I’ve been thinking that when the Fed turns its attention to inflation it will find itself way behind that curve, which it is by any mainstream standard, and that the curve then gets negative from a year or two out as markets anticipate rate hikes followed by falling inflation and rate cuts.

Didn’t know exactly how it would get from here to there, how long it would take or exactly when it would happen.

I never thought the Fed would let it go this far. Especially Governor Kohn, who has been through this before in the 1970s with Burns, Miller, and Volcker. This FOMCs inflation tolerance lasted a lot longer than I expected, even with a weak economy and perceived systemic risk.

Won’t be long before the mainstream comes down hard on this FOMC for letting the inflation cat out of the bag with a high risk, untested, counter theory strategy of aggressively cutting into a triple negative supply shock. The mainstream will see it as a ‘hail Mary’ move. If it works, fine, if not it was a foolish error with a major price to pay to fix it.

Maybe they just got what will turn out to be overconfident in their inflation fighting ability. Kind of a ‘we know how to do that and can do it anytime’ attitude.

Wrong. They will soon find out it is not so easy.

Maybe they got confused and saw the tail risk as that of the gold standard era when there were real supply side constraints to money to deal with.

Also, they probably blamed the whole 1970’s thing on labor unions; so, maybe they got blind sided this time because they thought without unions wages would be ‘well contained’ and therefore there would be no inflation.

Wrong on that score as well. It was about oil before, and it is about oil now.

And the fact is, they have no tools for fighting inflation. They think they do (hiking rates), but higher rates just make it worse by raising costs and jacking up rentier incomes. (Incomes of savers who do not work or produce = more demand and no supply)

The inflation broke in the early 80’s only because of a supply response of about 15 million barrels of crude per day that buried OPEC and caused prices to collapse for almost 20 years. (And even during the 20 years of low oil prices and falling imported prices inflation still averaged around 3%.)

That kind of supply response is not going to happen in the near future. I expect the Saudis to keep hiking and inflation to keep getting worse no matter what the Fed does. It is payback time for them from being humiliated in the 1980s, and they are also at ideological war with us whether we know it or not.

Markets might have a false start or two with the interest rate response and flattening curve, just to not make it too easy.

Also, as before, there could be an equity pullback when it is sensed the Fed is going to seriously fight inflation with hikes designed to keep a sufficient output gap to bring inflation increases down.

And along the way everything goes up, including housing prices, during a major cost push inflation. Even with low demand. Just look at all the weak emerging market nations that have had major inflations with weak demand, high rates, etc. etc.

10 Responses

  1. W, Nice Essay. One issue: I don’t see how housing can go up at least not
    in bubble markets like south florida where I live. With demand soft, inventory at unprecedented levels and rising down here, afford ability at historical lows, and with the specter of high mortgage rates looming how do housing prices increase?

  2. Warren – If oil is the problem, why not address it by selling oil from the Strategic Petroleum Reserve. This would add to supply and thus put downward pressure on oil prices. Also, it would remove currency reserves from circulation which would have a corresponding ripple effect throughout the economy. To make it work though, they would have to let the fed funds rate float.

  3. first, no such thing as letting the ff rate float. the fed is monopoly supplier and therefore price setter. see ‘soft currency economics’

    second, the sale from the spr would be a one time move. once gone, saudis/russians/(iran?) is back in the catbird seat as monopoly supplier at the margin and all are price setters again. and we have no reserves.

  4. ‘inflation’ drives up ‘affordability’ which has already moved up quickly on the charts.

    increasing personal income drives up affordability.

    supply has a way of quickly going away, especially with starts cut in half.

    costs of new construction go up

    inventory falls to a price where it clears and then prices go up with costs.

    rental vacancies are moving down a bit and are not high

    actual inventories are coming down nation wide

    see the latest valance chartbook at http://www.mosler.org under valance reports

  5. Didn’t Volker let the fed funds rate float for a while after October 1979, when the Fed targeted the money supply?

  6. he said he did, but all that meant was the ny fed had to decide the rate to lend at. it was a disgrace to have a fed chairman with so little comprehension of monetary ops

  7. Warren – Just to clarify my thinking, are you saying that it would be functionally and operationally impossible to target some other index, i.e. stocks, gold, oil….or price of labor as in ELR, while letting the ff rate float to wherever the market takes it?

  8. Don’t mean to butt in, but just wanted to mention that there’s no such thing as letting the ff rate go “where the market takes it.” First, as Warren said, the Fed is monopoly supplier of rbs–ONLY changes to the Fed’s balance sheet can alter rbs, unlike other markets where excess demand or excess supply alone will lead to changes in quantity. Banks hold reserve balances to settle pmts and meet rr–that’s it. If there aren’t enough circulating for them to do that, then the rate rises until the Fed supplies them; if the Fed supplies more than banks need to do this, then the rate rises until the Fed drains them. This is what every Fed chair has done (and what every other cb does)–Volcker just allowed more volatility in the rate before he’d step in and add or drain then others have (this is well documented by numerous researchers). The point is, because the Fed is monopoly supplier of rbs (and given flexible exchange rates) there’s no possible “anchor” to the fed funds rate determined by other “markets.”

  9. Scott – I don’t mean to sound dense but presumably rbs = reserve balances? If so, and “ONLY changes to the Fed’s balance sheet can alter rbs, unlike other markets where excess demand or excess supply alone will lead to changes in quantity.”, did you mean to say “…where excess demand or excess supply alone will lead to changes in [price].”?

    If the Treasury were to sell more debt than the government deficit spends, resulting in a reserve deficit, it would place upward pressure on the fed funds rate. The Fed could allow the funds rate to rise, or not and intervene to bring the ff back to target.

