‘Ignoring all the warning signs’: The markets are losing faith in the Fed
The US is engaged in an astonishing monetary experiment. The Federal Reserve is still conducting quantitative easing even as the rate of headline inflation hit 4.2 per cent.
Core inflation has risen to a 25-year high of 3 per cent, recording the biggest jump in a single month since 1981. Factory gate inflation has been running at a 7.1 per cent annual growth rate over the last six months even before full reopening.
The Fed’s monetary policies have markets on edge. Credit:AP
The Biden administration is running a budget deficit of 13 per cent of GDP this year even though the output gap closed in April and large parts of the economy are overheating. Small firms cannot find workers. Unfilled job openings have reached a record high.
Yet interest rates are zero and the Fed is still buying $US120 billion ($155 billion) of bonds each month, directly financing part of Washington’s “war economy” debt issuance. It is persisting even though the broad M3 money supply has grown at 24 per cent over the last year. It is downplaying all evidence of pent-up inflation as “temporary”.
“What the Fed is doing is a pure drop of helicopter money. Inflation could be headed for double-digits by the end of the year,” said Lars Christensen, founder of Markets and Money Advisory and author of a book on Milton Friedman.
“The economy is at full capacity and the money stock has grown by a fifth at a time when everybody was locked down and unable to spend. There is going to be a big one-off jump in prices, and it could happen very fast if the Fed allows the liquidity to feed through.
“They’re ignoring all the warning signs just as they did in the 1970s. At some point markets will stop believing that the Fed is behaving like a credible central bank,” he said.
Former New York Fed chief Bill Dudley said his old alma mater has fallen behind the curve, and the longer it delays, the more brutal it will be. “Once they start, they’re going to be late,” he told Bloomberg Surveillance.
“The thing that people don’t fully appreciate is that when they catch up, the level of short-term rates are going to climb much higher than currently priced by financial markets. People need to be cognisant of those risks,” he said.
The Fed insists that the inflation spike is “transitory”. Vice-chairman Richard Clarida, the high priest of policy, nevertheless confesses that the latest surge has caught the institution off guard. “I was surprised. This number was well above what I and outside forecasters expected,” he said.
The elephant in the room is the bloated stock of money sitting in bank accounts. The excess savings of US households have reached $US2.3 trillion.
The benign view is that inflation is distorted by “base effects” and by a handful of “reopening” items such as the 10 per cent jump in airline fares, or an equivalent surge in used car prices – linked in turn to the semiconductor crunch in the car industry. Clarida says Covid has “torn up the playbook” on the business cycle, turning the post-pandemic phase into a rollercoaster ride.
Yet one might ask what will happen when the 11 per cent rise in US home prices over the past year – greater the subprime peak in 2006 – filters into the “shelter” component making up a third of the inflation index. Shelter costs typically lag property prices by 12 months.
The other “benign” argument is that yields on 10-year US Treasuries remain calm and have not “confirmed” inflation angst. Unfortunately, there is a technical reason for this. Matt King from Citigroup says the US Treasury is running down its huge “TGA” account held at the Fed to cover spending needs.
This fund amounted to $US1.4 trillion in March. The frozen liquidity is now being released at a torrential pace and is flooding into the bond market.
“Over the last eight weeks or so we got, literally, a $US700 billion of boost to US bank reserves. It has almost tripled the effect of Fed asset purchases. It’s a QE-like effect, a whoosh of liquidity, with too much money chasing too few safe assets,” King said. Bond yields could spike this summer as the TGA drawdown peters out.
The Fed follows a New Keynesian lodestar and no longer pays attention to monetary data. We will find out soon enough whether this matters.
The elephant in the room is the bloated stock of money sitting in bank accounts. The excess savings of US households have reached $US2.3 trillion. The New York Fed said people have been using a third of their unspent holdings to pay off debt. But that does not mean they will continue to do so. They may go on a spree instead as the country reopens.
This extra money is inert as long as “velocity” of circulation remains at record lows. Andrew Harris from Fathom says velocity typically reverts to its trend level at a pace of 10 per cent a quarter after a period of divergence. If that were to happen in this case, it would imply an inflation peak of 8 per cent.
US Federal Reserve chairman Jerome Powell is under pressure.Credit:The New York Times
It is true that velocity kept falling after the Lehman episode. But that occurred in radically different circumstances. The credit channel was broken and banks were being forced by regulators to raise their capital buffers. Emergency QE was required to prevent a contraction of the money supply and a slide into deflation.
American banks are in rude good health today. The latest Fed survey suggests that credit standards are starting to ease again after tightening during the pandemic. If loans pick up rapidly, the banking multiplier will set off an explosive inflationary boom under current policy settings.
Christensen said that once people see prices rising all around them, velocity could take off very fast. This would ignite the excess stock of money. “For the last 30 years, people have been used to inflation being well-anchored. When they realise that it isn’t any more, there could be a rush to spend,” he said.
He compared the Fed’s insouciance to the onset of the 1970s. Others see echoes of the 1940s when the Fed was co-opted by the Roosevelt and Truman administrations to ensure cheap funding for federal programmes. It capped yields by means of financial repression. The aggregate price level rose by 50 per cent over five years. It was a haircut for creditors.
Ultimately the bond vigilantes may cease to believe assurances that inflation is under control and take matters into their own hands, imposing monetary tightening on a reluctant Fed. Rather than a taper tantrum, it would be a data tantrum.
Dudley said 10-year yields could hit 4 per cent in short order once the process begins. This would be an earthquake for the global currency system and for an edifice of inflated asset prices built on assumptions of near zero-borrowing costs. We have been warned.
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