Sunday, December 12, 2021

Another Fine Mess The Fed Has Gotten Us Into

 Laurel and Hardy had a catch phrase with variations on "well here is another fine mess you have gotten me into".  The Fed has blown many bubbles since it was created over 100 years ago but this is the first "everything bubble" and a really fine mess.

The core problem is that the bubble economy and government are now dependent on interest rates that are near zero but these low interest rates are causing inflation.   The Fed's duel mandate of high employment and stable prices requires that they raise interest rates to fight inflation.   But this is likely to pop the everything bubble.

The Fed is targeting 2% inflation.  The latest CPI reading was 6.8%.  It has been going up very quickly.   The current CPI uses owners equivalent rent, where they go around asking non-renters what they think their house could rent for.  This is just just aggregating made up numbers and not collecting real housing price data.  People experience real inflation and not the made up numbers.  If you use real housing data, like they used to, the CPI comes out to 11%.  There are other tricks in the CPI that cause it to understate inflation.  Really inflation is at least 9% above the Fed's target.  

There is a Taylor Rule for figuring out what interest rate the Fed should use to get inflation back to its target rate.  It is easy to try out the Atlanta Fed Taylor Rule Calculator  to see what rate should be used.   But really you should have 2 or 3% more than the current inflation rate.   The only way Paul Volker could control inflation was by raising interest rates above the inflation rate.  We really need something like 13% interest rates to control this inflation.  Staying near 0% will encourage more inflation.

Some people ask, "how could increasing interest rates fix supply chain problems?".   The wrong idea here is that the current inflation is just caused by supply chain issues and these are not things the Fed can fix.   Let me try to explain.   Imagine each businessman is seeing various costs for his input supplies going up at  numbers like 10%, 15%,  25%, 50%.  Also imagine that banks pays him 0% if he leaves the money in the bank and charges him only 2% if he borrows money.  The rational thing for him to do is order extra of his input supplies, either with cash on hand or by borrowing.   In these conditions he is better off using these input supplies as a store of value.   With 0% interest and these inflation rates, the dollar is not a "good store of value".   The dollar has lost one of the key attributes of good money.   But the supply chains were designed for normal monthly supply quantities and not for businesses also using supplies as a store of value.  This additional usage is too much.    If interest rates were at 13% many more businessmen would use money as a store of value instead of input supplies.  If the Fed raised rates to 13% the supply chain would be fixed right away.  Really. 

When the local money fails as a store of value, you always see laws against "hoarding" as if that was the core problem.  Hoarding is a symptom of bad money, not a core problem.

It is also not clear to many people how the Fed has caused the labor shortage, so let me try to explain that as well.  By dropping interest rates to zero the Fed has about doubled the stock market since the 2020 low.  This has made many people feel rich enough that they think they don't need to work, so they quit.   If the Fed were to increase interest rates, probably the stock market would crash, and many of these people would be looking for work again.

The US Federal Government has over $29 trillion in debt.    These days much of it is short term T-bills and not long term Treasuries.  If interest rates went to 13% the interest could be more than the total taxes collected.   Many companies and individuals have also taken on lots of debt to take advantage of the low interest rates.   If rates go up they will have a very hard time.

The market is only expecting two rate hikes of 0.25% each in 2022.  The market is thinking we will be at 0.5% interest 12 months from now.   This is nowhere near high enough rate to fight inflation.  Inflation has been going up 0.5% per month many times recently.  Without some serious effort to fight inflation soon, we will see far higher inflation by the end of 2022.     On the other hand, even 2% rates now would no doubt crash the stock market and slow the economy way down.   It is another fine mess the Fed has gotten us into.

Monday, December 6, 2021

Inflation Going Higher

The Nov 2021 CPI report comes out Dec 10th.   The Oct CPI was 6.2%.   Here are three different estimates for Friday's number:

  1. Cleveland Fed estimates 6.6%
  2. Lyn Alden says  economists are estimating 6.7%
  3. Trading Economics forecasts 6.9%

As Edward Garbarino commented in response to Lyn's tweet, "If Powell did not have information indicating significant worsening inflationary pressure on the horizon, he would not have jettisoned the "transitory inflation" narrative, IMHO."

This year the real CPI numbers have surprised to the upside many times.  We may be at 7% or more on Friday. 

People are expecting that about a 0.5% increase in the Fed Funds rate in 2022 will tame inflation.   This is naive.   Given how fast inflation has been going up (frequently 0.5% per month) that is far too slow a pace of increasing interest rates to ever get ahead of the inflation rate.   If interest rates stay far below the inflation rate, inflation will continue to go up.  Interest rates need to be well above the inflation rate to be "fighting inflation".

Historically when inflation starts going up the Fed tightens and the market goes down.  It really seems that this is likely soon.

However, if we have 7% inflation then it would take something like 10% interest rates to get control of it.  If we had such rates the economy would be dead and the government bankrupt.   But if interest rates stay low, inflation can get out of control.  It really could go to hyperinflation.  Either choice the Fed makes has a really bad result.   There does not seem to be any nice way out at this point.