Reflecting on Rates

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For the last few months now, I have been suggesting that the Fed needs to move the Fed Funds rate up much faster than they have been, arguing that they are not only “behind the curve” given their failed “transitory” position, but that they have totally lost the narrative as far as taking a “hawkish” stance is concerned.  

My suggested approach to rate hikes has been for the Fed to move in the range of +100 to +125 basis points at each scheduled meeting (of 2022) as well as implementing random “emergency” intra-meeting rate hikes and setting an overall target of at least 8.5% by as soon as conceivably possible.

Obviously, this may seem a bit extreme from the standpoint of the “recency bias” of our current distorted economic times as well as the current level of debt carried widely by households, firms and the Federal government, but historically, this approach is actually very modest.

The following chart displays the annual rate of change of the consumer price index (i.e. the inflation rate) (in blue), the 30-year fixed mortgage rate (in red) and the effective Federal Funds rate (green) as well as the upper-range target of the Fed funds rate (in light green) in order to present the Fed’s actual current target.

Traditionally, the Federal Funds rate (the green line on the chart above… click for larger interactive version) , particularly during periods where inflation was clearly “unmoored”, has always matched or been well above the rate of inflation as measured by the year-over-year change in the consumer price index (the blue line on the chart above… NOTE: you could also use the annual change of the PCE index, the Fed’s preferred inflation measure but CPI is historically the measure that is reported for inflation as well as the measure feeding into COLA calculations and the like, so I’ll stick with this comparison for now).  

Of course, there are notable exceptions, for example, during the two post-recessionary periods following both the “DotCom Recession” and the “Great Recession”, the Fed’s policy rate remained below the rate of inflation for extended periods in an attempt to breathe life back into the respective lackluster economic expansions.

But when it comes to periods where the immediate concern is NOT “deflation” but instead “inflation”, the Fed has either targeted or allowed the Fed Funds rate to float well above the rate of inflation in an effort to contract the money supply and thereby stamp out inflationary pressures.

Shifting our focus to the long-end of the yield curve, another important inflationary relationship is found in comparing the 30-year fixed mortgage rate (the red line on the chart above) to both the consumer price index (rate of annual change) and the Fed Funds rate.

Notice that since the mid-1970s, the 30-year fixed mortgage rate has ALWAYS been well-above the rate of inflation (as well as the Fed Funds rate), which is to be expected, when considering the lengthy maturity of these bonds and the fact that lenders are primarily concerned with the risk associated to the high probability of inflation when pricing this type of debt.

I say “always” but actually since March 2022, the inflation rate (i.e. annual CPI again) has been running above the 30-year fixed mortgage rate and WELL above the Fed Funds rate, a truly anomalous situation that is begging for a resolution.

Either the 30-year fixed mortgage rate has to go up considerably (minimally about 300-400 basis points to 8-9%) or the rate of inflation needs to come down considerably or a bit of both.

One thing is for certain though; the current 1.50% Fed Funds rate is way to low to make a notable difference in either bringing down the rate of inflation or influencing the yield curve enough to instigate the 30-year fixed mortgage rate to guide up.

Remember, I’m certainly not suggesting that raising rates this aggressively is convenient for either debtors (particularly massive ones like the Federal government) or the central bankers at the Fed and their global counterparts.

I’m only pointing out the very simple and sensible historic relationship of these rates and suggesting that since, as Chair Powell noted today, “[Central Bankers] now understand better how little we understand about inflation”, they should have now learned that their recent efforts are simply not enough.

They either want to stamp out inflation, or they don’t.

Jumbo Loans, Jumbo Problems

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Something stinks in jumbo mortgage-ville.

For all of my adult life, the interest rate for jumbo loans has been at least a quarter percent (or more) above the rate for conforming loans, but recently, this relationship has flipped.

Recall that the primary goal of the massive “Government Sponsored Enterprises” (GSEs) Fannie Mae, Freddie Mac and Ginnie Mae, is to provide more affordable housing financing to the American population.

The GSE mortgage backed securities (MBS) come with an implicit guarantee (that was shown to be actually “explicit” when Fannie and Freddie were taken into conservatorship during the worst years of the Great Recession) of the “full faith and credit” of the United States government, thereby allowing this market in mortgage securities to exhibit the preferential pricing of near-riskless investment grade securities to the benefit of borrowers seeking lower rates of interest.

By contrast, the private, “non-conforming” lending market (i.e. loans that do not conform to GSE limits/standards …the market in “Jumbo” loans) would logically demand higher rates of interest given that private lenders financing this market are shouldering the full credit risk and not gaining the benefit of an implicit or explicit government guarantee.

This generally meant that the private lenders would perform more due-diligence when originating loans, demanding more down-payment (i.e. more skin in the game), and were more critical of home appraisals, and, further, made the loans at higher interest rates as compared to GSE lending.

