Fed's Phase II
Macro Perspectives
In Wednesday’s Macro Perspective I mentioned we are in a hot economy, where demand is being throttled by the Fed.
This was intended to be a reminder, with all of the recession talk, that this is not the economy of the post-financial crisis decade - the Fed is holding the beach ball under water.
With that, I posed the question, "what happens when the Fed backs off (let's go)?"
Some say that's precisely why they won't.
That makes sense, assuming they had a choice. They don't. They have this thing called debt service to think about.
Let's take a look at what the Congressional Budget Office (CBO) has said about the sensitivity of debt service to the Fed's tightening campaign.
If rates rose faster than their projections, they estimated that each 100 basis points higher would equate to $187 billion in additional annual interest costs.
Indeed, they have undershot a Fed that moved 425 basis points in nine months.
The result: About a quarter of a trillion dollars in additional interest payments for 2022. This year, if the Fed does what it projected in December (5.1% on the Fed Funds rate), and if the 10-year yield reverts to its historical average spread of 90 basis points (above the Fed Funds rate), the Fed will have inflicted another $600 billion of interest payments on the U.S. government.
That will be funded by larger and larger deficits - compounding an already massive, and unsustainable, government debt-load.
Ironically, this unsustainable debt problem is precisely why we need inflation. We need to inflate away the value of the debt. But it only works if, simultaneously, we have hot growth. And it only works if wages reset/adjust to maintain the standard of living.
So, if we're lucky, we've just seen phase one of this inflationary environment, where the Fed normalizes interest rates. Now, phase two should be a Fed that sits tight, let's growth bounce back (driven by the mountain of new money created over the past three years), inflation will bounce back with it, and, as they are doing in Japan, policymakers should encourage employers to raise wages.
PS: A quick note to the readers of Macro Perspectives, thank you. I appreciate you taking the time to read through my thoughts, I hope you’ve found it useful and hope to continue providing value going forward.
Have yourselves a great Friday.
Given global and domestic inflationary pressures, it doesnt seem sustainable for BOJ to maintain YCC for an extended period of time. But their decision to keep policy unchanged can be interpreted to reflect a strong desire to exit in a controlled manner.
Even widening the band was a marked change at the end of last year after decades of ultra-loose monetary policy.
The BoE is very clear that its different approach to bringing inflation down – i.e. the recession will do the job – runs the risk of leaving inflation higher. The approach of the Fed and now the ECB – namely, to take rates to restrictive levels and maintain them there whilst also letting the economic downturn takes its effect – seems to be more focussed on indicating a clear and hawkish intent to break the back of inflation.
Have I understood correct that this is what happened to Boe and Boj ? They needed to back of and start intervene again?