naphtalina/iStock via Getty Images
naphtalina/iStock via Getty Images
At its last meeting of the year in December of 2022 the Federal Reserve slowed its pace of rate increases hiking its federal funds rate by 50 basis points breaking its string of 75 basis point increases as the markets had expected. However, this action still leaves the federal funds rate below all major inflation rates from the CPI to the CPI core to the PCE to the PCE core. While the Fed has raised interest rates aggressively this year it did that only after a record delay in getting started. Now, with the level of the Fed funds rate still below the inflation rate, the Federal Reserve has decided to slow its pace of rate hikes.
Inflation remains hot whether measured by the PCE or the CPI index. The Fed has slowed its rate increases based on the notion that monetary policy works with long and variable lags and since the Fed has been raising interest rates aggressively since March the Fed is concerned about the cumulative impact of all those rate hikes.
Interestingly, in December 2018, Larry Summers was urging the Fed to not follow through with that rate hike because it had been raising rates at basically every other meeting by 25 basis points for the last two years. Summers was concerned about these same long and variable lags and the cumulative effect of past Fed rate hiking. Why in this instance with the Fed having raised rates more aggressively over a shorter period do we not hear any similar protests from Mr summers?
The reason, of course, is that the real Fed funds rate is still negative. Which means that for all this past year when the Fed has been raising rates, the real Fed funds rate had an even more deeply negative value. In fact, if we go back to the mid-1960s 13 of the 13 largest negative real Fed funds rates have occurred in this business cycle. That's quite an impressive result. What this means is that monetary policy has been more stimulative during this period than it has been in any other period in our past. And, in the wake of this super stimulative policy, the Federal Reserve seems to be worried about "over tightening.'
You can read the above paragraph again. There are no typographical errors in it. I have not misspoken. The paragraph reads exactly the way I want it to, but what it says is extremely bizarre. The paragraph claims that the Fed has been running an extraordinary stimulative policy but now the Fed is slowing its pace of rate hiking because it's afraid that this highly stimulative policy could lead to a sharp slowdown in the economy ahead. The Federal Reserve is often referred to as an institution with 400 economists and people sometimes ask, how can 400 economists be wrong? I want to know why 400 economists can be this wrong.
It's true that the Federal Reserve has raised interest rates quite a lot since March of 2021. But here we're talking about an increase in nominal interest rates. You may be aware that at this recent Federal Reserve meeting the Chairman has begun to try to shift attention away from the speed of Fed rate changes to a discussion of the level of the federal funds rate. Of course, the level of the federal funds rate has always been the thing that has been the most important. And since the level of the funds rate has been below the inflation rate the real Fed funds rate has been negative which marks it as stimulative. In fact, we have seen a string of the most stimulative real Fed funds rates that we have ever seen in the entire post-war period. If the Federal Reserve is really concerned about the lags in monetary policy, it ought to be concerned about the lagged stimulus it has created for the coming months from its past policy of running such a deeply negative real Fed funds rates. The focus on the increase of the nominal Fed funds rates during this period distracts from the real point. The reduced degree of stimulus is not just a red-herring but a complete and total mistake of analysis. Even now Fed policy continues to stimulate the economy and push it ahead. All that Fed rate hiking has done is to reduce the amount of stimulus that's pushing the economy forward. Monetary policy is not restricting the economy in any way. And to look back at the Fed rate increases and to be worried about their impact on the economy as though they would slow the economy for the period ahead… it's simply odd.
The Fed's decision to slow its rate hikes is a situation that doesn't make any sense at all, in my opinion. If inflation is still too high - and it is - monetary policy should be doing all that it can to bring it to heel. That would imply making the real Fed funds rate positive, which requires the Fed to move the nominal Fed funds rate up faster not slower. And, because monetary policy works with the lag, once the Fed funds rate gets into the restrictive zone it will be restricting the economy and working its braking effect over some unknown and uncertain future, because of the lags. Furthermore, since the Fed is unsure where it needs to move the federal funds rate to make the real Fed funds rate properly restrictive, I would think the prudent course would be to get the Fed funds rate up to that level as soon as possible so the Fed can get the lags working on its side rather than to delay and have the impact of monetary policy have to wait for both the delay in raising rates and then for the lagged effects to take hold.
