The Fed does not have to shatter the economy to fight inflation. However, it will. There is a better solution.
We break the article into 5 sections. Sections 1 and 2 provide background on how we arrived at the current inflationary state. Sections 3 and 4 describe a weak economy where monetary policy has already destroyed significant value and slowed the real economy. Section 5 is our prescription for fighting inflation and repairing the economy in a sustainable manner.
1.) The Fed was late: The Fed ought to have tightened in Q4 2020 when asset values began to skyrocket, most notably equities, housing and crypto. Not only did it not tighten in 2020 or 2021, it waited until Q2 2022 to apply the brakes.
2.) The Fed caused inflation: I find the Fed’s tardiness puzzling as the Fed is the reason we have today’s inflation. It chose to print $5 Trillion during 2020 and 2021 to subsidize Treasury checks that were mailed to individuals. The Fed chose to print another $5 Trillion or so to subsidize other fiscal stimulus programs, including its own operations where it became an active participant not only in the credit markets with accelerated QE and various lending facilities, but also in the equity markets. The Fed is independent and did not have to print. The problem of course is that from a practical standpoint the Fed is the weak sibling to the fiscal side of the house.
The Fed ought not to have lended to individual companies, nor should it have participated in the equity markets which is against the Fed’s 1913 charter. The Fed got around this rule by hiring BlackRock to conduct ETF trades on the Fed’s behalf (a good chunk of that capital ended up in BlackRock funds).
Naturally, as one would expect given that corruption seems to be the default position in Washington D.C., a number of Fed officials front-ran the Fed’s activities which was abhorrent behavior. Those individuals were required to step down from their Fed positions including the Fed Governors of the Dallas and Boston Federal Reserve Banks. That penalty was a slap on the wrist (Try pulling that stunt as a sell-sider or as a buy-side investor).
Now, Fed Chair Powell is determined to fully break the two primary bubbles the Fed created – equities and housing – as he seeks to regain credibility (his primary motive) and to fight inflation (his secondary motive) in the process.
3.) The Fed says unemployment is too low, the labor market is too tight. Really? The employment situation is not as strong as the Fed and other politicians would have us believe. For example, consider the weak labor force participation rate which has yet to fully recover from its COVID lows. Also consider corporate headcount reductions over the last few months as well as growing credit card balances. These are symptoms of a weak economy. We believe the consumer, corporations and the economy in general will further weaken in 2023 as the Fed maintains elevated interest rates combined with a stagnant to shrinking monetary base.
- Weak Labor Force Participation: We have pointed investors to the weak Labor Force Participation Rate since Q3 2020 as evidence that the job market was not strong. Employers have had a difficult time filling low-end services jobs because Treasury pumped households full of money (approximately $5 Trillion Dollars in 2020 and 2021 subsidized by the Fed’s money printing operation). The chart below details the income/welfare programs that the Federal Government rapidly expanded during and after the COVID-lockdowns and plots those welfare Dollars against the Labor Participation Rate. These welfare programs exceeded $2 Trillion in 2020 and 2021 and will exceed $1 Trillion in 2022. Meanwhile, Labor Participation has barely recovered. I wonder why?
- Corporate headcount reductions: The past few months have been marked by weakness, especially in sectors such as retail (Amazon was not the only retailer that saw weakness and expects further weak economic conditions in 2023). Companies across industries are cutting headcount as the cost of capital has dramatically increased as the Fed has raised its Fed Funds Rate while simultaneously reducing its balance sheet.
- Increased consumer borrowing is a sign of weakness, not strength: The fact that consumers have increased their credit card borrowing has nothing to do with the economy reopening post COVID and everything to do with consumers dipping into credit to pay their bills. The cost of living has increased significantly in 2021 and 2022 (far greater than reported CPI figures). I believe that investors have finally come around to the fact that today’s higher credit card balances are a sign of consumer weakness rather than strength.
4.) Asset prices have rolled over: The NASDAQ Composite Index and other equity indices have rolled over as the Fed has raised rates and shrunk the monetary base. The housing industry has slowed both in terms of sales activity vs. inventory levels and has seen valuations decline since August. How much more value destruction does the Fed have to witness before it puts on the breaks? Monetary policy operates with a lag in terms of its full impact on the real economy. Sure, credit card issuers and banks adjust in real time. Equity and Credit markets adjust in real time. The real economy however recalibrates more slowly.
