The Federal Reserve hasn’t always conducted FOMC meetings (Federal Open Market Committee). It started meeting in late 1973 or early 1974. The purpose of the meeting was to address inflation primarily, in the economy; ways to control it, ways to stabilize monetary policy, ways to create price stability.
In the mid 1970s, the Fed began to release data regarding its work at the FOMC level. The primary discussion was around inflation, economic activity, and monetary policy, principally the fed funds rate. Although this is not the most exciting read on the planet, I’ve attached a history of the FOMC for anyone that is interested. It is available here: FOMC20030624memo01
More recent, the Fed began to broadcast the Chair’s presentation/remarks at the conclusion of the FOMC meeting. Listeners or Fed watchers (like me), want to hear about changes in monetary policy such as interest rates (Fed Funds Rate), up or down, and the Fed’s outlook on the economy. I’ve listened to many of the broadcasts and when I can’t I gather the minutes and review. I listened yesterday (Wed. the 20th) and in turn, what I heard prompted this post.
A few short years ago (about two), I heard the Fed Chair’s broadcast and his outlook for inflation, claiming it was likely transitory. My, how things have changed since.
Today, inflation is baked-in and arresting it will be an enormous challenge. While inflation has slowed across the recent months, it remains nearly double the Fed’s target of 2%. It crept up a touch last month and by all indications, it will do so again for August. What moved inflation down in previous months was energy costs, specifically gasoline and diesel and somewhat, electric. Gas and diesel are reversing, and crude (raw) is approaching $100 a barrel.
Rising energy moves costs up for nearly all other consumer and industrial products. There is a lag but as energy rises, within the following short period, the cost of goods produced and then transported to market, begin to reflect the higher cost of energy and petroleum related to production and shipping.
This post, however, is about how inflation got to where it is today and why.
The famed economist Milton Friedman defined inflation: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Friedman further defined the primary determinant of the quantity of money as government spending. In simple terms, any spending that does not tie to a productive outcome of some form when money is created or printed, is a contributor to inflation. Deficits for example, are inflationary if the same are financed via debt (Treasuries).
Yesterday, I acquired a simply stunning report or white paper from the Heritage Foundation on inflation, recent years. It is astounding in its depth and detail. It covers the roles played by Congress, the Administration (Trump and Biden) and the Federal Reserve in creating an incredible spending spree, most dollars tied to nothing productive in return (no additional tax revenue, no additional GDP growth, etc.). Fundamentally, the spending created a stunning amount of debt and deficit that when added to existing entitlement program unfunded liabilities, the result is jaw dropping. The Heritgage report is available here:Heritage Inflation Report
Beginning in 2020 with COVID response expenditures and running through current, the government (collective including the Fed), has added $7.464 trillion of new spending to the economy. Essentially, an infusion of $7 plus trillion with no correlation to productive output, thus nearly all became inflationary – see Friedman above.
As COVID recovery (late 2020 to current) ebbed and flowed due to pandemic policies around some facets of the economy remaining open and some remaining closed (state activities varied widely), spending at the federal level and even more at the states’ level, continued to add liquidity to the economy – more dollars. And, while average citizens gained some additional cash to spend, finding things to buy beyond staples was problematic. The classic too many dollars chasing too few goods (shorthanded, inflation).
As inflation really began to manifest, the Federal Reserve too slow to act initially via printing constraint and early rate adjustments, was forced to play catch-up. The Fed has limited tools to reduce money supply (constrictive or restrictive), basically reduced its balance sheet holdings of Treasury (and other) securities and/or raise the Federal Funds rate (the rate banks charge each other for loans). Neither is precise or fast with interest changes having a lagging effect.
Since the Fed began to raise rates, it has added fully 5% to the over-night rate in twelve months (the rate in March 2022 was 0.25 to 0.50%). Thirty-year mortgage rates accelerated, today nominally 7.5% and rising. As a result, the sales of existing homes and new builds, has plummeted. At the same time, since the government finances its deficits via issuing Treasury securities, the cost of debt as an element within the Federal budget has grown substantially. Another driver of inflation is deficits financed by debt – sort of a piling on effect.
Stopping inflation is a function of multiple events. To date, the Fed is really the only factor causing event change – interest rate increases and balance sheet shrinkage. The impact to the economy is a bit like using a hammer to smash soap bubbles. The net effect is demand destruction or simply, pushing the economy to a recessionary state, hopefully for a short and nearly unnoticeable period (soft landing). As Heritage points out however, this soft landing is unlikely and yesterday during the Fed Chair’s remarks, he more or less indicated the same.
The question thus, that begs, is why can’t a soft landing occur? Primarily because the sources of inflation remain unchanged, namely spending. The fire may be modestly contained but fuel continues to be added at the Federal level and at the state level. The current inflation is a policy problem; government policies that have constricted GDP growth and added excess liquidity (more money) to the system, unchained or disconnected from any return (no growth, no new taxes, no productivity, etc.).
Listening to Fed Chair Powell yesterday and then, reading the Heritage report, I came away with a bit of a negative outlook for the upcoming months, through 2024 and perhaps, beyond.
- The Fed’s 2% inflation target is a fool’s errand. Historically, inflation has not stabilized and consistently, ran at such a low level. Between 1960 and 2022, the average rate of inflation was 3.8% per year. The most important measure is inflation in relation to GDP growth.
- Recession is highly probable, beginning in early 2024 or perhaps, as early as late 2023.
- Continued rate hikes are not off the table though in my opinion, they should be. Rate hikes are a blunt instrument and can push the economy into a severe recession or alternatively, a prolonged period of stagflation, whereby inflation remains elevated and GDP growth is nominal or near negative.
- Debt financed entitlement programs such as Medicare and Social Security are marching quicker toward insolvency due to the higher cost of money (interest rates).
- Businesses that need capital are going to continue to find it expensive and constricted as more banks are either failing (due to continued deposit run-offs) or restricting their borrowing levels and conditions.
- Residential and commercial real estate are going to continue to be depressed and for a considerable period of time as all indications are that interest rates will remain elevated for some extended period (even without additional increases, cuts are unlikely). Fed Chair Powell all but admitted that assumptions about the neutral rate (the rate of interest that keeps inflation at a pre-set target) is likely higher than what was first conceived when rate hikes began. This is code for don’t expect rates below 2% or close, anytime soon.
TGIF! Hopefully, some better news is ahead in the upcoming weeks but somehow, I think the general trend remains a bit sour.