The week of April 4: inflation, recession, stagflation, and much, much more fun reading.
Some people have been nervous about the economy for quite some time now, not least due to their skepticism that inflation was “transitory.” In the end, “transitory” proved to be transitory, but inflation did not. There may be the odd down month ahead, possibly reflecting base effects, but the broader trajectory will be upwards. Judging by the contents of the now released March 15/16 FOMC minutes, the Fed is finally, not before time, trying to bring things back under control.
Interest-rate rises are already under way. Last month, the Fed increased its benchmark rate by 25 basis points (0.25 percent) — the first increase since 2018. We now know that — but for the Russian invasion of Ukraine — the increase would have been twice that. “One or more” hikes of 50 basis points (0.5 percent), a more rapid rate of increase than was anticipated until very recently, appear to be heading in our direction.
Christopher Rugaber for AP (April 6):
Markets now expect much steeper rate hikes this year than Fed officials had signaled as recently as their meeting in mid-March. At that meeting, the policymakers projected that their benchmark rate would remain below 2% by the end of this year and 2.8% at the end of 2023, up from its current level below 0.5%. But Wall Street now foresees the Fed’s rate reaching 2.6% by year’s end, with further hikes next year.
The tightening won’t stop there. The central bank will begin by effectively taking more than over $1 trillion a year out of the financial system (by not replacing holdings as they mature). As Neil Irwin of Axios notes, that’s roughly twice the rate — up to $95 billion a month, compared with $50 billion during the last period of QT (quantitative tightening), which began in 2017. Then again, back then, the Fed’s balance sheet stood at around $4.5 trillion. Now it’s, yes, roughly twice that.
This will be phased in over three months, or “modestly longer” if market conditions warrant, but with $4.5 trillion on the books, that’s unlikely to be much of a reprieve. To put the timing into context, AP’s Rugaber noted that “the last time the Fed bought bonds, there was a three-year gap between when it stopped its purchases, in 2014, and when it began reducing the balance sheet, in 2017.”
Rugaber mentions “estimates that reducing the balance sheet by $1 trillion a year” are “equal to anywhere from one to three additional quarter-point increases in the Fed’s benchmark short-term rate each year.”
That is on top of the likely increases in actual rates mentioned above. Put all this together and this, suggests Axios’s Irwin, will be “a more rapid tightening of monetary policy than has been seen since the Paul Volcker era in the early 1980s.” “Of course,” he adds, “inflation is also the highest it has been since then, so, maybe that’s not too surprising.”
All this, reckons Irwin, will have “unpredictable” effects in the markets. That may be an understatement. As he reminds us, the “trillions of dollars the Fed pumped into the financial markets through the pandemic lifted asset prices of all types.” What happens when those trillions disappear?
There will some nasty surprises. Cheap money is an invitation to malinvestment, and there can be little doubt that it has been eagerly accepted. As Warren Buffet famously observed, “Only when the tide goes out do you discover who’s been swimming naked.” To believe that such a reversal will incur without a severe shock to some corner of the financial system is to be remarkably optimistic. Even if that bullet is dodged, the risk of a market sell-off seems (to me) high. Fixed-income securities are already going through a decidedly rough patch, and stocks show some signs of wavering too.
Bloomberg’s John Authers recalls that
a 1% real yield, the level at which stocks began to tumble in October 2018 [a tumble that led the Fed to reverse direction], is still a ways away from here. But cheap money can become addictive, and equity traders have grown accustomed to negative real rates. Reaching 0% might conceivably be a similar point that prompts the stock market to revolt.
Who knows?
The underlying question is whether the Fed is prepared to let Buffett’s “tide” go out far enough to rein in inflation that may prove more intractable than the central bank (even now) is willing to believe. That impact of the Russo–Ukrainian war (and related sanctions) on food, metals, and energy prices will only add several turns to the inflationary ratchet.
We will have to see whether the Fed will be prepared to persevere with tightening in the face of market turbulence and (as discussed below) recession. And then there is the uncomfortable reality that U.S. government debt levels are far higher than in Volcker’s day. If a sustained increase in interest rates beyond a certain point (something discussed below) is required, it could get very expensive indeed for Uncle Sam. To get a sense of what that could mean, it’s worth looking at an article that the Manhattan Institute’s Brian Riedl wrote for Capital Matters in January.
Here’s a brief extract:
[Our current] newfound comfort with debt is based on the contention that low interest rates have rendered almost any government debt level to be affordable. The average interest rate paid by Washington on its debt has fallen from 8.4 percent to 1.5 percent over the past three decades.
Please read the whole thing, stiff drink in hand.
