Busting a Few Myths About the Fed and Inflation Fighting

I was always a fan of the Mythbusters show on the Discovery channel. Can one actually herd cats? Definitely not. Could Brodie have killed Jaws by shooting the scuba tank? Maybe, but the explosion wouldn't have looked like that. Anyway, in the spirit of that show, I thought I'd bust a few myths about the Federal Reserve and inflation fighting. Per usual, in the race for hot takes, there are a lot of bad ones out there. Keeping a cool head will help readers stay ahead of the crowd. Here are a few of the myths I've been hearing bandied about lately. Unemployment has to rise for inflation to cool Before I start, let me just say that I am not predicting a so-called soft landing, whereby the Fed manages to get inflation to cool without causing a recession. I've written a few times that soft landings are difficult to pull off, and probably made more difficult during this period by the simple fact that inflation is so high it is forcing the Fed to move very quickly. Hence it is certainly possible that the Fed tightens too much and causes a recession, which invariably would cause unemployment to rise. However we should consider that rising unemployment isn't strictly necessary for inflation to cool. What is needed is for nominal consumer spending to slow. Not necessarily decline but slow its pace of growth. I believe spending is unlikely to slow unless wage growth also slows. Wage growth probably only slows if the labor market loosens up a bit. That doesn't necessarily mean employers decide to lay people off, rather could mean they decide to forgo some hiring. All that does probably requires an economy that is growing slower (in nominal terms) than it is currently. But I would not say it automatically means unemployment has to rise. In other words, I don't know how likely a soft landing is, but such a thing is at least possible. The Fed is unwilling to cause a recession Obviously the Fed wants a soft landing, but readers should not underestimate their resolve. If given the choice between a hard landing and persistently high inflation, the Fed will pick the hard landing every time. The key mistake the Fed made in the 1970's was to assume that the Fed could choose to avoid a recession by accepting higher inflation. In reality, higher inflation begot more economic uncertainty in general, which ultimately left the economy weaker and more vulnerable to supply shocks. Absolutely no one within the Fed's economist ranks thinks that repeating this period is a good idea, regardless of the short-term consequences. If the economy starts to slow, the Fed may still choose to slow down tightening. After all, perhaps the slowing economy helps to solve the inflation problem, and they may as well give that some time to play out. However if it were to be that the economy was slowing without any sign of inflation subsiding, rate hikes would continue unabated. As investors, I would argue that we should consider the risk of a recession as much greater than of inflation remaining way above 2% persistently. I'd say that by 2024, inflation will be reasonably close to target. The question is how much the economy had to slow in order to get there. From a trading perspective, that suggests the yield curve will remain flat or inverted for a while to come, and perhaps becomes extremely inverted in a recessionary scenario. The Fed needs stocks to go down in order to tame inflation I am somewhat surprised how widely believed this myth is. It feels like not that long ago that everyone seemed sure the Fed would never allow stocks to decline, now all of a sudden people are suggesting the Fed has to try to make stocks fall. Anyway, the idea seems to be wrapped up in the concept of a wealth effect. This is the theory that when consumers feel wealthier, e.g., because their stock portfolio has been rising, they tend to spend more freely. Now to be clear, I'm not saying the wealth effect itself is a myth. Clearly if a household actually has more money in their investment account they can spend more by at least some degree. In addition, home values are also lumped in with the wealth effect, and consumers can borrow against rising home equity if they so choose. All of that certainly has some impact on total consumption. That being said, I argue that this effect is very small compared to the effect of wage incomes. Consider this hypothetical. Say stocks decline by 25% and home prices stay flat over the next year. Meanwhile households see their wage income rise by 10%. Under these circumstances, I doubt consumer spending slows at all, and therefore inflation probably doesn't improve. Nominal wages are far and away the most important variable in whether inflation can be quelled. Don't be distracted by ancillary factors like the wealth effect. A shock 75bps rate hike is needed to change the psychology of inflation St. Louis Fed President James Bullard has been outspoken in advocating for a shock rate hike of 75bps at a single meeting. This seems to be an allusion to Alan Greenspan's decision to hike rates by 75bps in late 1994. During this period Greenspan explicitly wanted to shock the market, in part because he was concerned markets were complacent on inflation. In reality, 1994 and 2022 are wildly different situations. In 1994, the Fed didn't telegraph their future moves at all. In fact, 1994 was the first year the Fed even published any kind of announcement about their rate decisions. This lack of transparency often resulted in large disconnects between what the Fed intended and how markets were priced. Because of this, a shocking action, like a 75bps rate hike, could have an effect of showing markets how serious the Fed was about tightening. Today the Fed already has markets convinced that it will hike rates to about 3% between now and the middle of 2023. The mere fact that markets have 275bps of addition hikes already priced in shows that everyone believes the Fed is serious about fighting inflation. I don't see what psychological value a shock hike would carry. As long as the Fed is continuing to tighten, the exact timing of how they get there probably isn't that important. Consider that in 1994, the Fed didn't hike at all in September, then hiked 75bps in November, and followed that by no action in December. Would things have actually been very different if Greenspan had just hiked 25bps at each of those meetings? Probably not. Has the Fed already failed? Lastly, I take umbrage with the most recent cover of The Economist magazine, which carries the title The Fed That Failed. Not that I think the Fed has done everything perfectly. I was arguing last summer that they should have started curtailing QE purchases, and had they done that earlier they might have also hiked a bit earlier. Maybe that would have prevented inflation from spiking as high as it has. However in central banking, perfect is never a realistic outcome. There are too many variables, many of which are extremely hard to predict and some of which are completely out of the Fed's control. During this period, the Fed had to deal with truly unique circumstances, with a pandemic resulting in horribly deep recession followed by unprecedented levels of fiscal support. I find it hard to blame the Fed for not threading the needle given all of those moving parts. The Economist may eventually prove right. If the Fed doesn't meaningfully tame inflation over the next year and/or causes a recession, then we can call it something of a failure. But I'd argue we should wait until then to make that judgment. If by the end of 2023 inflation is around 2.6% and unemployment is around 3.8%, then I'd hardly call this period a failure.

Busting a Few Myths About the Fed and Inflation Fighting

If by the end of 2023 inflation is around 2.6% and unemployment is around 3.8%, then I'd hardly call this period a failure.

Columnist Conversation

AAP Podcast: This Company Is Not Going 'Solo'

This Weekend on Real Money

AAP Podcast: A Tongue -- and a Market -- Twister: 'Get a Debt Deal Done'

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.