Thoughts From The Divide – Disconnect

Newsletter  •  Interest Rates  •  February 24, 2023

“Occasional episodic disconnects”

In a recent essay for PIMCO, (disgraced?) former Vice Chair of the Fed, Richard Clarida, explained that “markets are finally listening” to the Fed’s message of “ongoing increases”, noting that “higher-than-expected data on U.S. Consumer Price Index (CPI) inflation and stronger-than-expected data on retail sales as well as additional remarks from Fed officials together triggered markets to price in not only the the two rate hikes indicated by… [the dot plot], but also a material likelihood of at least one additional hike after that”. There was, however, the annoying reality (and here Clarida validates the market’s perception) of easing financial conditions. Not to worry, Clarida assures readers that “monetary policy operates with lags, meaning the U.S. economy likely has not yet absorbed the full force of Fed tightening to date”. Excellent, so we need not be too worried about “the occasional episodic disconnects observed between Fed guidance and some prominent indices of financial conditions”, and the Fed is resolutely steering us toward what Clarid calls a “softish” landing? But what if Warren Mosler was right to compare the Fed to a toddler with a toy steering wheel sitting in the back of the economic car? What if Congress and fiscal policy “has always been driving”? Or at least has a larger than understood “backseat” role.

There’s no doubt that yields matter, and interest-rate-sensitive sectors are already showing obvious signs of pain. The US housing market has lost 2.3 trillion dollars of value. Commercial real estate is seeing something more than hiccups as “defaults are escalating”. And housing starts have dropped to June 2020 levels. But a growing chorus of voices says the Fed won’t be able to engineer a soft landing on the current trajectory and/or by itself. On the latter point, Claudia Sahm, whose recession rule and comments we’ve covered before, wrote as much in an article for the FT, saying that “the Fed alone cannot get inflation back to the 2 per cent target”. More precisely, Sahm argues that the Fed can’t bring inflation back to its target in a way that addresses supply, noting that “the Fed’s main tool is not a precise one” and it “can only give us less demand and fewer customers”. Instead, Sahm wants Congress and the White House to “influence supply”, arguing that “an important advantage of fiscal policy is its ability to target certain sectors critical to restraining inflation”. Attempts to use fiscal policy to improve the supply side used to be called “industrial policy”. Nothing wrong with it if done right, but sadly, it is often done wrong (see British Leyland). Either way, whether fiscal stimulus will be consistent with the Fed’s inflation target is unclear. On that point, and addressing the idea that the Fed’s current path may not lead where it thinks, Stephanie Kelton explores the push and pull of rate hikes in a recent essay, looking at how the “balance” between the rate hike winners and losers affects aggregate demand. Using Warren Mosler’s blasphemous MMT framework as a starting point (and referencing Larry Summers), Kelton dives into the latest CBO report to highlight that “rate hikes substantially increase fiscal outlays while significantly reducing revenues”, i.e. sending the deficit to the roof, with the knock-on “projected rise in the debt to GDP ratio”. While Kelton admits, “I don’t know how strong the interest-income channel is or how much the Fed’s rate hikes might be contributing [or at least partially offsetting the hit] to aggregate demand and stickier inflation right now”. In discussing Mosler’s work, she argues that he “wants us to at least consider the possibility that we might have this backwards”, that it’s possible “that higher interest rates might be supporting aggregate demand”, that the Fed has “the brake pedal and the gas pedal confused”. MI2 is agnostic on this question, but we are not blind to the trajectory of Debt/GDP. We suspect that the net effect remains negative, only less so, which would make the Fed’s job of “steering” the economy much trickier. This likely means that one way or another, Mr. Policy Mistake will be visiting us all very soon.

P.S. If you want more on Warren Mosler’s thoughts directly from the source, you can find his RealVision interview with MI2 Partners’ own Harry Melandri here.

P.P.S. While unseasonably warm weather both stateside and across the pond may have helped Europeans avoid the worst-case scenario following the turbulence in energy markets, bankruptcies are on the rise across “all sectors” of the economy.

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