For the reasons expressed in the above paragraphs I have a very hard time discussing Fed policy and talking about it in a well-reasoned way issuing conventional language - the usual language is being misused. Fed policy simply doesn't make any sense to me. If we look at the projections that the Fed has offered at its December meeting (since there's a new set of projections on the table) we see that there are 17 of 19 FOMC members now looking for the federal funds rate to get above 5% in 2023. However, they don't seem to be in a hurry to get there. And beyond 2023 their outlooks for the Fed funds rate degenerate into inconsistent chaos.
Getting the Fed funds rate to 5% doesn't make the real Fed funds rate restrictive unless the inflation rate falls a lot from where it is. Let's understand that making the real federal funds rate marginally restrictive say at 50bp or 25bp at 5.25% or 5.50% compared to inflation at 5% doesn't do very much to slow inflation. Historically the Fed operated with a 2% real Fed funds rate as a matter of course. When the inflation rate was high the real funds rate was lifted to be even higher than that. The Fed does not envision that in this cycle.
So, can the Fed get inflation to 2% by end 2025?
Historic inflation accelerations and decelerations (Haver Analytics and FAO Economics)
Historic inflation accelerations and decelerations (Haver Analytics and FAO Economics)
I have compiled statistics to assess whether the Fed can be expected to hit its inflation target of 2% by the end of 2025, as it suggests it can in its current forecast framework known as the SEPS.
To assess this, I looked at the history of PCE inflation changes over three-year periods. December 2025 is three years from now. The Fed thinks it can get the inflation rate down to 2% in that time frame. What does history say? The current level of PCE inflation suggests that the inflation rate will have to fall about four percentage points in three years for the Fed to achieve that result. I set up a statistical screen to see if that was a reasonable expectation. The chart above shows the result of that screen that looks at large inflation accelerations across horizontal axis against the inflation decelerations that occurred in the wake of the accelerations, historically. I mark the 2025 drop in the PCE inflation rate with a red dot to help you identify it. You can see that it lies right on the trend line. This means that the Fed's expectation for inflation to fall to 2% by the end of 2025 is consistent with the way inflation normally might unwind after an inflation spike of the sort that we saw in this cycle. To create this chart, I looked at three-year changes in the PCE inflation rate, picking out periods with the largest increases and pairing them with the aftermath, in which inflation fell.
In some sense this chart provides us with a necessary condition that has been met. The condition says that inflation can in fact fall this fast in a period after it has risen this fast. But this is not a condition that is sufficient to say that the Fed will achieve its objective.
Let me compare this to Roger Bannister who was the first man to run the mile under 4 minutes. At the time people thought that it was impossible to do this. But Bannister worked very hard and trained. Eventually he succeeded in running a mile in less than 4 minutes, demonstrating that it was possible for man to run a sub-4-minute mile. And, of course, since that time the time of the mile continues to go down as training methods and physical conditioning among runners improve. The lesson we learned from this is that when Roger Bannister made this discovery it did not mean that every man could run a mile faster than 4 minutes - just that it was possible for someone with the right physique and training to accomplish that. Similarly establishing that the inflation rate can indeed fall to 2% by the end of 2025 does not mean that it will do it. The Federal Reserve has a number of things that it must do, just as Roger Bannister had to train to break the four-minute mile.
Unfortunately, the Federal Reserve does not seem to be queued up to do the things it needs to do to drive the inflation rate to 2% by the end of 2025.
To demonstrate this let's look at a few charts.
time-series of 3-year changes in the annual PCE pace (Haver Analytics and FAO Economics)
time-series of 3-year changes in the annual PCE pace (Haver Analytics and FAO Economics)
Chart 2 is the three-year change in the year over year PCE inflation rate. This chart is the basis for the inflation data in Chart 1, above it. In this case I present the full time series of data. This chart shows that the 3-year change in inflation generally hit its very highest peaks during or just before recession periods with a few exceptions. So that the 3-year drop in inflation that comes after inflation peaks comes, in most cases, because of the economy ran a recession. And the biggest drops in the inflation rate come during the most severe recessions.