Since early 2022 though, this relationship appears to have flipped with jumbo loan rates falling below conforming rates in the range of 25bps – 100bps! In my market, a local bank lender is advertising jumbo loans at a full percentage less than conforming loan rates.

The following is the Fed FRED visualization (click for larger dynamic version) showing the relationship of the 30-year fixed rate conforming versus Jumbo loan rates since 2017.

Clearly there is a different risk-return calculus being performed in the current private lending market that appears to have significantly influenced the pricing of potential risk coming from the performance of these loans.

One explanation could be that the underwriting is very strict allowing private lenders to provide highly preferential interest rates but I have my doubts given some of the dynamics that I have observed in my local market (Boston… a real bellwether housing market) during this cycle.

First, while there is no comparison between now and 2006 (the height of insanity that was the Great Housing Bubble) in terms of “creative lending”, there appears to be another gremlin afoot.  

In 2006, there were a plethora of creative loan products allowing borrowers to stretch to reach ever higher home prices (i.e. affordability loans); the negative/reverse amortization loans, interest only options, low documentation or no documentation (liar loans) together were all complicit in pushing home prices to their maximum in an effort to keep the party going for borrowers/buyers and the loan volume for originators/lenders.

Today, you don’t see these types of loan products advertised widely though I’m sure there are some examples that can be cited. What you do see though, are completed sales like the following (I have calculated the over-list sale amount for convenience as well as obscured the exact addresses):

Notice that these homes, generally speaking, are fairly typical 3 and 4 bedroom homes (one 5) in the suburban Boston housing market.  From my perspective, these are NOT exceptional homes. They are the types of homes most middle to upper middle-class families should expect to be able to afford at some point in their financial life.

But look at the prices and, more importantly, the outstanding over-list bidding wars!

This is nothing short of insanity and there is NO WAY prudent due-diligence was properly exercised by the lenders during the appraisal and underwriting process of these transactions.

I believe that this anecdote is revealing the most important Achilles' heel of the latest cycle of booming real estate, namely, that private lenders fell back into the same trap as the Great Recession housing boom, over-lending with the assumption that residential real estate is immune from market downturn.

Buyers, for their part, clearly went hog-wild throwing nonsensical sums at bidding wars in an effort to win a property at any cost.  This is to be expected with inventories so low and mortgage rates so favorable over the last two years, but the gatekeeper to the sound financing of these transactions is the banking system which should have prevented such madness but appears to have, again, failed that systemically important function.

I have no doubt that we are about to witness a severe housing downturn as prices within property markets across the country briskly reset downward as the ongoing surge in interest rates continues.

It will take some time, of course, given the snails-paced speed with which transactions settle in the residential housing markets, but the lesson we will learn from this new Housing Bubble 2.0 is no different from what we learned the last go around, namely, what goes up, must come down!

Durable Goods Orders – Consumer Demand Destruction Imminent

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 Today’s release of the Durable Goods Manufacturers’ Shipments, Inventories and Orders Report (M3) showed that new orders for manufactured durable goods increased in May by $1.9 billion (adjusted for seasonality, but not for inflation) or 0.7 percent to $267.2 billion while new orders for durable consumer goods declined by 0.62% to $42.9 billion.

The relationship between consumer sentiment and manufacturers’ new orders for consumer durable goods is pretty obvious as a pullback in consumer sentiment generally precedes the destruction of demand for consumer durable goods.

Given the historic pullback in the University of Michigan’s Consumer Sentiment Survey, it appears clear that we are about to see a significant pullback in consumer durable goods spending.

While this is the precise demand destruction that the Fed is looking to achieve with their new “inflation fighting” interest rate policy, to date, the decline in consumer sentiment consumer durable goods spending is likely primarily coming as the result of higher consumer spending on non-durable goods as rising prices for food and energy are forcing consumers to make hard spending choices. 

The following data visualization (click for dynamic version) shows New Orders for Consumer Durable Goods (in blue) on the left axis and the University of Michigan Consumer Sentiment (in red) on the right.

Notice the significant gap that needs to close in order for the current level of new orders for consumer durable goods to match the current level of consumer sentiment.  

Obviously, we should look for a significant decline in new orders for consumer durable goods in the months ahead.

Reflation Gave Way to Inflation

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It is surprising how many macroeconomic commentators propagate the false notion that “quantitative easing doesn’t cause inflation” typically offering up some esoteric accounting of the Fed’s balance sheet or the difference between bank reserves and currency in circulation or the highly structured means by which the Fed implements QE or some other means of obfuscating, through needless complexity, the obvious goal of this unusual monetary policy tactic.

Let’s recount for a moment the reason the Fed began “quantitatively easing” in the first place.