In the course of a generally gloomy article for the Wall Street Journal, Alan Blinder, a former vice chairman of the Fed (among other achievements) finds one bit of hope (sort of), at least until he start identifying some . . . questions:
Fortunately, expected inflation doesn’t appear to have gotten out of hand, at least not yet. The 10-year “break-even” inflation rate implied by bond prices is only 2.8%. That’s a bit higher than the Fed would like, but only a bit. The key questions: How long will the expectations dam hold if high inflation continues? If the dam breaks, how much will the Fed have to raise interest rates to beat down inflationary psychology?
Key questions, indeed, but so is the question whether the Fed is willing to raise those rates to the necessary level, whatever that may be. For added gloom, check out what believers in the Taylor Rule have to say about this. For some discussion of how applicable that rule still is, please go here, and for a less rigorous interpretation of the rule take a look here. In case you were wondering, the “traditional” formula currently throws out a rate of about 11 percent. What could go wrong?
One way or another, I find it hard not to think that we are heading toward a U.S. recession. As Dominic Pino noted the other day, Deutsche Bank became the first major bank to forecast a U.S. recession in 2023: “We no longer see the Fed achieving a soft landing. Instead, we anticipate that a more aggressive tightening of monetary policy will push the economy into a recession.” Underlying the bank’s argument was the notion that the Fed had left matters late and that it would take reversing economic growth to get inflation down. Dominic warned about this in October:
if inflation is not transitory, and unemployment keeps declining, the Fed may wind up in a really tricky situation: It may be forced to contract the money supply and reverse good unemployment numbers in the short run to get inflation back in line. In other words, inflation had better be transitory because the bed might already be made — and we’ll have to lie in it.
That bed, I suspect, will not be soft, even if Deutsche predicts that the recession will be “mild.”
CNN:
With unemployment peaking above 5% in 2024. That would still translate to considerable layoffs. During the Great Recession unemployment peaked at far higher levels of 14.7% in 2020 and 10% in 2009.
Those, it must be said, are rather bleak years to choose as benchmarks.
CNN:
This coming recession would allow inflation to get back towards the Fed’s target by the end of 2024, Deutsche Bank said.
“With the unemployment rate receding only slowly following the peak, inflation should continue to moderate, falling to the Fed’s 2% objective in 2025,” Deutsche Bank said.
As a habitual pessimist, I cannot help worrying that the “bed” could not only hard but Procrustean. Moreover, some of the current supply shocks could mean that the familiar binary choice between recession and inflation could be complicated by the arrival of stagflation, too.
Jim Grant (of Grant’s Interest Rate Observer) is not always a ray of sunshine either, but he knows a lot more about these matters than I do, and here he is being interviewed by Richard Hurowitz for the Octavian Report. Check out the whole piece, but, for now, it’s worth noting that Grant sees rising commodity prices as more than a matter of spillover from the war in Ukraine:
What is driving commodity prices is not so much the Russian invasion of Ukraine, and before that the lockdowns due to COVID, but rather 10 years of underinvestment in new commodity production. That’s especially been true in the realm of oil and gas. The world is facing a hydrocarbon first in which it will be consuming more than the producers are pumping. The market is very tight. And that’s also true of a number of other industries: metals, oil and gas and the like. So, yes, we’re bullish on commodities.
Later, Grant includes agricultural commodities in that list.
Nevertheless, while most of the Covid effect (Shanghai notwithstanding) ought to fade, some may linger. As economist John Cochrane has observed: “A one-time shock, no matter its nature, does not necessarily lead to a one-time inflation. When the shock ends, the inflation does not necessarily end.” What’s more, we don’t know how long another shock — the disruption arising from the war in Ukraine— is going to last. And a supply shock in an already tight market looks uncomfortably like the sort of thing that will lead to stagflation, even more so if the climate warriors’ continued grip on the U.S. and other Western governments holds back investment in new oil and gas production.
Overall, Grant (who is predicting a much longer-term upswing in rates, as, he concedes, he has done so before, prematurely) is not surprised at the position in which we now find ourselves:
I think it’s the confluence of things, including record-smashing fiscal deficits, record-smashing growth in the Fed’s balance sheet, near-record growth in money supply as broadly defined, and the constraints on supply attendant on COVID at first and now the disruptions that are part and parcel of the war in Ukraine. If I had no shame about using clichés, I would use the phrase “perfect storm.” There has been a confluence of events that at once suppressed supply of the margin and stimulated demand at the margin. All this at a time when governments are running immense deficits, and central banks are printing extraordinary amounts of money. So you kind of wonder, what did they expect to happen?
Indeed.
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which appears weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and NRI trustee David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.
In the 61st episode David is joined by Ramesh Ponnuru, editor of National Review. From market monetarism to inflation hawkishness to decades of central-bank history, David and Ramesh get into it all.
