The Fed and its loose monetary policy are to blame, according to Lacy Hunt, for high inflation, excessive risk taking, slow growth and other maladies afflicting our economy.
Hunt, an internationally known and award-winning economist, is executive vice president and chief economist of Hoisington Investment Management Company (HIMCO), a firm that manages $4 billion in pension funds, endowments, insurance companies, and others.
Hunt was a keynote speaker on May 3 at John Mauldin’s Strategic Investment Conference, which I attended virtually.
I have heard Hunt speak many times, and his articulation of the historical research – especially econometric studies – on the effects of fiscal and monetary policies is exceptional. The theme of this talk was consistent with his prior presentations. I’ll go through his thesis and then offer some reasons to question what he said.
Before I do that, however, let’s look at what Hunt said at this same conference a year ago. Hunt wrongly predicted that there would be a recession in 2022. He warned, “The degree of financial risk is greater now than at any time in modern times.” Nothing happened in the year since he spoke to validate that warning. The series of bank failures, starting with Silicon Valley Bank (SVB), were far less consequential than, for example, the failures during the dot-com and housing crashes.
Hunt again said a recession is imminent, but he came to that conclusion through a novel way of looking at business cycles. He contended that there are three cycles at work in the economy: financial, GDP and price-labor. The financial cycle is a leading indicator, GDP is coincident (by definition, it is the business cycle), and price-labor is lagging.
The peaks and troughs of financial cycles are determined by five factors:
- The degree of monetary increase and length of time it is at an elevated pace;
- The duration and length of debt or credit creation;
- The length of time real interest rates are low, and how low they are;
- The amount of risk taken when monetary policy is loose; and
- Forward guidance – when the Fed says it will stay “looser for longer.”
Metrics for each of those five factors show that the financial cycle has bottomed and, as a leading indicator, a recession will follow.
Looking at each of the above five indicators, Hunt said that monetary policy was “extremely loose” in 2020 and 2021. The real M2 money supply was at its highest level since 1952, many times higher than its previous high, although, he said, now it is in an unprecedented decline.
He called debt the “silent killer,” strangling the economy and exacerbating the wealth divide. Delinquencies are increasing on all types of loans, he said, and the “upticks are fairly significant” as banks have raised their lending rates.
He acknowledged that debt can be helpful, but said returns diminish as debt increases. He cited the Reinhart and Rogoff research that found that economic growth slows when a country’s debt-to-GDP ratio is above 90%.
As for real interest rates, 10-year TIPS yields were below from February 2020 to May of 2022, but have been positive since then and are now approximately 1.2%
Hunt did not offer any data to quantify the amount of risk taken when monetary policy was loose, although the failures of SVB, Signature and First Republic were in part due to their unhedged “bets” on low interest rates.
The Fed’s loose monetary policy was in place for roughly two years, following the COVID-19 pandemic, although a period of loose policy preceded that. Hunt said that loose policy leads to high inflation and excess risk taking.
Hunt cited a pattern of economic research to support his thesis that debt, in particular, inhibits economic growth. That pattern began with the 18th century Scottish philosopher David Hume who, according to Hunt, said that the “over-accumulation of debt leads to tranquility, languor and impotence.” In the 19th century, Knut Wicksell said that growth happens when the market rate of interest is aligned with the natural rate of interest, but reducing the market rate provides only a temporary boost to growth.
In the 20th century, Hunt cited research by Irving Fisher that over-indebtedness and deflation are the price paid for loose policy. Hyman Minsky showed that debt leads to instability but, according to Hunt, he did not connect monetary largesse and excess debt accumulation. “But based on what we know now,” Hunt said, “loose money leads to excess risk, financial instability, and eventually a Minsky moment.” Charles Kindleberger, according to Hunt, saw the monetary element in financial cycles.
Hunt cited more recent research by Raghuram Rajan, Robert Barro, and other economists that supported the view that monetary policy provides only a short-term boost to the economy that is reversed when it is removed. Central banks have kept rates too low for too long, according to this research, which led to an investment boom, capital overhang and long-term slower growth.
“Growth is falling behind the trend as monetary policy has been more extreme,” Hunt said. “I expect the economy to weaken.”
Hunt spoke before the Fed’s announcement of a 25-basis-point rate increase, with language that suggested it would be the last of this hiking cycle. He said the Fed will eventually lower rates and engage in quantitative easing. “But it won’t work,” he said, “and will provide only transitory benefits.”
“Fed policy boom-booms and then slump-slumps,” Hunt said, “but it does not change the trend rate of growth.”
Should you be skeptical of Hunt’s views?
I am, for several reasons. The research he cited is based on historical data. But most of that data was from a time that bears no resemblance to today’s U.S. economy. As I wrote in my summary of David Rosenberg’s talk two days earlier, our economy has become dramatically more reliant on the service sector over the last half century. A service-based economy is not as closely tied to the financial cycle (to use Hunt’s paradigm), because it is less interest-rate sensitive. We should not expect monetary policy to have the dampening effect on service-sector growth as it did on the good-producing economy of the past.
Hunt claimed that inflation was due to loose monetary policy. That is the same view that Larry Summers took in a talk I summarized last week. But I am more persuaded by the view (which Hunt barely mentioned) that recent inflation was caused by supply constraints brought on by the pandemic, followed by a spike in consumer demand as restrictions were lifted. It was not a monetary phenomenon; it was excess consumer demand chasing too few goods.
The labor market is strong, as Hunt acknowledged, and that is inconsistent with the forecast of an imminent recession. Hunt’s explanation was that labor is more “fragile” than people think. Firms are overstaffed, he said, and as earnings fall unemployment will go up. There is anecdotal evidence that supports that view, given the recent layoffs in the technology sector. But with roughly 80% of our workforce in service-related businesses and many companies still looking for good talent, unemployment may be more stable than Hunt expects.
The final reason to be skeptical of Hunt’s view is counterfactual reasoning. What would have been the outcome if the Fed had not lowered rates during the pandemic? What would have happened if the Fed had not raised rates over the last year? Without an answer to those questions, one must acknowledge that the Fed’s policies may have been the best for the economy.
Hunt even acknowledged that himself toward the end of his talk when he said, “We need to get off this treadmill, and I don’t know how to do that.”
Robert Huebscher is the founder of Advisor Perspectives and a vice chairman of VettaFi.
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The Fed and its loose monetary policy are to blame, according to Lacy Hunt, for high inflation, excessive risk taking, slow growth and other maladies afflicting our economy.