Back in the fall of 2008, in the face of the almost continuous flow of horrific economic trends for housing and the wider economy and in the wake of the collapse of Bear Stearns and Lehman Brothers, the Fed finally “blinked” and went beyond their normal policy tools to engage the crisis head-on with an approach that was new to the American economic landscape, namely, Quantitative Easing (QE).

The following two articles (click for larger versions), published at the start of the Fed’s QE1, paint the picture well:

Note the air of crisis and desperation as American’s and those worldwide with economic interests tied to the American real estate markets were truly panicked over fate and fidelity of the American economy.

QE1 was a one-two punch of zero percent interest rate policy (ZIRP) on the short end of the yield curve (the Fed’s traditional Fed Funds rate policy) coupled with an ad-hoc targeted yield control tactic on the long-end by the Fed participating directly in the mortgage market through mortgage backed security (MBS) purchases from Fannie and Freddie, the large government sponsored entities (GSEs) that essentially make the conforming mortgage lending market.

It’s important to note that the Fed’s purchase of GSE MBS was NOT simply an effort to force mortgage rates lower but, by the fall of 2008, the mortgage market was essentially completely impaired leaving the Fed to literally step-in to replace the collapse in demand for these securities with their own artificial demand.

Losses coming from imploding sub-prime mortgages as well as near-prime and even prime were mounting steadily as vast swaths of new or recent home buyers (the top of the market buyers) decided to mail the keys back to the lender (jingle mail) rather than suffer the further downside coming from steadily falling home prices, thereby grinding the mortgage market to a halt.

This was a catastrophic outcome for the highly financialized and highly complex mortgage finance system and without the Fed’s artificial purchase of MBS re-liquefying the market in mortgage lending, home prices would have likely fallen on the order of 40%-50% nationally rather than the roughly 25% that the Fed successfully held it to.

So, put more directly, the Fed’s QE MBS policy not only work to depress rates for mortgages, it also LITTERALLY MADE THE MARKET for home loans from 2008-on as the Fed transformed from a lender-of-last-resort to, ultimately, a permanent fixture in mortgage finance.

By 2010 and on into 2011, it was becoming clear (at least to me here, here, here, and here) that QE was here to stay, a fact that would leave an indelible and fundamental mark on our economic landscape as our highly financialized debt markets would simply adapt to accommodate the Fed’s participation on an on-going basis, thereby allowing this falsehood to permeate deeply into the dynamics of the system.

In fact, it has been recently estimated that even today, roughly 30% of the overall U.S. mortgage market is directly financed by the Federal Reserve, a startling fact made even more alarming by the realization that the Fed’s QE was not just limited to the purchase of MBS but also Treasury securities thereby working to artificially finance Federal debt just like it worked to finance mortgage debt.

This level of support was not just done in an effort to simply fend off “deflation” (a specifically expressed goal of the policy) but also to evoke a “reflation” of the markets and bubbly conditions that existed prior to the crisis in an effort to blunt the trauma felt widely by firms and households thereby working to sure-up systemic confidence.

The result of all of this Fed action is pretty clear as the crisis steadily abated and confidence and sentiment gradually improved throughout the 2010s leading to a notable and lengthy bull market in stocks, a steady reflation of the housing markets and a major improvement in outlook for the economy more generally.

But this “reflation” was, in fact, a form of inflation as it is quite clear that price levels of most asset classes (and probably even consumer prices) would be much lower today had the Fed not stepped up to “rescue” our economy from this notable bout with deflation.

Further complicating matters, by early 2020, the COVID-19 panic circumvented the Fed’s initial attempt to walk back some of this extraordinary support again putting the it directly in the position of “savior” of the economic system, for which again it leveraged ZIRP and QE to do battle with a major economic crisis.

But unlike in 2008, the post-COVID economy was already replete with hot money having benefited from over a decade of historically accommodative easy monetary policy and almost euphoric attitudes coming as a result of ongoing stock market and housing market “wealth effects” on firms and households.

The Fed’s COVID-era ZIRP and QE and the Federal government’s massive fiscal actions (PPP and various stimmies also funded by Fed Treasury QE) thereby worked to transform the prior economic “reflation” into literal, unadulterated “inflation” as economic participants caught in the volatility of the pandemic began to thrash wildly about throwing hot money at speculative absurdities like high-flying frothy stocks, endless cryptos, meme-stonks, NFTs, SPACs and a new wave of totally insane real estate speculation.

Now, with inflation clearly “unmoored” and with literally no easy pathway out of this maelstrom of economic insanity, the Fed and the economy more generally, will finally have to square off with the inescapable reality of this challenging period.

Reality is an Unavoidable Imposition

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Arguably the most unique trait of the human condition is our unbridled inventiveness. 