The Return of the Regional Seminars
National Review Institute is back on the road with its biennial Regional Seminars. This year’s series, titled “Creating Opportunity,” will feature panel discussions and one-on-one conversations that make the moral and practical case for free enterprise.
Notable speakers include William B. Allen, David L. Bahnsen, Jack Brewer, Dale R. Brott, John Buser, Veronique De Rugy, Kevin Hassett, Pano Kanelos, Rich Lowry, Karol Markowicz, Andrew C. McCarthy, Andrew Puzder, Amity Shlaes, Kevin D. Williamson and, less notable, me.
We hope you will join us. You can learn more and purchase tickets here.
The Capital Matters week that was . . .
Inflation
One of the more foolish ideas in an era that is full of them is that price controls will somehow help “cure” inflation. In fact, what they do is create or increase shortages. To put it very simply, introducing price controls discourages producers from producing and retailers from selling, and is an invitation to black marketeers to set up shop . . .
Despite the conventional wisdom and historical evidence, the Fed this time believes that inflation will begin to cool off on its own, with mild increases in the federal funds rate aiding the slowdown. Cochrane pulls directly from the Fed’s economic projections when explaining that. In other words, even though Jerome Powell has stopped saying “transitory,” it seems that the Fed, as an institution, still believes that the current bout of inflation is not the result of bad monetary policy and is instead the result of other factors outside the Fed’s control (supply shocks, pandemic recovery, etc.) that will resolve themselves independent of the Fed’s policy.
Cochrane is not fully convinced of that story . . .
The inflation levels of the last year are stuck around President Biden’s neck like a tight noose and, if the current polling is any indication, will likely be a major problem for Democrats in the 2022 midterms. The politicization of inflation is normal, unavoidable, and has a great tradition in 20th-century political economy.
Some conservative economists (present company included) have been cautious of the inflation narrative, believing that more is at play than the easy narrative to which many have understandably subscribed . . .
Energy
Any car-owning American who has taken a recent trip to the pump will be able to tell you one thing: Gas is expensive. Really expensive. Indeed, as of last week, a gallon costs $4.231 — up $1.379, from a year ago. (The same trend is true for natural gas.) The crisis has evidently lasted longer — and proved more economically serious — than the Biden administration suggested.
Curiously, the cabinet official best equipped to address it has remained completely mum on the issue. I’m referring to former New Mexico political activist, former member of the U.S. House of Representatives, and current secretary of the Department of the Interior, Deb Haaland . . .
For quite some time, different countries have been choosing different ways to fail in their energy policy. Thus, under Merkel, “the indispensable European,” Germany opted for the Energiewende, a policy that gave it soaring energy prices, a dangerous dependency on Russia, and didn’t do much, if anything, for the climate.
In Britain, the Tories embarked on a headlong pursuit of reaching net-zero greenhouse-gas emissions without giving much thought about how this goal could be implemented without wrecking the economy. (To be fair, in doing so they were cheered on by most of the British political establishment.) And no, this effort was never going to do much for the climate, either. To combine recklessness, incompetence, and pointlessness in this fashion took quite some doing, but the Conservatives did it . . .
Replacing Russian fuel in the European economy would be — or, rather, will be — a difficult and expensive proposition. Wildly so, in all likelihood. To replace Russian gas imported by European consumers would require a great deal of equipment and infrastructure that does not currently exist: The United States produces a great deal of gas and has the capacity to produce more, as do many other petroleum-producing nations, but we do not have the LNG-ready ships, the necessary terminals, or the regassification facilities in Europe to make that happen; nor do the Europeans have all the pipelines they would need to connect to other providers closer at hand. But we know how to build LNG-ready ships, terminals, and regassification facilities. We know how to build new pipelines. None of that requires groundbreaking work in physics or the invention of new technologies. It doesn’t need a team of Einsteins and Oppenheimers. All it needs is doing. That is not to say it will be easy — only that it relies on technologies and capacities that already exist and do not have to be invented . . .
Elon Musk and Twitter
On April 3, Elon Musk tweeted that he was “increasingly convinced that corporate ESG is the Devil Incarnate.” Harsh, perhaps, but ESG (a form of “socially responsible” investing) is closely intertwined with stakeholder capitalism.
Make of that tweet what you will, but I suspect that Musk believes that the best way to reform Twitter’s speech policies is for shareholders to take a stand. This makes the news that he has just bought a 9.2 percent stake in the social-media company of . . . some interest. As the Financial Times noted, that’s four times the holding of Jack Dorsey, a founder of the company and, until recently, its CEO. This purchase, moreover, makes Musk Twitter’s largest shareholder . . .
If Musk wants to avoid helping his opponents in Washington (whose numbers, I suspect, will have multiplied), he needs to avoid handing them the weapons with which to attack him . . .
