The Fed and Inflation

Yesterday, the US Federal Reserve kept its policy stance unchanged. It recognised in its statement that the US economy is surging, and that inflation is rising. However, it argued that employment is still below pre-lockout levels, and that the inflation was mostly “transitory”. In his press conference, Fed Chairman, Jerome Powell, said that they knew how to deal with inflation, and that, if it started to become entrenched, they would act. The Fed is trying to calm financial markets, particularly bond markets, which have seen inflation rising sharply, and have begun to raise interest rates, reflected in the sell-off of bonds and rising bond yields.

Powell spoke about the strength of the US housing market, but was then asked, in that case, why is the Fed still buying $40 billion of Mortgage Backed Securities (MBS) each month? Powell seemed to have no answer to this question, other than to say that the Fed had always bought some MBS's from the start of QE, as one means of adding liquidity to the system. Anyone who has read about the 2008 financial meltdown, or seen the film The Big Short, will know that it was the selling of mortgages to people who, in many cases, would not be able to them back, in the case of rising interest rates, which led to the inflation of house prices, and which led to the creation of Mortgage Backed Securities as a means of continuing to issue those sub-prime mortgages, which was a spark for the crisis. It was outright manipulation, and possibly fraud, which enabled that to continue, with the MBS's being given AAA credit ratings, by the credit agencies that enabled money to continue to pour into investments that were essentially worthless. What the Fed is doing is pretty similar, except, it is simply buying those MBS's directly itself. If it didn't, and so put a safety net underneath them, many speculators would probably not touch them with a barge pole.

In other words, it is similarly interested in keeping inflated asset prices inflated, not just property, but also MBS's, and other derivatives. The argument that the economy needs this monetary stimulation is clearly nonsense. The US economy grew by 6.4%, in the first quarter of this year. Its likely to grow by more than 10%, in the second quarter, as the country opens up, and fiscal stimulus begins to ramp up demand. It feeds into a global economy that is also surging, causing primary product and agricultural product prices to soar. Demand is rising so fast in some sectors that demand for microchips has led to shortages, with an increasing number of companies having to curtail their own production of commodities, because they cannot get the chips they require.

Although employment and unemployment is uneven, with some jobs disappearing, and others will disappear as furlough schemes end, in other sectors, firms can't get the workers they need, resulting in wages being bid up rapidly. Yet, the opening up of economies, and effects of oceans of liquidity fed out in income replacement schemes, direct payments from government and so on has not even begun to show up in the data. The US PCE deflator data, which is a measure of inflation, looks to be coming in at between 3.5 – 4.0%, whilst the current reading of inflation is itself 2.6%. Yet, as set out previously, the inflation data is itself massively understated, because its compiled using baskets of goods that in many cases cannot be bought due to lock-outs, but under-represents or misses out all those goods that consumes have been buying during the lock-outs, and whose prices have risen sharply.  The real level of inflation is already around 10%, when adjusted for the effects of lockouts.  One survey done for the BBC showed food prices rising by around 23%.

The problem for the Fed is that inflation is already here. It says its transitory, and will act if it seems to be resulting in higher inflation expectations, but by then it will be too late. It will only take a few months of consumers and businesses seeing prices rising sharply for them to factor that trend into their expectations. Most know the inflation is already here, and as the economy opens up, and surges in demand hit sector after sector, as the huge amounts of liquidity surge into pumping up monetary demand, it will not just be microchips whose supply is inadequate to meet that demand. The first response of firms will be to hike prices, as has already been seen on previous occasions when lockouts were temporarily lifted. Seeing that surging demand, and rising money profits, as inflation rises, they will seek to expand their own production rapidly, but will hit the same kinds of bottlenecks when it comes to their suppliers, and available workers.

Suppliers will then also hike prices, and as firms scrabble to get workers, they will have to offer higher wages, meaning that existing workers will demand their own wages be increased. All of the additional costs that have been imposed as a result of the fracturing of supply chains, dependent on Just In Time, will mean that these costs will be increased further, Britain will suffer even more because of Brexit, breaking those supply chains and imposing increased costs to an even greater extent. The US is forecast to create at least 7 million jobs over the coming Summer. Its not just the number, but the speed of creating them that represents a problem for firms.

The Fed says it knows how to react, and will not fail to do so, but the trouble is that it takes two years for changes in monetary policy to feed through into the real economy. So, if the Fed waits until the Summer to raise its policy rates, it will not be until the Summer of 2023 that this begins to impact inflation. In other words, in the intervening months, inflation would most certainly have become well embedded in expectations. It would mean the Fed would end up well behind the curve as bond markets continue to sell off, and yields begin to rise. The Fed would become rapidly side-lined from real events, an occurrence it is not likely to relish. The only way it would be able to regain control would be to raise its policy rates sharply, in the way that Paul Volcker did in the 1980's, but that would mean raising them very sharply indeed, because the intention would be to cause a recession to slow the economy, and, thereby, rein in the inflation.