Reading the transcript of Blake Lemoine’s “interview” with LaMDA, Google’s remarkable, and possibly sentient AI, makes that perfectly clear but also highlights the potential for this type of ingenuity to overrun the current limits of our capacity to forecast the impact and, ultimately, the cost of such creativeness.

Putting aside whether or not LaMDA is truly sentient for the moment, reading the exchanges got me thinking (with my software engineering consultant hat on… my day job) of the amazing ways that I could leverage a service like LaMDA within my existing software application domains and further, how it could redefine the role of the user within such applications.

More specifically, with a service capable of generating real original intelligence and insight (either about data analysis or protocols or policy or art or culture or whatever!) on demand, bolted into functional software applications, I began to wonder, where does the user fit-in within this equation?

In a sense, we already delegate our raw math and calculation needs over to the magical micro-processor that is far more capable than we at executing such tasks (almost magically so), once we can easily delegate intelligence just as effortlessly, what is left for the human to do?

My guess is that we “humans” will be more available to do the one thing that we have always excelled at… invent and re-invent anew.

But our inventiveness, whether in academia and philosophy, industrialization and finance or pure hard science and technology, has generally come with significant overshoots leading to natural, catastrophe-punctuated, growth spurts as new modes of operating usher in immense bouts of “creative destruction”, continuously laying waste to the ever outmoded present.

Nowhere is this “two-steps-forward and one-step-back” pattern more pronounced than in high-finance and the economic domain.

As I have pointed out previously, we have a great capacity to engineer financial matters; so much so, that we routinely overrun the bounds of prudent and sensible financial conduct and leverage our great means of financial inventiveness to irresponsible ends. 

The last several decades of financial inventiveness brought about a financial system that was so abstracted and structured and securitized and digitized and market-ized so as to allow for a massive expansion in general debt and then, once the economic picture soured sufficiently, allowed the Fed, with its supposed limitless access to new monetary base, to just drop in and engage in direct “open market operations” as the apex-lender/buyer of last resort bailing out the entirety of the economic system.

The idea that our central banks, albeit during an historic and painful financial meltdown, could essentially finance large portions of formerly functioning markets (mortgage backed securities) or even nations (the U.S. Treasury securities) was beyond ambitious… it was just plain reckless.

Reality though eventually imposes itself on all human ingenuity and in so doing, reacquaints us with the basic “real world” parameters by which we are all ultimately bound and forced to abide by over the long run.

The process of our current realization of this harsh reality, for the economy, appears to be playing out with each passing day.

The Fed and the Federal government choose to leverage our financial system’s integrity in order to bailout and backstop the 2008 Great Recession which further set the precedent for continuous use of such techniques since then and, finally, an epic second incarnation of this approach once the COVID pandemic panic set in.

Now, with real evidence of runaway monetary inflation and an abrupt pivot to a new policy regime, the Fed, challenged with living up to meet its primary mandate, is forced to do an extended and likely very painful battle to reestablish its credibility thereby regaining some measure of squandered systemic integrity.

As this rout unfolds, one has to wonder what the world will look like in two to five years after a major “one-step-back” has reacquainted our dreamy and inventive human sensibilities with the fundamental bounds of cold, hard reality.

The Unmooring of Inflation Expectations

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It’s been so long since our last bout with entrenched inflation that many, if not most, Americans including policy makers and central bankers, have likely forgotten how inflation expectations become “unmoored” and what that truly means for the fight ahead.

Recently, Federal Reserve of St. Louis president James Bullard addressed current inflation and the potential downside risk:

“The current U.S. macroeconomic situation is straining the Fed’s credibility with respect to its inflation target,” Bullard said.

Bullard noted that, in the past year, near-term inflation expectations of financial markets, households and businesses have risen. He added that the current divergence between actual inflation readings and expected inflation based on Treasury Inflation-Protected Securities will have to be resolved, possibly resulting in still higher inflation expectations.

“In the 1970s, inflation expectations became unmoored, and it took years for the Fed to bring inflation back to lower levels. The real economy was also volatile during this process,” Bullard said.

Like a ship adrift on the open ocean, once inflation expectations have become “unmoored”, the population’s concern for inflation is free to float off aimlessly into the distance getting ever further from where it was once very stably anchored.

Then once blown about by the epic squall of emerging economic headwinds, re-anchoring inflation is no small task given the momentum it gains and the forces and erratic volatility that comes of it once it really starts to run wild. 

At this point, I believe that it’s safe to say that the Fed has fully lost the narrative.  

Everywhere you go people are talking about inflation in one form or another; rising gas prices, food prices, new car availability and prices, used cars availability and prices, outlandish home sales bringing stunning bidding wars with $200K, $300K and even $500K over-list contests.  The effects of hot money appear to be everywhere!

