The Federal Reserve is planning to tighten credit even as forecasts call for U.S. economic growth to slow and the recent high inflation rates to recede. With just the smallest of missteps, the central bank risks either overkill, or a further loss in credibility.
The incoming economic data has been falling below estimates at a degree not seen since the early days of the pandemic, based on Citigroup Inc.’s Economic Surprise Index. Consumers show few signs of spending their pandemic-related stimulus payments, having saved 71% of their June 2020 checks, even more -- 74% -- of December’s payment and still more, 75%, of the money received in March, according to Federal Reserve Bank of New York surveys. Also, the Fed’s attempts to spur borrowing and spending have been fruitless. Since the fourth quarter of 2019, it has pumped up the money supply as measured by M2 by 34%, but that money lies fallow with the velocity, or turnover, dropping 22% to record lows.
With the end of the extra $300 per week in federal unemployment benefits, real incomes – already eroded by the recent spurt in inflation -- will fall further after dropping 1.7% from January through August on a weekly basis. The highly transmissible delta variant of Covid-19 may further curtail economic activity as many companies including Apple Inc., Amazon.com Inc., Wells Fargo & Co., Chevron Corp., Prudential Financial Inc., and Microsoft Corp. delay opening their offices in full to employees. Payroll jobs rose just 235,000 in August, down from 1.1 million in July and the least since January.
Although inflation rates are dropping more slowly than the Fed may have hoped, they should continue to recede as frictions related to the re-opening of the economy and supply bottlenecks pass. Already, the monthly core Consumer Price Index dropped from 0.9% in June to 0.3% in July and 0.1% in August.
Anticipatory spending is unlikely to be spurred by consumer inflation fears. As usual, one-year inflation expectations reflect the recent past, but over five years, consumers look for 2.9% annual inflation, according to the University of Michigan surveys. That expectation is no doubt too high, as is normal, given the human tendency to overestimate inflation. If prices they pay fall, consumers credit it to their smart shopping, but rising prices are thrust upon them by forces over which they have no control, they complain.
The breakeven rate, the difference between yields on conventional U.S. Treasury securities and Treasury Inflation-Protected Securities, or TIPS, shows that traders expect relatively higher inflation rates in coming years. Still, the implied forecast of 2.5% over the next five years is the same as back in 2007.
So, despite slowing economic growth and falling inflation rates, the Fed has signaled a tapering of its monthly purchases of $80 billion in Treasuries and $40 billion in mortgage-backed securities, likely starting in November. Investors fear a follow-on interest rate hike, and the sell-off in Treasuries in late September brought back memories of the 2013’s “taper tantrum.” Since Sept. 22, the yield on the benchmark 10-year Treasury note has jumped from 1.3% to 1.5%, and from 1.8% to 2.1% on the 30-year bond.
The increase in yields are vastly overdone. Over the entire post-World War II era, inflation accounts for 60% of Treasury bond yields, and significant inflation in future years is unlikely. China and other Asian economies are big producers and exporters but parsimonious consumers. So the supply of goods and services exceeds demand, a highly deflationary reality.
Other factors that depress inflation include aging populations worldwide that curtail consumer spending. Even before the recent spike, Treasury yields were higher than the sovereigns in virtually every other developed country. So Treasuries are attractive to foreign investors, even more so as the strengthening dollar further enhances the returns in other currencies.
It’s possible that Fed tightening will alleviate investors’ inflation fears, knowing that policy makers are awake at the switch. That could result in a flattening of the yield curve as the central bank pushes up short-term rates while long-term Treasury yields fall. But that scenario faces headwinds; a 100-basis-point rise in the overnight federal funds rate, the Fed’s policy rate, has historically resulted in a 36-basis-point rise in 10-year Treasury yields and a 24-basis-point boost in 30-year bond yields.
The Fed risks tightening to the point that it precipitates major financial problems and a recession. Also, a big rate hike could well reveal bankruptcy-inducing excess debt levels in a number of financial sectors, while areas that have seen excessive speculation, such as cryptocurrencies, SPACs and individual investors tied to Robinhood Markets Inc. are vulnerable.
At the same time, the Fed looks more and more like an arm of the federal government, not only financing an expanding budget deficit by purchasing Treasuries but by providing the monetary fuel for stocks and other so-called risk assets since the 2008 financial crisis. Years ago, Wall Street coined the phrase “the Greenspan put,” suggesting that any stock market weakness could be “put,” or sold to the Fed in return for central bank support. Then came the “Bernanke put,” followed by the “Yellen put” and now the “Powell put.”
The last time the Fed took a truly independent and unpopular position was when, under Paul Volcker, it pushed up interest rates to recession-inducing levels in 1980. But that was in reaction to dire circumstances: double-digit inflation rates and foreign central banks’ refusal to continue to support the dollar. I believe the Fed will try to stop short of the credit tightening that would precipitate serious financial and economic problems. But it’s questionable that the Fed can fine-tune its policy enough to restore its credibility without pushing financial markets and the economy over the edge.
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