Currently the Federal Reserve is not forecasting a recession. In fact, I would be surprised if the Federal Reserve ever forecasted a recession. It's something that just is not politically possible for the Fed to do. So, there's a little bit of kabuki in the Fed's communication with us around periods when it's raising rates, slowing the economy, and causing the unemployment rate to go up. Still, what the Fed is forecasting is some increase in the unemployment rate and an increase that is relatively modest.
Real Fed funds rate deflated by PCE headline (Haver Analytics and FAO Economics )
Real Fed funds rate deflated by PCE headline (Haver Analytics and FAO Economics )
Historically the real Fed funds rate was about 2% in normal times and over 5% when the Fed was trying to push inflation down. Now, the Fed faces its highest inflation in the last 40-years and sees a 1.5% real Fed funds rate as sufficiently restrictive? How can that be?
The next thing to observe is the real Fed funds rate. Notice that during these past periods when the inflation rate moved up, the real Fed funds rate was much higher than it is now. Note that the 3-year inflation change had reached peaks in the 1973-75 recession, the 1980 and 1981 recessions and ahead of the 1990 recession. All these periods saw the real Fed funds rate rise to at least touch or to stay at and/or rise above the 5% level. Let's note that I'm speaking of the real Fed funds rate, calculating it using the PCE index as the deflator. Compare that to the current period where the Fed is talking about getting the nominal Fed funds rate to 5% at a time that the inflation rate being run according to the lower core PCE is at about 5% and 6% by the PCE headline. No comparison…
WHY FED POLICY WILL SEIZE DEFEAT FROM THE JAWS OF VICTORY- In short, the Fed is not stepping up to the plate to do the things that it's done historically to reduce inflation as quickly as it's possible. In other words, it's technically possible for the Federal Reserve to hit its inflation target of 2% by December of 2025. The Fed is simply not doing those things it needs to do to get there. Similarly, if Roger Bannister had laid on his couch and watched television and eaten ice cream and potato chips, he never would have been able to break the four-minute mile barrier. To attain a difficult result, you need to be willing to do those difficult things to achieve that goal. The Federal Reserve simply isn't there, it isn't doing those things. It has set a goal that it will now pretend that it plans to achieve, by saying all the right stuff but DOING too little.
However, the complications and the strangeness of these times do not stop there, with the Fed. Markets are of the opinion that the Fed is raising rates already to a point that will create a recession and will bring the inflation rate down faster than what the Fed thinks. When that happens, markets assume the Fed will loosen its grip on the Fed funds rate as well. To my way of thinking this market view is quite strange. In the paragraphs above I have just gotten done arguing that the Federal Reserve is not doing the things it needs to do to drop inflation to 2% by the end of 2025. However, markets seem priced for the Fed - doing exactly what it's doing - to create a recession and a situation where the inflation rate will drop more sharply than the Fed thinks and cause the Fed to start cutting interest rates sooner than it currently plans. Something here is very wrong.
One thing I'm going to encounter here is people arguing that times have changed. And that's certainly true. There are changes in this post COVID period. But these changes have reduced labor force participation, swelled job openings compared to hires, interrupted global supply chains, coincided with green policies in the US that have restricted oil supply and led to higher oil prices, in addition there continues to be a war between Ukraine and Russia… and so on. For the most part I see the risks on the side of raising inflation higher not causing inflation to fall faster. There is less global trade, less competitiveness, and less pressure to reduce prices. In short inflation risks are elevated compared to what they had been in the period since the Great Recession- we may be back to the 'old normal!' Looking at this as being part of a post COVID environment only confuses me even more about what's going on not only with the Federal Reserve but with the market's thinking. Is the market thinking? I don't see what it sees.
