A Deeper Dive Into a Thought Mentioned in Tuesday’s Overnight Rundown of Developments
July 11, 2023
I postulated earlier today that the Federal Reserve would likely have been closer to its first priority of returning U.S. inflation to its 2.0% target in a sustainable manner if two things had been done differently at the initial stage of the interest rate tightening cycle: 1) starting the process sooner and 2) making a big initial rate hike rather than hiking initially by the smallest of moves, namely 25 basis points. Critical to this conclusion is the acceptance of a tenet of monetary policy theory that changes in interest rates fully impact real economic demand and inflation with long and variable lags. The full consequence between a rise in the overnight interest rate and inflation is generally thought to be no shorter than a half year and as lengthy as 18 months or even longer in some special instances. No two cycles are the same. Other economic shocks may occur in the process, and changes in foreign exchange rates during the process may either augment or counteract the central bank’s attempt to tighten monetary conditions and lower inflation by raising interest rates.
Another issue monetary policymakers have to bear in mind is that the longer above-target inflation persists and the wider gap by which inflation exceeds the central bank’s preferred base, the greater becomes the upward drift in short- and more importantly longer-term price expectations. Policymakers are right to pay attention to core as well as total inflation in order not to chase a spike that might be short-lived, but it is equally important to understand that in a genuinely upward shift of inflation must be identified reasonably quickly and counter-punched early and hard.
The Fed’s first rate hike in March 2022 was implemented a year after core PCE inflation had moved above 3.0%, that is by 50% of its 2% target. By the time, that tiny 25-basis point hike was done, core inflation was hovering at 5%, and by the time that first hike had any discernible effect toward resolving the problem, a year and a half had elapsed since inflation crossed above 3%. Moreover, core inflation had been hovering around 5% for a year. Given the mere change in the funds rate target to 0.50% from 0.25% of that first move, one sees clearly that the overall thrust of monetary policy when the the effect of the first rate move were actually being reaped was still incredibly expansionary. Now one can look back at earlier monetary policy cycles, for example the doubling fed funds rate from 3% to 6% engineered in the year through January 1995 and say “wait a minute, the U.S. economy slowed amazingly sharply that time and came within a whisker of slipping into recession.” The difference is that starting at 3% is a whole lot more advantageous than launching a tightening cycle from what was effectively a zero interest rate policy.
The Fed followed up the initial 25-basis point rate hike with a 50-bp increase, then four straight hikes of 75 bps each, and a 50-bp hike in December 2022. Only then when the funds rate ceiling was at 4.5% and inflation measured by the core personal consumption price deflator, which was 4.6%, might one argue that monetary policy had reached a neutral level, neither promoting nor depressing the U.S. economy.
Fed officials have drawn the analogy of policy tightening to slow inflation to driving a motor vehicle. Now that they believe most of the heavy lifting has been done, prudence requires that one put less pressure on the gas and perhaps pump the brakes to bring the vehicle to a gradual stop, or in the economic vernacular a soft landing that avoids recession. But the age of internal combustion car engines is fading, and an era of electric vehicles is now dawning. Anyone who has driven a Tesla knows that not only do EV’s accelerate like a jack-rabbit, they also slow abruptly merely by taking one’s foot off the accelerator. There is no brake to tap.
Three more 25-basis point rate hikes were made in the first half of this year followed by a pause in June to assess how the economy is responding. But it’s raining, roads are slick, the wind-shield is mesmerizing, and frankly it’s hard to make out what the mixture of data is really saying. Employment and wages are still climbing briskly, and core inflation is stubborn not just in the United States but in manay other countries, too. Fed officials are preparing the world for two more hikes in the second half of the year but also saying that policy will be ultimately guided by real-time data. If policy six months ago only returned to a semblance of neutrality and thus only now can be expected to exert a drag on demand and inflation, this saga will need to catch some lucky breaks for the Fed’s mission to be accomplished before the next U.S. presidential term begins. One cannot understate the importance of keeping the election away from the process. Whatever Fed officials say about their independence, image of political influence by itself can damage democracy further.
An initial Fed rate hike in September 2021 could have been justified. That was the sixth straight month in which the core PCE price deflator posted a 12-month increase of more than 3.0% and October was to see a half percentage point additional jump in inflation to the 4% octave range. A more controversial decision would have been to implement a full percentage point hike on that occasion to 1.0-1.25%. And let’s say the FOMC continued to front-load tightening with increases of 75 bps, then four 50-bp moves. By May 2022 when core inflation printed at 4.9% following back-to-back results above 5.0%, the federal funds target ceiling would have been 4.0% instead of 1.0%, its level on the road map that was actually followed. At 4% the funds rate would have been less than one percentage point below PCE inflation instead of 3 percentage points behind the curve, and that discrepancy would go on to exert its effect on the economy in inflation from last November onward. That half-year span was the one that covered the four straight 75-bp hikes, reaching 4.0%. If the Fed had followed my suggested road map and continued to tighten over the balance of 2022, the rate could have reached 6% by yearend without any increase exceeding 50 basis points.