- Risk assets have re-priced lower: The chart below is a bit of an eye test. Clicking the source link below the chart will take you to the interactive view. The takeaway is that as the Fed has decreased the monetary base, it has reduced the value of risk assets from equities to housing to private companies to crypto to you name it. How much more value destruction does the Fed have to observe before it lets up? There is a better way to slow inflation without destroying the economy.
5.) A shared, small government philosophy where fiscal and monetary policy take a back seat to the real economy and private markets. I realize this is a dream. Our founding fathers did not foresee the career politician. Some 250 years ago elected officials served in Congress for brief stints as most members of the House and Senate had businesses to run at home which they handed over to family members to run while they served in office. Many Congressmen returned home to find their businesses decimated by mismanagement. People served their country out of a sense of duty, not as a career choice. Today’s career politician is primarily concerned with staying in office. That politician believes in buying votes through various welfare programs such as stimulus checks, unemployment checks, child tax credits, gasoline credits, pandemic relief programs and the like. We put numbers to these programs in the first chart in this article which excludes Social Security, Medicare and a variety of other programs which we could have categorized as social welfare programs. All told, welfare programs in the aggregate are approximately 30% of U.S. GDP.
The problem is our economy does not produce enough goods and services to where Government tax receipts (already at punitive levels), are sufficient to pay for the various welfare programs and other fiscal spending areas. Therefore the Federal Reserve monetizes fiscal deficits by printing money, which is why the Dollar has lost approximately 98% of its value since President Nixon took the U.S. off of the Gold Standard in August 1971. Here is our high-level recipe for repairing economic conditions in a long-term sustainable manner:
The Fed / Monetary Policy:
- Get the Fed Funds Rate in line with the 2-year Treasury yield. Hold that rate steady for an observation period of several months before deciding whether or not to take further rate action (up or down). Longer-term the Fed Funds Rate should be 1-2% above headline CPI.
- Pause QT and hold the monetary base flat for an observation period of 3-4 months. Our sense is that inflation as measured by the CPI would exit 2023 in the 4-5% range if the Fed held its policy rate in the 4% range while keeping the monetary base flat to very modestly up. 5-6% growth in the money supply has historically resulted in 1-3% CPI. The Fed ought to keep money supply growth in the 2-3% range in order to hold CPI flat. There is not a valid reason to aim for 2% CPI growth each year. CPI growth equals Dollar value destruction. We will feel economic pain as companies and the Federal Government roll over debt at much higher rates. We have got to work through this pain. I believe it is more important to have positive real rates along the entire yield curve than to have ultra low rates. Ultra low rates will further expand the debt bubble which will accelerate the destruction of the Dollar. There is no fiat currency that has ever survived over the long-term. Our debt-funded economy will only pull the Dollar’s demise forward.
- End QE.
Congress / Fiscal Policy:
- Reduce welfare spend as a percentage of GDP.
- Don’t spend what we can’t afford. Refrain from policies that require the printing of new Dollars where that printing is not directly tied to Productivity.
- Refrain from transfer payment policies such as the stimulus checks of 2020 and 2021. These left pocket, right pocket programs exacerbated the inflation problem. I know, you want to buy votes, but you are killing the American consumer with the inflation tax which is the equivalent of taxation without representation.
- Reduce corporate and individual income taxes. The Reagan tax cuts helped pull the U.S. Economy out of recession in 1982. Lower taxes will increase the supply of goods and services and are therefore deflationary. I am in favor of repealing all income taxes and replacing them with a sales tax (pay-as-you-go), for companies and individuals.
- Slim down regulation. Repeal punitive regulations that only add costs that are passed on to the consumer. Start with the oil and gas industries.
- End all subsidies. Stop subsidizing various industries at the Federal and state levels. The Government needs to get its hands out of private markets so that competition may thrive which can only benefit the consumer. The Healthcare and Insurance industries come to mind as does “Green Energy”. We would not have electric cars nor windmills without tax credits.
- Remove constraints on the U.S. Energy industry. Allow the United States to become Energy independent once again. The fact that we import oil and gas is outrageous.