Friday, May 27, 2022
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The Fed Sets Out to Kill the Economy to Save It

In case you missed it, Mr. Market is in a funk about the Fed girding its loins to go out and wage war on inflation. The Financial Times gives a representative take:

European equities dropped on Thursday as a sell-off that began with highly valued technology shares gathered pace after the US central bank signalled a swift end to its pandemic-era monetary stimulus…

The moves came after minutes from the Federal Reserve’s latest meeting revealed that officials at the central bank, which has boosted financial markets since March 2020 with a massive bond-buying programme and record-low interest rates, broadly agreed it was time to accelerate the withdrawal of this support.

In fairness, as we’ve said for quite a while, the Fed has quietly recognized that its super low interest rate experiment was a mistake. I recall thinking when the Fed dropped interest rates below 1% in the runup to the crisis that that would prove to be a mistake. But the central bank then had fallen into the “75 is the new 25” pattern, of using big cuts to signal seriousness about saving the markets, when at very low interest rates, the impact of rate cuts and increases is magnified.

As as even casual market watchers will know, the Fed has wanted to back out of its super low interest rate corner since at the 2014 taper tantrum era, but the central bank has also been afraid of spooking the market. Now with investors fulminating about inflation, job markets nominally tight (even though due to workers exiting, when strong economies typically pull marginal laborers in) and markets overheated even by the standards of the past decade, the Fed sees itself as under pressure to act by hitting the brakes.

I really should say more, but the spectacle of the Fed having engaged in mission creep and becoming the self-assigned regulator of the economy is now coming to its logical and sorry conclusion. In a system where economists have long been the only social scientists with a seat at the policy table, those experts have done a poor job of devising policies that will create stability, to the extent that can be achieved in a dynamic environment, and a reasonable level of growth. Of course many will now question the legitimacy of growth as an aim given global warming and the need to marshal resources better, but we’ll put that to the side.

It has been convenient for politicians to fob responsibility for economic stewardship to a typically oracular Fed and no do simple-minded things like emphasize economic stabilizers, as in programs that are countercyclical, where payments (economic stimulus!) rises when times are bad and fall when activity rebounds. But the wee problem is the most effective programs will target citizens with a high marginal propensity to spend, as in the low income, and in America, we hate the poor. Congress has also hidden behind the skirts of the neoliberal propagandist masquerading as evenhanded CBO; we’ve written some scathing posts about how the agency not only often puts a finger on the scales when it is making its analyses but also invests a lot of energy in providing conservative talking points.

A final issue is that the Fed still lives under glow of the myth that Volcker driving interest rates to the moon is what broke the deeply entrenched 1970s stagflation. In fact, Warren Mosler has put together an analysis that shows that not only was that great inflation substantially due to oil price increases, which were outside the central bank’s influence, but more important, that oil prices were finally falling in 1979 and inflation has started receding too. So that inflation would have worked its way out of the system, albeit more slowly, had the Fed stood pat.

As we wrote in comments on a recent post:

The problem is that “inflation” has been acute in categories that matter: energy, food, cars.

Energy cost rises have absolutely nothing to do with the Fed. It’s demand being whipsawed by Covid and producers not being able to respond quickly enough and retailers gouging to a degree.

Food is considerably due to weather-related poor harvests and Covid impact on supply chains.

Cars are due to chip shortages and again a Covid whipsaw.

These are all totally out of the Fed’s purview and despite having considerable importance to inflation measures (fuel cost rises propagate through all other cost), they have squat to do with the monetary stories about inflation.

And on top of that, macroeconomic forecasts are about as good at the CDC’s of Covid. Plus speaking of Covid, if Omicron does not recede pronto, economic disruption will again become widespread and will dent growth. And unlike 2020, no one is in the mood to throw a ton of money or controls (like eviction freezes) at propping up demand should it unexpectedly sag.

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