It’s starting to really interfere with the normal operations too, as was well testified by a totally unsolicited discussion I recently had with an older, local restaurateur.  He seemed simply in pain as he recounted how difficult times have gotten.  After over two years of struggling to keep his business afloat throughout the pandemic, now he is stretched to the absolute limit by increasing prices.  My bill too, as it was easily up 30-40% over what I paid just about a year ago.

But this small anecdote pales in comparison to the damage done by the Fed’s inaction and the administration’s totally incompetent and confused approach to “leadership”.

The Fed’s insistence that inflation was “transitory” only to be forced to walk back that terminology back and pivot to a more nuanced language about Ukraine, China lockdown supply chain issues and ongoing COVID disruptions that only imply “transitory” represents a completely misjudged or misguided approach to managing market expectations.

Either the Fed does not understand that the inflation we are seeing today is general monetary inflation coming as the result of over 13 years of recklessly easy monetary policy (QE, ZIRP) and still believes that the current exogenous events are causing it or they fully understand the truth but are simply unwilling to indicate so publicly.

In the latter case, the Fed would have been wiser to have at least indicated early on that monetary inflation could be responsible while also citing the other causes that they preferred it be rather than going all in on exogenous “transitory” sources only to look completely out of touch once inflation persisted further than “transitory” could have ever implied.

Amazingly though, Powell and the other members of the FOMC have not appeared to have learned from this mistake, indicating yesterday that:

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The invasion and related events are creating additional upward pressure on inflation and are weighing on global economic activity. In addition, COVID-related lockdowns in China are likely to exacerbate supply chain disruptions. The Committee is highly attentive to inflation risks.

Again, they are essentially doubling down on “transitory” by placing such an emphasis on temporary conditions being the source of the persistent inflation while only vaguely implying that there is some other source by stating “creating additional upward pressure”… additional to what?

The “what” is exactly what they apparently do not want to discuss too openly, namely general monetary inflation that they themselves (including former Chair now Treasury Secretary Yellen) created in their effort to act as the apex-lender-of-last-resort after the Great Recession and ongoing to today.

By not being forthright about the cause of inflation, they will continue to appear hopelessly out of touch and uninformed, exactly the opposite of what is needed in order to truly regain the confidence of the markets.

The administration, on the other hand, has been nothing short of a total disaster attempting to control the inflation narrative like they would any purely partisan political issue.

Whether it’s an appearance on popular late night television or various inflation-themed photo ops, the administration appears to believe that you can just talk inflation down by assuring the public that the executive “feels their pain”, but this is absolutely the wrong approach. 

Like the Ford’s absurd “Whip Inflation Now” campaign or Carter’s sad and depressing fireside chats, trying to control inflation by simply messaging (regardless of the message) the public directly, is counterproductive at best.

What the public needs to see in order to be convinced that the administration is on the right track in the battle with inflation is simply one thing, action.  

This can come in many forms; a call for Congress to tighten the budget to avoid further deficits, reopening or expanding cancelled or stalled energy sources (pipeline, coal, gulf rig counts, Anwar oil fields, etc.), working to smooth disruptions in global trade and supply, negotiating new agreements with other trading partners, eliminating any vestige of pandemic related encumbrances.

But our current administration is missing this point entirely and thereby squandering this very brief moment where the inflation story is still not deeply ingrained within the American collective psyche.

Taken together, the Fed’s mischaracterization of the source of the inflation and the administration’s lack of leadership is currently working to seriously undermine confidence, thereby sowing the seeds of a prolonged bout of persistent entrenched inflation as the public learns to expect ever-present uncertainly, volatility, cost pressures and a lack of vision from the authorities tasked with leading the way out of this difficult period.

FOMC Statement Critique (June 15th 2020)

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The following is the complete text of today’s FOMC statement with my comments inline:

Overall economic activity appears to have picked up after edging down in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.

Sold: While the above is somewhat accurate, there have been many instances of inflation-driven headwinds coming from retailer earnings, slowing reported retails sales, historically low consumer confidence and CEO guidance.   Further, given that we are probably at the literal turning point for employment, the above sentiment seems a bit backward looking at this point.

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The invasion and related events are creating additional upward pressure on inflation and are weighing on global economic activity. In addition, COVID-related lockdowns in China are likely to exacerbate supply chain disruptions. The Committee is highly attentive to inflation risks.

Sold: While there is no doubt that the Ukraine affair and the continued COVID disruptions are contributing factors to the inflation that we are currently seeing, the above statement is a major misstep and shows a pretty significant lack of judgment.  

This rational is quickly becoming the new “transitory”, or “inflation peaking” charade as the Fed is looking to obviously temporary conditions for an explanation of the inflation that we are currently seeing.  Notice that they say “additional upward pressure” implying that these temporary conditions are only part of the explanation of inflation and that they don’t call out any other instigator.  

