not yet. In the past, the federal funds rate proved restrictive when its level equaled or exceeded the growth in gross income and output (see chart). In other words, to slow domestic demand, the Fed had to raise rates equal to or above the increase in gross income and output.

At the end of the third quarter of 2022, the growth in GDP exceeded the Fed funds rate by almost 600 basis points. That's huge, indicating the economy is far from one of the conditions in place before prior recessions. Even if the Fed median forecasts of higher official rates and markedly slower nominal growth are on the mark, the GDP-Fed funds' gap will not be closed before mid-year 2023. A recession beginning around mid-year runs counter to the bullish forecasts of a strong half for 2023.

Many believe an inversion in the market yield curve, or the spread between the yield on three-month Treasury bills and the 10-year treasury, is a robust forecasting tool due to its consistent and reliable track record. Yet, yield curve inversion, by itself, is not a sufficient condition for an economic recession. Slowing or contracting credit growth and official rate levels equal to or exceeding income growth are also necessary conditions. Those conditions are not present, so until they are, the yield-curve recession signal will remain a forecast, not a reality.