    Similary, if oil were sold from the SPR it would drain reserves via debit to a reserve account at a commercial bank. Again, such an action would place upward pressure on the fed funds rate, which the Fed could allow to rise or not. To my way of thinking such an action would have the same impact as non-sterilized currency intervention. Am I missing something?

    In any event, it only seems to be fueling inflation for the government to be purchasing oil for the SPR because they are monetizing the price of oil at higher and higher prices. It seems to me that they should at least halt the purchases.

    Regarding Volker’s modus operandi, if he was targeting the fed funds rate, he was doing it as you suggest in a very volatile manner. However, I’m not entirely convinced that the extreme volatility in the fed funds rate during that period was a conscious decision by Volker and not functionally a consequence of attempts to target the money supply. Can you refer me to some reading on this subject that makes the case? Is it possible that the fed funds volatility was a result of lurching back and forth between trying to target the money supply and then losing focus and reverting to targeting the fed funds rate? It is after all impossible to target two birds with one arrow. At any point in time the Fed would have to be targeting either the fed funds rate or the money supply…no?

  10. Warren – Just to clarify my thinking, are you saying that it would be functionally and operationally impossible to target some other index, i.e. stocks, gold, oil….or price of labor as in ELR, while letting the ff rate float to wherever the market takes it?
    YES, UNLESS THE FED BOT/SOLD THAT SPECIFIC COMMODITY/INDEX

    FROM SCOTT:
    Banks hold reserve balances to settle pmts and meet rr–that’s it. If there aren’t enough circulating for them to do that, then the rate rises until the Fed supplies them;
    AND, AS A MATTER OF ACCOUNTING, ANY REMAINING ‘SHORTFALL’ IN A BANKS RESERVE ACCOUNT IS BOOKED AS A DISCOUNT RATE LOAN BY THE FED, SO EFFECTIVELY THAT SETS A CEILING ON RATES, APART FROM ANY STIGMA, AND OF COURSE THAT’S A RATE SET BY THE FED, SO THE FED IS SETTING RATES, ONE WAY OR ANOTHER
    if the Fed supplies more than banks need to do this, then the rate rises (I’M SURE YOU MEANT FALLS) until the Fed drains them.
    CORRECT, BUT RATHER THAN USE THE WORD ‘DRAINS’ A TERM WHICH SOME AREN’T FAMILIAR WITH, I WOULD SAY SOMETHING LIKE ‘UNTIL THE FED ARRANGES FOR AN INTEREST BEARING ALTERNATIVE.’

    FROM ED:
    If the Treasury were to sell more debt than the government deficit spends, resulting in a reserve deficit, (YES, ANY INCREASE IN IN TSY BALANCES AT THE FED DOES THIS) it would place upward pressure on the fed funds rate. YES The Fed could allow the funds rate to rise, or not and intervene to bring the ff back to target. YES, BUT AS ABOVE IT WOULD RISE TO THE DISCOUNT RATE PLUS ANY STIGMA, WHICH IS ABOVE THE FED’S TARGET AS YOU STATE.

    YES, TRUE IF THE FED OR TSY BUYS ANYTHING- SECS, OIL, FX, PAPER CLIPS, ETC. BUT AGAIN, AS ABOVE, THE DEFAULT CASE IS A DISCOUNT RATE LOAN, SO IT’S NECESSARILY ‘STERILIZED’ IN THAT SENSE AS A MATTER OF ACCOUNTING.

    In any event, it only seems to be fueling inflation for the government to be purchasing oil for the SPR because they are monetizing the price of oil at higher and higher prices. It seems to me that they should at least halt the purchases.
    TRUE, BUT THEY ARE SMALL, AND THE PRICE HIKES ARE COMING FROM THE SAUDIS HIKING PRICES, NOT DEMAND PER SE. SO IN THEORY IF THE GOVT QUIT BUYING FOR THE SPR SAUDI PRODUCTION WOULD FALL MAYBE 100,000 BPD BUT PRICE WOULD REMAIN WHERE THEY WANT IT.

    However, I’m not entirely convinced that the extreme volatility in the fed funds rate during that period was a conscious decision by Volker and not functionally a consequence of attempts to target the money supply. CORRECT. HE WAS TRYING TO TARGET NON BORROWED RESERVES FOR THE MOST PART. THIS SHOWED A TOTAL LACK OF UNDERSTANDING OF MONETARY OPS, AS HIS STATEMENTS OFTEN CONTINUE TO REVEAL.

    At any point in time the Fed would have to be targeting either the fed funds rate or the money supply…no? THE FED CAN NEVER CONTROL THE MONEY SUPPLY OR USE QUANTITY MEASURES AS A TOOL. THAT CONCEPT IS INAPPLICABLE GIVEN TODAY’S INSTITUTIONAL STRUCTURE.

    LOANS CREATE DEPOSITS WHICH CREATE RESERVE ‘OVERDRAFTS’ BEFORE THE FED FINISHES ITS FIRST CUP OF COFFEE. THE QUANTITY DEED IS DONE. THE FED CAN ONLY SET PRICE.

    THAT SAID, THE FED CAN ALTER THE MIX BETWEEN DIFFERENT TYPES OF BANK DEPOSITS, AND IF YOU INCLUDE SOME IN ‘MONEY’ AND NOT OTHERS THEN YES, WITHIN THOSE SORTS OF DEFINITIONS THE FED CONTROLS THE ‘MONEY SUPPLY’ BUT THOSE ARE FUNCTIONALLY WORTHLESS CONCEPTS.

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