This is a risky move given that inflation will likely continue on beyond these temporary conditions or will show itself to be greater than what can be reasonably accounted for by these disruptions leaving the Fed, yet again, looking unprepared and out of touch with the economic climate.

Obviously, the inflationary instigator that the Fed wishes to avoid highlighting is the plain and simple monetary inflation that they themselves caused by 13+ years of reckless quantitative easing (QE) and zero-percent-interest-rate (ZIRP) policy.

Until the Fed, and particularly Powell, own up to exactly what we are facing, they are doomed to forever be behind the curve on confidence and credibility.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 1‑1/2 to 1-3/4 percent and anticipates that ongoing increases in the target range will be appropriate. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in the Plans for Reducing the Size of the Federal Reserve's Balance Sheet that were issued in May. The Committee is strongly committed to returning inflation to its 2 percent objective.

Sold: This is a generally strong statement as the Fed is forcefully indicating their intent to continue moving forward with their balance sheet normalization plan but the Fed Funds rate range is so paltry compared to the latest reads on inflation.  

The following details where inflation is as of April:

• Consumer Price Index (CPI) 8.5% 
• Personal Consumption Expenditures (PCE) 4.9% 
• University of Michigan inflation expectations 5.4% 

Bear in mind that these data-points are all a bit lagged and have likely to truly capture the intensity of the inflationary pressures coming from rising energy (particularly gasoline) prices as of late.  The Feds Federal Funds rate will need to get a lot closer to the general inflation rate in order to reach the 2% goal that the Fed currently purports to desire.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; James Bullard; Lisa D. Cook; Patrick Harker; Philip N. Jefferson; Loretta J. Mester; and Christopher J. Waller. Voting against this action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate by 0.5 percentage point to 1-1/4 percent to 1-1/2 percent. Patrick Harker voted as an alternate member at this meeting.

Sold: Apparently Esther George concluded that a 50bps hike was sufficient either given the yet to be fully realized effects of the two prior hikes or as a result of the obvious impact that these hikes have been having on financial markets, but in any event, the consensus was for the more substantial hike.

Frankly the Fed should have gone with an even bigger +100bps or +125bps hike given that “inflation physiology” is in full swing among the general population.  Going in to today’s meeting, the Fed was clearly behind the curve, coming out, it appears that at best they singled their willingness to take up the fight but with inflation raging and the narrative fully unmoored, it is hard to truly see today’s announcement as actually catching up. 

The Great Moderation Gives Way to the Great Agitation

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When Ben Bernanke in 2004 (prior to his chairmanship but as a Fed governor) detailed his thoughts on the various causes of the “Great Moderation” to the Eastern Economic Association, little did he know that he was, ironically, right on the precipice of the beginning of the end of this unique period.

Generally defined as a period of decreasing volatility where firms, households and institutions could rely on a steadier, stable and predictable macroeconomic backdrop, the Great Moderation is generally accepted to have begun in 1984 after the Fed’s successful defeat of the rampant stagflationary period of the 1970s.

As recounted by Bernanke:

“In particular, output volatility in the United States, at a high level in the immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early 1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary policy performed quite poorly, relative to both earlier and later periods.  Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.”

Bernanke then goes on to detail various possible causes of this period of stability, digressing into voluminous explanations involving the Taylor Curve, and ends by roughly concluding that “improved performance of macroeconomic policies, particularly monetary policy” was likely the main instigator: 

“I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.”

What is completely absent from Bernanke’s assessment though are the significant instances where the Fed itself worked specifically to moderate volatility thus thwarting normal market function in the name of a new implied Fed mandate of “economic stability” and, over the long run, setting up the circumstances for a new emerging era of significant, possibly uncontrollable, volatility and tumult.

In response to the “Crash of 1987” then Fed Chair Alan Greenspan, barely two months in office,  snapped into action directing the Fed to function in its role as “lender of last resort” supplying liquidity through their open market operations and issuing a statement providing, in clear and unequivocal terms, the Feds position on the matter.

“The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system".

And with that one statement Greenspan, singlehandedly, created the “Fed Put” (once called the Greenspan Put), an implied guarantee that the Fed would always work to place a floor under the stock market in the interest of maintaining the stability of the financial system.

The “moral hazard” created by this single Fed policy change is hard to overstate.  

Markets are nothing if not a risk discounting mechanism and by injecting itself into the downside portion of the risk calculus, the Fed severely disrupted normal market function, distorted investor’s perception of risk and particularly kneecapped the process of creative destruction.

From that point on, the Fed assumed a new implied mandate, namely maintaining “economic stability”, to add to their existing primary functions of maintaining “stable prices” and “maximum employment”.

