Crying Over Expensive Milk (No More Free Lunch)

Let’s be clear about something: The Fed has abandoned the idea that it’s possible to retain an ultra accommodative policy stance in perpetuity in order to secure a free lunch for the economy.

The apparent demise of the Phillips curve and other frameworks for assessing the relationship between key economic variables, tempted us to rethink what’s possible. The pandemic forced the issue.

But, in a cruelly ironic twist, the exogenous shock that finally tipped the scales in favor of a policy conjuncture aimed at fostering an almost literal interpretation of the term “full employment” simultaneously introduced severe supply-side disruptions. Those disruptions translated to a powerful inflationary impulse which, at least temporarily, supplanted and overwhelmed myriad well-documented deflationary forces that most of us assumed would everywhere and always predominate.

At the risk of rankling some readers, it’s far from clear that a free lunch isn’t possible. I still believe it is. We were just dealt the wrong crisis. One could conjure any number of exogenous shocks that would’ve compelled the same policy rethink (i.e., the institution of fiscal-monetary partnerships) without the accompanying inflation. The nature of this shock was incompatible with many key disinflationary forces (e.g., globalized supply chains), even as it magnified others (e.g., too much debt).

In any case, the free lunch idea is out, for now. The Fed saw the whites of inflation’s eyes, and now the Committee is about to flex on it. Success is far from assured. Although excess demand is part of the problem, and while asset price inflation certainty factors into the equation, this still isn’t that kind of inflation, to speak colloquially.

Read more: The Real Cause Of Inflation

It remains the case (because how could it be otherwise?) that the only real way for monetary policy to exert downward pressure on inflation catalyzed mostly by disruptions on the supply side, is to engineer demand destruction such that even if supply takes years to normalize, depressed demand will close the gap.

The problem with that is obvious: It’s just a euphemistic way of saying that if monetary policy starts to feel impotent, and attempts to effectuate change through the expectations channel prove insufficient, the Fed can always nuke the economy.

We’re not there yet, but, again, let’s be honest about what it means when we say the Fed is currently “pleased” with the recent tightening in financial conditions.

Recall that headed into the January meeting, the question was how Powell would respond during the press conference when a reporter invariably asked him about financial conditions. The surge in equity prices from the pandemic lows was responsible for the lion’s share of the easing in Goldman’s FCI index, and the same rally is also the main point of contention for critics who argue that the Fed has fostered an unproductive bubble. The idea, then, is that forcing a de-rating in equities by telegraphing an aggressive hawkish pivot (and thereby inviting real yields to surge), is a relatively “painless” way to start down the road towards normalization and correcting the “mistakes” the Committee has the capacity to address.

But it’s not that simple. The goal really isn’t to sink stocks. If the S&P falls to 3,000 next week, it’s not as if the Fed would say, “Well, mission accomplished! And we didn’t even have to hike!”

The goal, rather, is to deliberately cool the economy and tap the brakes on the labor market. That doesn’t sound as palatable as, “We’re trying to burst unproductive asset bubbles,” which is why the Fed needs to be cautious.

As the University of Michigan’s Richard Curtin wrote this week, the general public won’t necessarily understand how engineering a slowdown or pulling support for the labor market helps reduce milk prices. We understand that, as people who spend our days steeped in the debate. But try to view it through the lens of someone who isn’t. That person is being asked to accept what doubtlessly seems like an absurd proposition: Milk is too expensive, so eventually, you may have to lose your job, but in lieu of that, your small stock portfolio needs to fall by at least 10%.

Unfortunately, 10% isn’t going to do the trick.  “If Fed officials conclude that they need to slow GDP growth to potential in order to prevent further labor market tightening from adding to inflationary pressure, they would likely think that they have a long way to go,” Goldman wrote, in a piece published Friday.

The bank’s David Mericle Jan Hatzius went on to note that “the median FOMC participant forecasted 4% GDP growth in 2022 (Q4/Q4) in December, 2.2pp above the estimate of potential growth [and] so far, the impact of the recent tightening in financial conditions in the aftermath of the Fed’s hawkish pivot on GDP growth falls far short of closing that gap.” Have a look at the figures (below).

What does that mean, exactly? Well, it means that if the Fed wants to leverage the financial conditions channel to fight the inflation battle, market pricing for hikes isn’t aggressive enough even considering the recent repricing of the rates path.

As Goldman put it, “tightening financial conditions significantly further to impose more deceleration on the economy would likely require delivering more rates hikes than the market has already priced.”

Note the language: “…to impose more deceleration on the economy.”

Of course, this could all backfire, something that’s certainly not lost on Goldman. “The last week has provided a reminder that market conditions can change sharply and abruptly, and it is possible that too little FCI tightening could at some point become too much,” the bank said.

I’m not sure whether that line — “too little FCI tightening could at some point become too much” — was meant to be ironic and clever. In all likelihood, it was probably supposed to mean that the Fed could inadvertently over-tighten.

But you could read it as a quip: The Committee could discover that an FCI tightening which is too little to effectuate the kind of economic change consistent with the goal of bringing down inflation is still far too much for financial assets.

If Goldman was trying to be ironic and clever, hats off. Because that line is perfect as written.

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2 thoughts on “Crying Over Expensive Milk (No More Free Lunch)

  1. Thanks H, for the common sense explanations, and in this article an effective use of effectuate, which I seldom choose to use. Since effect (v) is nearly synonymous and more generally used, especially in the context of “effecting change”, my first reaction here was that you’d gone overboard with effectuation and used extra letters where unwarranted. But… when I remembered the old rule of thumb and tried substituting “bring about” for “effect” and “bring into effect” for “effectuate”, and darned if effectuate doesn’t seem a little bit more perfect the verb in this sentence. I suspect the coupling between tightening and appropriate economic change is a bit too loosey goosey to warrant “effect” here. I use too many words… thank you for all you write.

  2. Goldman, like Hallmark, as an indicator for every occasion. Just looking at their Bear Market Probability Indicator a few minutes ago and the bear is pissed. That indicator is in a place where bad things tend to happen the longer the indicator stays elevated. Of course, when it comes to investor timing, the indicator is usually vaguely right, in that official recessions do follow, but, it is precisely wrong 99.9999% precent of the tradable moments before it isn’t.

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