John Puri doesn’t hold back when it comes to his verdict (“stupid”) on the Fed’s decision to cut interest rates at a time when they were not particularly high in the first place — and when inflation seems stuck at around 3 percent:
The Fed said it was done lowering interest rates last year, after multiple consecutive cuts, but then it started cutting rates again this year. None of those rate cuts were justified — not when annual inflation remains stuck at 3 percent, 50 percent higher than what the Fed says it wants inflation to be.
Its actions say otherwise. If the Federal Reserve’s principal mission is sound money, it has abdicated. Tightening monetary policy through higher interest rates is the only way to quash persistent inflation, but the Fed is loosening monetary policy instead. We should expect 3 percent inflation to continue because absolutely nothing is being done to stop it.
That may be optimistic. As I argued after the last rate cut, 3 percent inflation may, however discreetly, be becoming the new normal. If that occurs, 3 percent will not be the new normal for very long.
The rate cut was agreed upon by an unusually divided Fed (6-3), with one of the dissenters, Stephen Miran, probably the governor closest to the administration, voting for an even steeper cut. Perhaps this can be explained by question marks over the economy, perhaps this can be explained by politics, or perhaps it can be explained by both.
Mr. Powell said rates are now in “neutral” territory, which is Fed-speak for neither inflationary nor a drag on employment. That’s debatable. When the rate cuts began more than a year ago, officials predicted they’d get inflation back to the Fed’s 2% target by 2026. That deadline keeps getting pushed back, and in the Summary of Economic Projections released with Wednesday’s policy decisions, the 2% arrival date is now 2028.
Only some of this is explained by President Trump’s tariffs, which are adding to some price increases but whose inflationary effects may dissipate with time. More of the sticky inflation problem has to do with the Fed’s failure to tighten financial conditions. Witness unusually buoyant equity valuations, an explosion in private credit markets, and even the gushers of money available for takeovers like the bidding for Warner Bros. Discovery.
Speaking of financial conditions, this FOMC meeting also introduced what you might call “QE Eternity. . . .”
What could go wrong?
Well, plenty, including this (from Reuters, December 9):
U.S. President Donald Trump said support for immediately cutting interest rates would be a requirement for anyone he chose to lead the Federal Reserve, according to a Politico interview published on Tuesday.
Asked if it was a litmus test that the new central bank chair immediately lower interest rates, Trump told the news outlet “yes”.
Fed chairman Powell steps down in May, but the president will nominate his replacement well before then. The litmus test implies that the nominee must be able to feel confident that cutting rates is the right thing to do well before he or she takes the chair. That would be . . . bold.
There are various possible explanations for this, none of them very comforting. In no order, one is that Trump agrees that signs of weakness in the jobs market — a Fed concern — will still be reason for action next year. Another is that Trump, a man of the real estate market after all, has — let’s put this politely — a strong, and near perpetual, bias in favor of lower interest rates. The third is that the president believes that the only way out of the country’s fiscal fix is to juice up the economy, regardless of the increased inflationary risk. The fourth, not entirely distinct from the third, is that we are in the early stages of “default” by inflation, which — if it goes far enough — will mean that we are entering the age of fiscal dominance.
Fiscal dominance?
I have written about this phenomenon a few times, most lately in a recent Capital Letter. As before I will quote the handy definition provided by Charles Calomiris of the St. Louis Fed in 2023:
Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low.
To put it another way, a country’s finances have deteriorated so badly that its central bank can no longer keep control.
Calomiris:
The essence of fiscal dominance is the need for the government to fund its deficits on the margin with non-interest-bearing debts. The use of non-interest-bearing debt as a means of funding is also known as “inflation taxation.” Fiscal dominance leads governments to rely on inflation taxation by “printing money” (increasing the supply of non-interest-bearing government debt).
One problem with this (there are many) is that markets tend to notice. Treasury yields can bounce around a bit on a day like yesterday. But it will be worth looking at how (among other measures) the difference — the “spread”— between the interest rate payable on longer-term debt and short-term government borrowing evolves over the next few months, as one very quick, very crude measure of investors’ longer-term inflationary expectations. The yield spread between ten-year and two-year treasuries turned positive some time ago and has risen since, although very far from a level that would reflect anticipations of fiscal dominance. With notable exceptions such as (maybe) the price of gold, other measures such as the TIPS spread (ten-year) show the same thing, albeit without expectations of a return to 2 percent.
Too complacent? I think so. Time will tell, but if one of next year’s stories turns out to be that the Fed is paying too much attention to the president, complacency will likely fade. That could prove expensive for taxpayers, bondholders, or, quite possibly, both.