But Greeenspan did not stop there, with the Fed’s new implied “economic stability” mandate expanding in 1989 from simply covering systemic shocks coming as a result of stock market loss to also providing a bailout backstop against losses incurred by banking and financial interests, specifically the savings and loan thrifts of the late-1980s “Savings and Loan Crisis”, in an effort to contain the impact of numerous insolvent institutions on the financial system. 

“Arrangements have been established for the provision of liquidity support to savings and loan associations by the Federal Reserve Banks and the Federal Home Loan Banks,” Greenspan said in February 1989 in a joint statement with M. Danny Wall, chairman of the bank board.

Expanding this implied mandate even further still, Greenspan in 1998, in an effort to contain the potential systemic shocks coming from the abrupt collapse of the highly leveraged hedge fund Long Term Capital Management, brokered a private $3.6 billion dollar bailout by a number of financial institutions.

“Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own,” Greenspan said.

Yet, Bernanke speaking in 2004, never mentions this obviously consequential shift in Fed policy in his analysis of the causes of the Great Moderation’s lower volatility and, not surprisingly, once confronted with similar systemically damaging circumstances as Greenspan faced, Chairman Bernanke blinked in the face of the fear of the fallout coming from the collapse of the massive housing bubble in 2008 and took the Fed to epic levels of support, backstopping and bailing to an extent that Greenspan probably could have scarcely imagined.

Finally, over a decade later, the COVID-19 panic was met by current Fed Chairman Powell with more of the same, seeing the Fed immediately slash their primary policy rate to the zero-bound and re-engaging the quantitative easing schemes created by Bernanke in an effort to specifically to ensure against economic instability coming from this outsized exogenous shock.

But now, after 35 years of bailing and backstopping and freighting levels of monetary creation, inflation is finally raging and the actual cost of all of this “moderation” is coming due.

The “Great Moderation” era has finally and fully relented to a new, polar opposite age, the “Great Agitation”, where not only will the Fed not have the ability to moderate volatility but, instead, will be forced to create volatility by imposing “tight” monetary policy. 

While many believe that the Fed will ultimately have to give up its aim of tamping down inflation and ultimately continue expanding the monetary base in support of the stability of the economic system and the solvency of the Federal government, my sense is that this perspective is misguided.

If the Fed were to continue to attempt to expand the monetary base in the face of rampant inflation and against a backdrop of an inflation narrative that they have completely lost control of, it would be a system ending maneuver.  There would be no more need for additional accommodation since there would be no remaining vestige of a legitimate economic system to protect.

What we can expect from the coming years of “agitation” should be pretty predictable as volatility generally brings unrest and resentment and societal tumult, and while there is a plausible, even likely possibility of a positive outcome from this reckoning, clearly, the pain will be widely felt and the stakes are very high.

The Better of Only Bad Options

The Fed’s back is firmly against the wall and no amount of sanguine Fed-speak or modern monetary engineering is going to do anything to change that fact.  Now is the time for action and an honest recognition of what is truly at stake for the economy. 

The only reasonable path forward, at this point, is for the Fed to face the challenge head-on and fight inflation with every “tight money” tool at its disposal. 

After 13+ years of recklessly “easy money” policy and more than double that duration of literally nurturing “moral hazard” through market bailouts and backstopping (Crash of 87, LTCM, DotCom/911, Housing Bust, COVID) the Fed and the Federal Government have reached the final leg of the “Great Moderation” period and the start of a new era that will be marked by extremes, volatility and a decidedly less temperate tone.

We have come a long way since the waning days of our last most extreme secular cycle when, in 1983, then Federal Reserve Chair Paul Volcker finally succeeded (determined in hindsight of course, since this fact was still unknown to his real-time vantage point) in breaking the back of persistent inflation by disabusing all market participants of the notion that an easy money environment would soon return.

An article published in the UK’s Sunday Telegraph dated July 10 1983 captured the sentiment well: “Back in 1979 Volcker jerked the Fed Board out of the old habit of playing the monetary game by Wall Street rules.  The big shift was the policy change on the money supply.  No longer would the Fed jump every time the Wall Street money markets moved a shade over desired limits.  The Fed’s old tools of measuring the money supply – the M1, M2 – were refurbished for greater statistical accuracy.  The Fed policy was to set a desirable growth rate for the various aggregates and let market rates seek their own level.”

When asked at a congressional hearing in mid-1983 if he thought long term interest rates would ever return to the 5% or 6% range (rates being nearly double that at the time of the hearing) Volcker stated “I hope those days aren’t gone forever.  If you have confidence in a stable financial environment over a long period of time, those types of interest rates would be quite normal.  It’s going to be very hard to get back to that climate, because everybody has lived through the late 1960’s and late 1970’s.”