Flummoxed!- I present these ideas to you hopefully to help you look at the markets and have a better understanding of the forces that are at work. I am simply and honestly trying to present to you the facts as I know them and see them and the policies that are being run so that we can look at markets and Fed policy to decide how they will mix together to create actual outcomes in the future - outcomes that certainly will be different from what the Fed is now planning as well as different from what markets are expecting.
We cannot tell where the Fed is going to draw lines. But if the market is right about forecasting recession, and if the market is right that the inflation rate will start to come down faster than what the Fed thinks, then it is likely that the Fed will not stick to its rate path and then it will begin to cut interest rates sooner-that means 'too-soon.' If the Fed does this, then it is highly unlikely that the Fed will get to its 2% inflation target by the end of 2025 (as I already have argued). In fact, what this begins to look like is the 1969-70 recession where the Fed raised rates, created a recession, and did not stick with the rate hikes, resulting in a recession that was relatively moderate, that raised the unemployment rate by 2.6 percentage points, and that left the inflation rate higher in the wake of the recession than it was before the recession began. Here we go again?
That of course laid the groundwork for further increases in inflation, another tightening cycle by the Fed, and an even worse recession in 1973-75. That recession had a similar outcome as once again the Fed failed to hold the federal funds rate up high enough long enough and once again the inflation rate was too-elevated when the recession ended…do you see a pattern here?
Is it surprising that central bankers who are not tough enough to keep inflation at bay to begin with, are not tough enough to hike rates enough and keep them high enough to drive inflation back where it belongs in a recession? Pre-recession policy failure reflects either policy misjudgment or fear of coming political pressure. Ongoing tough action in a recession require a Chair with ice-water in his (or her) veins as political pressures will become more intense. Paul Volcker endured homebuilders mailing cinder blocks and 2x4s to the Fed saying you can have them we can't use them… Powell let inflation get way too high… can he break the mold on the other side? Having failed at being pre-emptive can he be restrictive enough for long enough and take the coming political heat?
No period in history is an exact analog for any following period in history. The late 1960s and early 1970s were special but then every period is 'special.' This one features: COVID, monetary policy excess, fiscal policy excess, and the Ukraine Russia war.
I am very concerned about where the Fed is leading us and whether the Fed has the backbone to hold the Fed funds rate up, particularly in the face of the criticism that continues to come from progressives. One silver lining is that progressives are losing control of the House and they won't be able to flex any muscle against the Fed because of that. But there will still be plenty of rhetoric and there's no telling where policy will go once the Fed is faced with the dual dilemma of a rising unemployment rate and an inflation rate that's still too high. There is no clear prescription in the Fed's mandate on how to deal with that situation. I'm afraid that Powell is just too-much of a compromiser. The Fed squandered its compromising with inflation in 2021 in letting inflation get started it can't afford any more compromise.
If this is where we're headed it's likely that the stock market will perform better than the bond market because inflation is toxic to bonds. If the inflation rate has been brought down to a more moderate 3% to 4% range, there are a host of stocks that can still perform well in that kind of habitat. However, with inflation high(er), long-term interest rates are likely to migrate up from their current levels as the bond market will have to re-handicap the future. And, in that environment, it's unlikely that the mortgage market is going to be able to support a vibrant housing market. If we find ourselves in that situation, we do not know what the Fed will do or how quickly it will realize that inflation isn't falling anymore and is instead stuck at these higher levels. When that realization dawns, how will the Fed recalibrate policy to try to get back to its 2% target? Some suggest that the Fed will have to give up on its 2% target. I'm not in that camp and that's a discussion for another day; it's a whole new can of worms but they are there, and they are wriggling. Clearly whatever it does, the Fed will have a lot of explaining to do. Meanwhile, investors we will have to be nimble.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Things are coming to a head as the conflict between what the Fed is doing and how markets are priced continues and views clash. More disturbing is the disconnection between what the Fed is doing and what history prescribes to get the result the Fed claims to seek. The Fed has been 'in denial' and is gradually bringing its plans up toward historic requirements- - it remains woefully short of what history has demanded. This article connects the dots to reveal the contradictions and to suggest what the future will hold for investors. To say the least, it is complicated.