The Fed is attempting to do the impossible.
That characterization could be applied to any number of tasks facing Jerome Powell’s beleaguered panel of technocrats who, at this point, probably wish they’d chosen a different profession or else avoided the public sector, where every job is thankless irrespective of performance.
From a big picture perspective, the Fed is tasked with tackling an inflation problem that’s partially attributable to factors beyond the control of monetary policy. I do agree with Harley Bassman who, in a new commentary, wrote that for households trying to make ends meet, insisting there are two “types” of inflation “is a difference without a distinction.” Similarly, I agree with Larry Summers who, in remarks to The New Yorker for an article questioning his newfound claim to superhuman prescience, said simply, “Look, the job of macroeconomic policy is to balance demand and supply. If you get accelerating inflation, that means you failed.”
Still, it’s disingenuous not to at least acknowledge the fact that “money printing” didn’t create port logjams (not directly, anyway), nor can reverse money printing (i.e., balance sheet runoff) alleviate them. The only way monetary policy can “solve” problems on the supply side is by engineering so much demand destruction that whatever supply there is (no matter how previously inadequate) ends up being too much. At that point, prices and wages will fall.
And therein lies the impossible task: The Fed is currently being asked to balance supply and demand solely from the demand side without causing an economic contraction. All clichéd analogies aside, the US economy isn’t a ship. It can’t be “deftly steered.” Large economies are discordant symphonies of human behavior. And there’s no such thing as a “good” conductor — only lucky ones.
There are two ways conductors can make their own luck. One is to deliberately generate inflation by creating money, but even that’s difficult because as we saw in the aftermath of the financial crisis, there’s no guarantee the inflation will show up where you need it. You may, for example, end up generating a bubble in stocks and bonds rather than wages and nominal growth. The second way monetary conductors can make their own luck is by deliberately causing a recession. The problem with that is simple: Everyone hates you for it unless and until the benefit of hindsight compels politicians and the public to admit you were, at worst, not wrong.
Within this broader context, we can identify microcosms of the larger mission impossible. Consider, for example, Goldman’s “jobs-works gap,” which the bank defines as the difference between the total number of jobs (as measured by employed workers plus job openings), and the number of workers (the labor force). On that measure, the US labor market is the tightest in at least 70 years (figure on the left, below).
The bank previously suggested that in order to bring wage growth down to levels consistent with 2-handle inflation in 2023 and 2024, the Fed needs to narrow the jobs-workers gap by 2.5 million. That would “require the Fed to slow GDP growth by another 75bps to 1-1.5% for a year by generating an incremental 75bps of tightening in our financial conditions index,” Jan Hatzius said.
“The key to a soft landing,” Goldman went on to write, “is to generate a slowdown large enough to persuade firms to shelve some of their expansion plans, but not large enough to trigger sharp cuts in current output and employment.”
That would be impossible to manage at the municipal level. At the national level, it’s a laughable ask.
Hatzius knows that, of course. “Slowing growth by just the right amount may be easier said done,” he said, in the same note, on the way to pointing out that “similar to our old rule of thumb that any increase in the three-month average of the unemployment rate by more than 35bps has been associated with a recession, the jobs-workers gap has likewise historically only ever declined by more than 0.6pp from its cyclical peak during recessions, and never without a simultaneous spike in unemployment.”
Note the chart header on Exhibit 2 from Goldman (figure on the right, above). There’s no precedent for what the Fed needs to do in order to achieve the mix of results Goldman sees as consistent with a soft landing.
On the bright side, when the bank expanded the sample in order to overcome the inference limitations inherent in such a small “n,” Goldman found that although “an increase in the unemployment rate of more than 0.35pp and decline in the jobs-workers gap of more than 0.6pp has always predicted a recession in the US,” for the broader G10 set, it only resulted in a downturn 80% of the time.
There are some extremely wealthy people who have ridiculous proportions of money relative to anyone’s actual need. And in the US, during my lifetime, many, many people, including me, have made a good living, such that we had cash to invest and potentially grow our income further. And there are many, many people in the US who “get by” because they lack education, or have limited income, or don’t relate to our rat-race culture.
Things have changed from the more evenly distributed wealth of my youth. Since “Reaganomics,” and from its effects over the years since 1990, money has congealed at the top of the economy – not unlike a scab. The fact that money and income is so unevenly distributed around the economy is unfortunate and not a comfort to me. But that time cannot be taken back.
At the moment, I’m not concerned about inflation. I’m not “fat cat.” But I have no sympathy for anyone who’s portfolio (beyond a retirement income source) is affected by inflation, including myself. I’m not a twenty-four-year-old, just getting his feet wet, as I was in the 80s. Recalling the scare of hyper-inflation during the 70’s and 80s, I have every sympathy for younger or disadvantaged folks today being concerned about inflation.
Our current bout with inflation is puny and will be short-lived, if Jerome Powell and his colleagues can get up the gumption. As far as I’m concerned, the Fed can rip the throat out of the measly inflation we’re experiencing now. My biggest concern right now is the war in Europe, and unintended consequences it may yield.
Is a recession not part of most investors’ base case? May be unclear if it will be mild or wild, now or later, but seems the most probable scenario.
Sorry Larry Summers got lucky- he is no genius. Smart but no genius. And the Fed is playing with fire if they believe they can raise rates rapidly concurrent with shrinking the balance sheet. This is not going to be pretty.
H
Thanks for acknowledging that the Fed can’t fix inflation from just the demand side. They can’t unclog ports, fix shortages, etc. unless they nuke the economy. And that sure as hell wouldn’t be much of a legacy for Powell. For more than a decade the Fed seemingly took every step they could to reach a 2% positive inflation target, something that always seemed anathema to me. Then, in the ultimate “be careful what you wish for” moment of irony, they suddenly found themselves with the worst inflation mess in forty years or so. People will blame them as a major cause of this. In fact, the steps they are taking now almost seem to telegraph an admission of guilt on their part. However, the real root cause, in my humble opinion, is that most of the large major corporate players in our economy, desperately seeking profit maximization reduced system slack to near zero, which made it impossible to adjust to any serious disruption in the economic flow in the system. My cartoon analog for what happened is an old Mack Sennett “Keystone Cops” movie when a bunch of bumbling police are chasing some bad guys and one or two of the lead guys suddenly have to make an unplanned stop and everyone behind them starts crashing into one another. Once the value/supply chain started to unravel, we couldn’t even buy a roll of toilet paper, food got scarcer, and thousands of small firms had to close. All this even though we pumped trillions into the system. Until our corporate goods makers, their laborers and their suppliers find the new balance point and add back the slack needed to get the system working smoothly the mess will not go away. BTW, the GDP print at -1.5% growth in Q1 looks like a recession to me, not so much a function of money, rates and macro issues as much as a continued strangulation of the value chain which can’t yet take care of itself.
Lucky One – “However, the real root cause, in my humble opinion, is that most of the large major corporate players in our economy, desperately seeking profit maximization reduced system slack to near zero, which made it impossible to adjust to any serious disruption in the economic flow in the system.”
Yep. One recent example is the shortage of experienced locomotive engineers and conductors faced by the rail freight carriers. A few years ago the sector (and the analysts covering it) got swept up in a wave of “labor rationalization” thanks to the success and deification of Hunter Harrison at Canadian Pacific and CSX. Now they are scrambling to find workers to replace those that were fired.
Heck, we can’t even quickly ramp production of Stinger and Javelin missiles.
Modern industry, whether that be semiconductors, defense hardware, or LNG facilities, is so complex and investment-heavy that rapid and large supply increases are very very hard. Rapid increase in demand results in much greater change in price than in supply. This suits the industry just fine, because that large increase in profit didn’t require a commensurate increase in investment or expense, hence ROI and margin benefit disproportionately.