The front of the inflationary storm is here, and yet the Fed is just hinting at starting to let interest rates rise in the future. The only “action” from the Fed so far has been multiple soft advances from the starting line. Revealed in the minutes of the meeting was the last: March – maybe. Meanwhile, the inflation hawks are shouting, “Just do it! while saying to himself: “It’s too late”.
But won’t the inflation rate come down once the supply, shortage and Covid issues dissipate?
This hope could be the reason the Fed continues to hesitate. However, the underlying numbers say otherwise.
The 2021 CPI inflation rate of 7% (5.5% excluding food and energy) has helped put the issue on everyone’s minds, including Fed governors. However, this rate contains some increases due to supply, shortage and the widely discussed Covid effects.
To understand these effects, consider the January 12 BLM press release. Table I shows data for the components of the market basket – weights and price changes. The many areas without unusual demand/supply effects show price increases centered around 4%. In other words, even when the supply chain, production shortage and Covid-free issues are resolved, inflation does not look like it will come back down to 2%.
Therefore, the Fed must take action to mitigate the inflationary environment that is fostered by the Fed’s lax and easy money policies.
The Fed’s Remedies Aren’t Bad – They’re Just Late
“Degressive” means phasing out the Fed’s bond purchases. (Buying bonds increases the money supply because the Fed pays for the bonds by creating new demand deposits). Above all, tapering means reducing “QE” (quantitative easing). It is not about engaging in “QT” (quantitative tightening). Therefore, when the Fed finally gets to zero bond buying, it just means the Fed is no longer easing – i.e. it is neutral.
However, there remains a problem. All the excess inflation-friendly money created from previous purchases that sits in the Fed’s gigantic wallet is still floating around in the financial system. This brings us to…
“Portfolio reduction” which is QT. It is the reversal that pulls money out of the financial system both through bond maturities and through bond sales prior to maturity. The speed of this portfolio reduction will determine the effectiveness of the Fed’s fight against inflation. A long and weak plan will send a signal that the risk of higher inflation is here to stay.
Now let’s move on to interest rates…
“Rising interest rates” also has two parts:
Reduced EQ – The first movement is in the area of quantitative easing. It is the rise of abnormally low interest rates to “normal” market determined interest rates. When rates return to normal, the Fed’s stance will be neutral. But this will not be an inflation-fighting stance. To achieve this, the Fed must commit…
Increasing the time interval – This tightening results from the fact that the Fed is pushing rates above the “normal” level of interest rates. Should or should the Fed do it? It depends on the economic and financial environment when rates return to normal.
The frightening abyss facing the Fed
The above actions are easier for the Fed to talk about than to accomplish. Can the Fed maintain a healthy financial system (the Fed’s main objective) while reversing fourteen years of excess? There are many reasons why the Fed could unleash a financial storm that would spread to businesses and consumers. (A scary scenario is what could happen when the same steps are taken by every other country that followed the Fed’s easy money lead.)
Alternatively, following a tentative course of action, the Fed faces the prospect of runaway inflation and skyrocketing interest rates and all the ills the environment creates.
Conclusion: The Fed Hesitated Too Long – Now the Future Looks Darker
Think about it: Wall Street, banks, corporations, governments and all other organizations are full of employees, managers and leaders whose career spans the last fourteen years. This means that their understanding of “financial normalcy” is skewed by this long-term experience. Therefore, when conditions move away from this Fed-created environment, the new market-based reality will seem wrong: wrong, risky, and in need of a solution.
The result? A financial meltdown, or business as usual, but with adjustments?
Who knows? We have to wait and see. The first blow in the coming saga is on the head of the Fed. The reactions to what they do (or don’t do) will indicate what to expect.
From The New York Times (Notice – Guest Essay by William D. Cohan – June 15, 2021), “The Fed Can’t Control Its Easy Money Monster”
“It’s unclear if the Fed has the will — or the ability — to end all of this. Or if it even knows how to scale back the bond-buying program without driving up interest rates, stifle the nascent economic recovery and panic all those who are now addicted to low interest rates.