There is another problem, here, due to the ridiculously low absolute levels of its current policy rates. For large companies, the consequence of QE, and the bond buying of the Fed, has been that they too could issue bonds at high prices/low yields, i.e. they too could borrow cheaply. That is because, rather than using the funds raised by such bond issuance for productive purposes, they have used it to buy back shares, to boost balance sheets, and make capital transfers to shareholders. Smaller firms have, meanwhile, been in no such fortunate position. Most of them could not borrow money, because banks have used money also to buy financial or property assets, or lend to those engaged in such activity. Small firms have had to rely on their own personal financing, to borrow on credit cards, and other high cost sources.

So, for large companies, if the Fed raises its policy rates from the current 0.25%, to even 1%, the effect of this, in deterring borrowing and investment by big firms, is going to be negligible. A company that sees its money profits rising by 20-30%, as demand soars, and inflation pushes its prices higher, is not going to be deterred, by having to pay an extra 0.75% to borrow the money to cover its expansion. In the 1980's, Volcker had to raise US policy rates into double digits, to cause the economy to slow, and persuade people to save money rather than borrow it, taking it out of circulation, and so causing inflation to be curbed. Yet, the 1980's was actually a period of long wave downturn and stagnation, albeit in the early 1980's a period of stagflation. The rate of profit in the early 1980's was still low, having been increasingly squeezed by rising wage share during the 1960's and 70's.

Today, the rate of profit is high, and we are in a period of long wave uptrend that has merely been hibernated by the deliberate policies of governments and central banks to slow the economy, and divert money into financial assets. Slowing the economic surge that is coming will be much harder than it was for Volcker in the 1980's. Yet, it has been precisely in order to inflate asset prices that central banks have bought those assets, and, thereby, reduced yields, in many cases even to the extent of producing negative yields. The process of capitalisation, which determines the pries of assets, means that asset prices move in a proportionally opposite direction to interest rates. If interest rates double, asset prices halve. The problem then becomes pretty obvious. If the Fed doubles its policy rate from 0.25% to even just 0.5%, and this is reflected in yields through the economy, then the prices of assets are halved. If it raises rates to 1%, then asset prices fall to a quarter of where they are now. That would take the Dow Jones back to around 8,000.

Now, its not entirely that simple, because the other factor involved, is the actual revenues these assets produce. If a combination of a surging economy, plus inflation means that company profits increase rapidly, then they can also pay out more in dividend/interest, so that revenues increase, and that would offset some of the effects of capitalisation. But, given that, in order to try to restrain the economy, and so inflation, the Fed would need to be raising interest rates way beyond 1%, the problem it faces can be seen. More significantly, and the reason it is wanting to try to placate the bond markets currently, is that long before it moves, the real interest rates in the economy would already have been moving up sharply, and the bond markets selling off.

So, far, the commentary on interest rates is only focussed on rising inflation, but as I pointed out some time ago, its not primarily inflation that causes interest rates to rise, but a shift in the balance between the supply and demand for money-capital. As CNBC Bond Market reporter, Rick Santelli, said last night, what bond traders are looking at is not just rising inflation, but the huge amount of borrowing that has already been undertaken, but not yet manifest in new bond issuance, by governments, to cover it. That is before we consider the $2 trillion of additional borrowing that the Biden government is proposing, which will almost certainly grow much larger in coming months, and is matched by similar borrowing by governments across the globe. And, as businesses seek to quickly ramp up their production to meet all of this rising demand, they too will have to borrow massively to fund it, as well as using much larger proportions of their own profits to fund such expansion. In short, the demand for money-capital is rising, to coin a phrase exponentially, whilst the supply of money-capital gets reduced.

It seems unlikely that the Fed could now raise interest rates as sharply as would be required to slow the economy, in these conditions, so as to get inflation under control. What is for sure, the idea that central banks are not going to raise their policy rates until 2023, is nonsense. They will have to raise rates this year, and even then they will be way behind the curve as market rates of interest rise, and bond markets sell off sharply. The first response of central banks seeing such sell-offs in asset markets will be to double down in trying to print money tokens to buy up those worthless paper assets. They will do that, because they still want to inflate those prices so as to protect the paper wealth of the top 0.01%, who own all of their wealth in the form of this fictitious capital. But, in these new conditions that will not work.  The borrowing is going to fund consumption, both unproductive consumption and productive consumption, feeding through into additional demand, which with rising liquidity simply means further rising inflation.

A huge crash in asset prices is now inevitable, a crash that will make 2008 look like a blip.