Three Longs & Three Shorts

What if the Fed is Wrong?

Author: Roger Lowenstein
Source: Roger Lowenstein’s blog ( )

The unprecedented amount of monetary and fiscal stimulus in the developed world has not only pulled the global economy of the Covid scare but on various measures triggered a strong and broad-based economic recovery to the extent inflation in the US has hit a 30yr high. This has in turn driven the need for tightening liquidity (which the Fed has now begun) and potentially raising interest rates. The Fed has been arguing that some of the inflation is transitory given Covid driven supply constraints and hence should ease as global supply chains normalise. This piece evaluates the consequences if Fed is wrong in this assessment. Roger Lowenstein, the American journalist, famous for his thrilling book – When genius failed: The rise and fall of LTCM, takes arguments from both sides of the debate to help us understand which way we are likely headed. The article is from earlier this month – since then Jerome Powell has been reappointed as the Fed chair and of course, a new variant is threatening another set of Covid related restrictions to the global economy.
“The Fed continues to say that rate increases are many months or even a year away. Its argument is that inflation is caused by transitory supply-chain issues, which will eventually moderate.
But the Fed did not anticipate the supply-chain problem, did not anticipate the inflation that resulted from it, did not (once inflation emerged) anticipate how acute or persistent the problem would become.”
So he suggests that the Fed should rather look at facts than try predicting. And what do the facts say? Some are on the Fed’s side:
“Mark Zandi, the chief economist of Moody’s Analytics, rejected the suggestion of a one-point rate hike with the observation that, even given last month’s booster shot of a half-million new jobs, the U.S. remains four million jobs shy of the pre-pandemic peak. A sharp rate hike would jolt markets, even “shock” them, Zandi said.
…Julia Coronado, President of MacroPolicy Perspectives, sloughed off the comparison to the 1970s, when inflation rose to double digits (a period that left my generation traumatized). She noted that, unlike in the salad days of Jimmy Carter, the U.S. dollar now is not under pressure from foreign currencies….Coronado also acknowledges that the labor market has been tighter, and demand stronger, than expected. And therefore, inflation has been “stickier.” Although she expects absent workers to return, relieving pressure on wages, “There is some risk that the labor market remains tight and a self-reinforcing dynamic between wages and prices develops.” She hasn’t seen it yet, and she is confident that were this to occur, the Fed would quash it.”
“The argument on the other side is simply that every day that banks lend overnight money at zero percent, it adds to the inflationary fires. Lending at zero when inflation is 6% is an invitation to borrow, because the debt can be repaid with depreciating dollars. Borrowing is how money is created. Just so, in the last year, M2, a measure of the money supply, has risen 13%. This is a source of classic monetary inflation, as distinct from the supply-chain driven variety.
…If the labor market is flourishing at a 0% interest rate, it will also do fine at 1%. Indeed, that would still be five percentage points below the inflation rate, which the textbooks would describe as radically stimulative.
On the other hand, if the Fed is spiking a generalized inflation, it will want to reverse course before the potential ‘self-reinforcing dynamic’ Coronado alluded to gathers steam.
…“Putting everything together,” Mankiw sums up, “The Fed should — and likely will — tighten sooner than they previously anticipated.
“I worry that they might move too slowly, as any rapid change in policy would in effect admit that their previous thinking was mistaken. And the Fed, like everyone else, hates admitting error.”
The irony is that easy monetary policy is starting to hurt workers, one group that the policy is designed to help. Inflation is more than offsetting wage gains. Since January, real wages are down 2.2%.
This is uncomfortable for Biden, to say the least. No incumbent wants to face a midterm election when gas, grocery, and other prices are soaring.”