Markets held tight ranges this week, the 10-year T-note entering its sixth month trading between 2.90% and 3.00%, lowest-fee mortgages roughly 4.75% throughout.
The week brought little new economic data, and efforts to think about anything were discombobulated by political eruptions. The most important economic aspect, the onset of tariff war was still tops on the addled minds in markets.
One bright moment of clarity came in a speech by Chair Powell on Wednesday. Instead of reading the predigested propaganda of Wall Street and its economist sales-assistants, go to the source. Powell is not an economist and writes in English. He was educated by Jesuits, who insist on good thinking.
Powell’s speech is short. The opening sentence: “…The U.S. economy is performing very well.” The last sentence of the introduction: “…the case for continued gradual increases in the federal funds rate is strong.”
If you find ambiguity there, please let me know. Markets disbelieved the Fed’s warnings of rate hikes to come from 2012 forward and were right. Now their skepticism is misplaced.
The body of his speech is a concise (two page) discourse on the inexact science of central-banking, and a fine historical review concluding with “The lack of useful historical precedent leaves us with some uncertainty….” Yellen agreed.
Powell concluded that there are no early signs of inflation despite extraordinarily low unemployment, but our risks are not limited to inflation. “We have often seen confidence become overconfidence and lead to excessive borrowing and risk-taking, leaving the financial system more vulnerable. Indeed, the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation. While some asset prices are high by historical standards, I do not see broad signs of excessive borrowing or leverage.”
We do not have current inflation or exuberance problems, therefore we are undertaking prudent pre-emption because the economy and employment are so strong.
How much pre-emption is prudent? Back to Powell’s first paragraph: “Growth is meaningfully above most estimates of its long-term trend — though admittedly, that trend is not as strong as we would like it to be.” The first half of that sentence is for us in markets, the second half to keep idiot politicians off his back, those who think the economy can grow to the sky without risk, and the Fed is the problem.
The longer we grow above trend, the riskier growth becomes. If the economy begins to show signs of inflation or imbalances, the Fed will lean hard and recession would follow. Instead the Fed would love it if we would slow down gently and soon for any reason — rate hikes, tariffs, or no reason. The new tax cuts and spending reduce the likelihood of spontaneous slowdown, and so the Fed is forced into this gradual pre-emption, hoping to detect a slowdown and stop hiking before over-doing. What are the Fed’s chances?
Fortunately, in today‘s world, the chances of premature recession are higher than the chances of letting inflation out of the box. You kids under 60 do not want to live through a time of Fed catch-up. I’ll take a too-quick recession every time.
A brief history of Fed time follows, which Powell shows that he is studying carefully.
Modern economies and central banking began at the end of WW II in 1945. Since then two big changes have altered the Fed’s operations.
Prior to 1978 the Fed’s Regulation Q capped the interest rates which banks paid to depositors. Creating a recession was simple: sell short-term Treasurys, forcing up yields until they exceeded the Reg Q cap, and deposits then flooded out of banks into Treasurys. No money to lend, old loans had to be called — a “credit crunch” and recession. Let the recession run long enough to extinguish inflation, then back to normal.
By 1978 Reg Q had to go. Electron thingys had infected money, which began to flow around regulations of all kinds. So, in 1979 when Paul Volcker had to stop inflation running at one percent per month he had no choice but to run interest rates to the moon until the economy cracked. 18% mortgages and 22% “prime” — both nearly double the rate of inflation to get inflation to come down.
The second big change since 1945: the 1990 end to the Cold War and the opening of China and eastern Europe. Nobody saw it at the time, but the natural tendency of economies to overheat into inflation gave way by globalization to wage and price suppression and a natural tendency toward deflation.
Powell’s speech included a look-back to the last time US unemployment was as low as now, and the onset of inflation — in the 1960s, and not comparable to today. US labor markets had no overseas competition. Japan exported transistor radios, not yet autos; wide swaths of Europe had just come off war-rationing of food. An overheated US labor market quickly went to wage-price spiral.
Our recessions since 1990 changed prior pattern. The one in 1990 was partly old-fashioned: after the Crash of ’87 new Chair Greenspan took Fed funds back up to 10% (mortgages 12%), inflation then 5%. Yup, recession — although the Fed was surprised, and had to ease all the way to 3% in 1993 to get us out of it.
Then from 1994 to 2000 the economy ran hot but inflation did not, and we entered a phase of self-congratulation. And an IT bubble. Inflation rose from 2.5% to 4%, the Fed went to 6.5% and… both bubble and inflation crashed. Note how little above inflation the Fed had to go to get a recession result. (Further note: falling inflation and rates create asset bubbles; as the rate of discount falls, present value jumps.)
Next, in a period of idiocy having nothing to do with Fed monetary policy, instead the greatest financial crime of all time, Wall Street intentionally manufactured and sold several trillion dollars of IOUs guaranteed to default. “Financial imbalance.” The Fed’s brief maximum rate in the period was 5.25% versus inflation about 3.5%. Then as all good kids know, the Fed had to go to zero for seven years.
Globalization and wage and price suppression live on today. The last three times the Fed lifted its rate significantly above inflation (“imbalances” be damned) we had surprise recession and a surprisingly deep one. The Fed’s rate is now at the rate of inflation. How far up before — in the magical prescience of a fortune-teller — the Fed accurately anticipates a slowdown ahead and stops?
Chart is from 1983 to present, core CPI inflation in blue, Fed funds in red. Prior to 1990 the Fed had to hike far above inflation to stop it, and into the mid-‘90s above inflation just to keep it under control, but less and less. Since 1990 accidental overdoing has been the rule: