Taming inflation isn't an economic struggle.
Some sympathy for the Fed.
(This is the follow-up to the article I published last week. You don’t need to read that before reading this, but I recommend you do. A summary below:
QT defined: the opposite of QE, when the fed lets assets it holds mature and/or becomes a persistent seller to decrease liquidity in the economy. i.e. burning money.
There are a few pathways QT could lead us to.
Path #1: The Fed engineers a soft landing.
Path #2: Like the last time QT was enacted, QE i.e. money printing makes a comeback.
Path #3: QT crashes the stock market, but doesn’t fight rising everyday prices much.
Path #4: QT is inflationary instead of being disinflationary/deflationary.
To find out which path we’ll be heading towards and why — keep reading!)
The Fed will shortly begin going hard on inflation. If you thought that 2017/18 was bad when quantitative tightening was first implemented, wait till you see the numbers Powell’s going to crunch out in the coming months.
For context:
Oct 2017 to Dec 2017: QT begins gradually; Fed starts burning $10B per month.
Jan 2018 to Sep 2018: QT picks up pace; Fed starts burning $30B per month.
Oct 2018 to Dec 2018: QT really gets going; Fed starts burning $50B per month.
Jan 2019: the famous pivot; Fed creates $60B, restarting the money printer.
Last time, the Fed started “burning money” at $10B per month. This time round, the Fed’s projected to be starting the incinerator at $95B. The end-goal appears to be to shrink their balance sheet by $3T over three years.
Take note: the Fed’s currently owns about $9T worth of assets. To just meet that goal, they’d have to burn $167B every month for thirty-six months straight.
This piece posits two simple things:
Firstly, that if the Fed sticks to its plan on tightening and raising interest rates consistently, it will be able to get inflation under control.
And secondly, that the above will not happen.
Taming inflation can be done.
To some extent, the market has already priced in the expected impact of the Fed’s tightening. Safe assets like treasuries are up and riskier assets are going down, as is obvious from the S&P500 and the Dow.
It seems that markets are expecting some sort of turmoil, and that expectation alone makes them right. Remember, the market is always king: if people expect turmoil, that in itself will lead to turmoil — regardless of how well-engineered the tightening program is.
There is no reality where everything’s perfect and inflation goes down with zero pain in any market.
The question is, however, will the Fed let inflation go down despite the pain? The short answer is no. Because: although taming inflation is possible,
It won’t be done.
Taming inflation isn’t an economic struggle. It’s a political one.
Fundamentally, this is because the government refuses to acknowledge it faces a two-pronged problem: inflation is a problem of not just supply, but also demand.
With regards to supply: the Ukraine war and new Covid-19 closures in China are not supporting the Fed in its disinflationary endeavour. Perhaps supply chains will get better, but given the state of what’s emerging around the world, even if we’re being optimistic, they won’t improve by much.
With regards to demand: democrats still largely refuse to acknowledge that excessive easing was even part of the problem, largely blaming Russia, Covid-19, and other obtuse factors like corporate greed. I’m not saying that Republicans are any better in admitting fault or publicly talking about issues with nuance. But just see the below:
Biden in March: Inflation = Putin’s Price Hike
(Inflation was over 7% even before the Russian invasion was announced…)
Fed in March: Announcing that interest rate hikes would be best appropriate to combat inflation.
Isn’t it weird that the US President is saying that inflation is a supply-side problem, while the Fed, the US’ central bank, says that raising interest rates, a demand-side policy, would be best suited to fight that same inflation?
Which brings us to the crux of the issue: that though curbing inflation is possible, the government won’t let that happen, because inflation’s always easier to explain than a recession.
I don’t think that Biden is oblivious and genuinely believes that Putin is the largest cause of all his inflationary pain. On the other hand, it’s more likely that he’s, rightly or wrongly, just scared of further political backlash should he acknowledge having eased excessively. And the fact that mid-terms are approaching only exacerbates his struggle.
Here’s my guess at the order of events once QT begins:
Stock markets fall further
Rates in the Repurchase Agreement Market (the economy’s plumbing system, if you will) increase steadily
Trickle down effect into the economy that fights inflation while causing a recession
Fed reverses course and restarts QE — but maintains higher interest rates and its balance sheet has indeed shrunk in size
We currently live in an era where 2-3% inflation is norm. I believe that we’re transitioning towards a phase where 3-4%, or even 5% (as measured by the government) emerges as the new normal.
I think that Jerome Powell wants to do a Paul Volcker. But what Paul Volcker did also contributed to Jimmy Carter getting shoved out of the white house. Today’s political scene is too toxic to acknowledge that decisions are difficult and trade-offs need to be made. Republicans critique Democrats’ every move, and vice versa. They aren’t entirely to blame: voters aren’t fans of nuance either. Unfortunately, too many Americans are expecting all good without any bumps along the way.
And perhaps that’s the crux of the problem.
Eventually, Biden will tap Powell on the shoulder and tell him to stop the tightening or worse, to switch on the printer. And thus, the coming months will also serve as a test of how truly independent the Fed is from the government.
My guess: not enough.
I’ll see you next week. Take care and till then,
Ja ne.
P.S. I created this newsletter to share, get roasted, and learn along the way. So if there’s anything you feel that I got wrong, or you’ve feedback in general, do let me know in the comments or DM me on Twitter!
Market Simplified, good job Ram!!
Good article, short and sweet;
Bold predictions indeed!