In reality however, the Fed would not have needed to be nearly that aggressive because rate neutrality would have been achieved much earlier, and the pass-through of policy to changes in growth and inflation would have been much more complete. One can never be sure how everything would have transpired if the road not taken had instead been chosen, but odds heavily favor not having to ultimately raise interest rates as much as it looks like they are now destined to go. A further advantage is that price stability could have been restored before the home stretch of the 2024 election when politics inevitably intrudes into all aspects of economic life.
Even if the FOMC didn’t begin to raise interest rates until March 2022, the impediment of an excessively delayed start might have been partly mitigated by packing in a mega-hike of 200 basis points to 2.0-2.25%. The ceiling rate would still have been just half as high as PCE core inflation of 5.2% that month. The 0-0.25% previous band could have then been characterized as an emergency corridor that no longer made any sense with immense fiscal support and social gathering increasing as well. To be sure, the Russian invasion of Ukraine was immobilizing the urge to be daring, but as it turned out, the Russian army proved to be no where near as adept as thought. If the Fed had followed up the big bang in March 2022 with three 75-bp increases and then two 50-bp moves, last November’s new target interest rate band would have been 5.25-5.50%, 150 basis points above the actual level then and three-quarters of a percentage point above inflation. Fast forward to now, and the scene would be set for rapid price deceleration during the second half of this year.
The risk of this alternative way is recession, which in fact still remains a possibility certainly in the early part of 2024. If one truly believes that total harm from chronic inflation above 2% is going to be larger the longer one puts off the task of fighting the problem and if one also believes that the trade-off between price stability and long-term economic growth is a false distinction because price stability is a pre-condition for growth and not vice versa, then a front-loaded assault on aberrant core inflation will almost always be the correct choice.
A stronger argument in favor of gradualism and caution at the onset of a cycle of interest rate increases involves the dismaying example of Japan in 1989-91. A newly arrived Bank of Japan governor put monetary tightening on steroids to convince without a shadow of a doubt his determination to nip nascent inflation in the bud. Japan’s discount rate had been 2.5% from March 1987 to July 1989. Japanese real GDP and money supply had expanded very rapidly in the 1980s. Inflation by July 1989 had risen to 3.0%, but such fell back to 2.6% by the end of that year. An initial 75-bp hike in the central bank discount rate in July was followed by back-to-back 50-bps increases in November and December (that latter at an unscheduled meeting on Christmas Day, no less). The rate was jacked up 100 bps in April 1990 and 75 bps six months later to 6.0%. Japanese inflation peaked at 4.5% in January 1991, but that reading was sandwiched by one’s of 3.8% in December and 3.9% in February. By March 1992, inflation had receded to 2.0%, The 6.0% discount rate was maintained until July 1991, and Japan’s 3-month money market rate, which had been 4.63% in May 1989, went above 8.0% in September 1990 and stayed above above 7.8% through mid-1991. Oil prices spiked in the summer of 1990 when Iraq invaded Kuwait but retreated quickly thereafter.
Fifteen years later, the Fed also went about raising interest rates in a gradual manner, implementing 17 uninterrupted 25-basis point rate hikes that lifted the federal funds target from 1.0% at mid-2004 to 5.25% at mid-2006. That methodical normalization laid the seeds for an overheated housing sector, the sub-prime mortgage financial crisis, and a deep recession from which few economies were spared. Gradualism sounds like a wise approach, but sometimes it can be akin to the fable of a frog unknowingly being boiled to death in a pot heated too slowly for the frog to think of jumping out.
Japan’s situation in 1889-91 never warranted the heavy dose of monetary medicine that was administered, and such exposed structural weaknesses in its banking system that mishandled by subsequent policy moves fueled an ensuing slide into deflation. The current U.S. situation has repeatedly proven very resilient, demonstrating that a more aggressive early counter-force against inflation likely would have been adequately tolerated. The Fed will have to make the best of its late and initially timid start to tightening monetary policy. This analysis suggests that perhaps the next time a cycle of monetary restraint seems required, perhaps officials well be more pro-active. At worst, that’s the only way to create a data point for learning how this alternative approach would unfold.
Copyright 2023, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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