Tax
Tax day is coming soon. Before this dreaded day even arrives, the Internal Revenue Service is already anticipating a months’ long backlog of millions of tax returns. With an added $675 million from the omnibus spending bill passed in March, the IRS is dedicating much of that funding to enforcement and investigatory activities, rather than radically focusing on this backlog. This is terrible news for hardworking Americans in the lower income-tax brackets who rely on a tax refund . . .
Senator Rick Scott (R., Fla.) is, I regret to report, still at it on his plan to raise taxes on 100 million Americans. He gave a major speech on the topic last week to the Heritage Foundation and continues to make the cable TV news rounds. The last few days have seen devastatingly good pieces on the policy and political folly of the idea from NRO’s Kevin Williamson and my old boss Grover Norquist at Americans for Tax Reform. They join several others, including a good piece on top to bottom taxation in America by Josh Barro.
In his own words, the rationale for this bizarre idea is that Senator Scott believes “there’s a lot of people that could work and have decided not to work because they figured out how to live off the government.” . . .
Health Care
President Biden’s proposed budget for 2023 lacks specifics about how to cut drug prices, cover the uninsured, and lower premiums — and that’s probably a good thing.
Don’t get me wrong: Health care has gotten unbearably expensive and making it more affordable should be a priority. But there are no quick fixes to our health-care woes. The various laws proposed in the past year — such as allowing Medicare to negotiate drug prices and lowering the age of Medicare eligibility from 65 to 60 — would be financially devastating for patients. There’s no reason to lament their absence in the budget . . .
ESG
Before too long, there will need to be a great deal more discussion (and not, obviously, just in Canada) about the extent of the West’s economic relationship with China, a discussion that ought to cover far more than investment in Chinese securities.
In the end, however, when it comes to investments in such securities, portfolio managers will have to decide for themselves what to do, but they should not be allowed to escape criticism for putting them in funds where ESG is supposedly an important investment consideration (ESG is a “socially responsible” investment discipline which measures actual or potential portfolio companies against a set of environmental, social, and governance benchmarks).
To repeat my earlier comment, “ESG. China. Pick one.”
Pakistan
Last weekend, Pakistan’s Prime Minister Imran Khan attempted to side-step a much-anticipated vote of no confidence by pointing fingers at unnamed foreign regime-change agitators and advising President Alvi to dissolve Pakistan’s Parliament. But yesterday, Pakistan’s supreme court overruled the dissolution of Parliament and set Khan’s vote of no confidence for Saturday morning. Just what provided the opening for Pakistan’s political turmoil? The economy — namely, the recent surge in inflation . . .
The Economy
Yesterday, Deutsche Bank became the first major bank to forecast a recession in 2023. Economists David Folkerts-Landau and Peter Hooper predicted that the Fed’s raising interest rates to control inflation will cause a recession next year and bump the unemployment rate up to 4.9 percent in 2024 (it’s at 3.6 percent currently). “Our call for a recession in the U.S. next year is currently way out of consensus,” they wrote. “We expect it will not be so for long.” . . .
Antitrust
Ocasio-Cortez was on a roll. She said she wanted to “draw a picture of corporate consolidation in the United States,” and went first to — you guessed it — the meat-processing industry. It’s the same example that President Biden gave in his State of the Union address. In trying to decipher Biden’s ad-lib comments in that speech, I suspected that when he said “four basic meat-packing facilities,” he actually meant four beef-processing companies, since there are four such companies that are responsible for about 70 percent of U.S. beef production: Tyson, Cargill, National Beef, and JBS.
Ocasio-Cortez was much more articulate and specific than the president. She was referring to all meat processing, not just beef, and named JBS, Cargill, Tyson, and Smithfield as the four companies that combine for a 53 percent market share in the industry.
This seems like a pretty strange go-to example of market consolidation. Another way of saying that 53 percent of the market is controlled by four companies is that 47 percent of the market is controlled by all the other companies, which doesn’t seem that bad . . .
The Fed
Bryan Cutsinger and Alexander Salter:
Unemployment last month reached an historic low, but inflation remains at a 40-year high. The Federal Reserve’s mandate requires it to pursue both full employment and price stability. Fed officials are now scrambling to get a handle on inflation. However, commentators are worried monetary tightening will hamper the ongoing labor-market boom.
These concerns are misplaced. There’s no tradeoff between inflation and unemployment. In fact, provided the Fed is competently managing total spending (the sum of spending by consumers, businesses, and all levels of government), valued in current dollars, price stability and full employment go hand-in-hand. This isn’t a fringe belief. It’s the hard-earned macroeconomic wisdom of the last four decades, inexplicably abandoned when we need it the most.
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