Fast forward to today and the legacy of The Maestro, Helicopter Ben and Dovish Yellen and Powell have taken their toll and instilled quite the polar opposite sense in today’s market participants.  

Speculators, traders, bankers, financiers, business owners and average Americans alike are all dazed by frothy liquidity and simply cannot believe that the easy money regime is actually over.

Watching the business media pundits cycle go through endless loops of conjecture over the prospect of the Fed’s next 25 or 50 basis-point rate hike and whether the peak of inflation may already have been reached given the Fed’s recent action seems laughable in contrast to the severe struggles against “public enemy number one” that persisted throughout the 1970s and 80s when the Federal government even went so far as to engage the public in a misguided and nonsensical battle to “whip inflation now”.  

If the fact that 25 or 50 basis points would seem like a rounding error in the era of Volcker were not bad enough, consider that this is happening against the backdrop of a Fed that has made this regime changing lift-off from the literal zero bound.

The market and all its participants are rate-sensitive in the extreme with expectations that are wildly outlandish and even childish as an ever coddled financial system has gotten weaker and less capable of accepting even economic conditions that would have seemed exceedingly favorable for most of modern history.

Further, there is almost a sort of incredulity to this era where many observers express total disbelief that the Fed would (or could) ever actually wage a legitimate war against inflation instead, as some observers predict, choosing to somehow inflate its way out of this inflation problem in an effort to spare the Federal government from the consequences of its own, self-imposed, albeit immense, debt liabilities.

“The Fed does not want to engage inflation, but would rather inflate the debt away…” one observer noted, “always has and always will be the easiest and preferred choice of central banks.” While another observer notes “Hyperinflation or default -- both end badly of course.  But hyperinflation probably takes longer to play out and is harder to pin blame on than an outright default so it is the preferred option of politicians and central bankers.”

Many even astute macroeconomic observers believe that the Fed will give up on pivoting to a tight money regime and revert back to a loose money posture at the first sign of stress, but is this truly a realistic scenario?  Could the Fed be so weak an institution that it will fold immediately shirking its primary responsibility and dooming the whole American economy and particularly millions of American households to a death by a thousand cuts future risking general social stability and even the real prospect of a hyper-inflationary end-state?

Let’s look to a short passage from Miami Herald dated October 14, 1979 to gain some valueable real world perspective about the cost of unmoored inflation particularly in the American context:

American’s back in the late 1970s learned that letting persistent inflation run amok risked the stability of the entire economic system as every single household, firm and institution struggled to each independently cope with the chaos caused by such extreme economic circumstances.  This widespread volatility and ultimately the economic hardship that was caused, was felt unevenly resulting in a sense of inequity that spilled over into the social and political realms creating instability in the truest sense of the term.

The Fed, motivated by the fear of widespread systemic instability, won’t let this happen again.

In 2008, as the economic crisis caused by the collapse of the national housing markets was bearing down on the economy and causing similar hardships to households, firms and institutions (except from an decidedly deflationary perspective), the Fed panicked leading it not only to act but to overreact to the circumstances and stopped at nothing to blunt the effects of that period and, in their view then, rescue the economic system from disaster.

Today will be no different as the Fed recognizes the inflation to be unmoored and persistent and holds firm to the tight money posture in an effort to secure the stability of the overall economic system even as the pain endured by higher interest rates is widely felt.

Granted, this pain will likely most notably be felt by the Federal government itself as the portion of the federal budget allocated to servicing the outsized national debt grows substantially leading to hard decisions about national priorities.

But it is important to note that the entirety of the federal debt doesn’t just immediately get refinanced at higher rates in-line with the Fed’s interest rate policy but instead guides up over time as portions of the existing debt mature and new debt is issued at the prevailing higher rates.

The Federal government will need to make some hard choices in the form of real cuts to spending that will have real measurable effects on some households and firms but as bad as a new era of fiscal austerity may seem, it is unequivocally the better option if given an alternative of the rapidly and even violently eroding living standards and life savings of most Americans coming as the result of unchallenged and unchecked inflation.

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Countdown to Minsky Moment

Today, like 2007, the economic zeitgeist is marked by a palpable sense of significant headwinds and the uneasy feeling of oncoming disaster.

True, the uncertainty and potential risks driving this sense of doom now are very different from the circumstances that existed then, but every cycle always brings a unique set of challenges and a distinctive narrative as to why markets overshot and why they are bound to revert to the mean.

This is simply how history rhymes… the precise circumstances don’t just play out over again but instead, provide a rough guide that an astute observer can leverage to navigate the ever evolving market conditions.

With that said though, there are some repeated dynamics that effect every cycle that play out like basic truisms coming as a result of the fundamental foibles of human behavior as expressed collectively by the market.

For example, the “boom-bust” cycle itself appears to be a “two steps forward and one step back” natural growth scheme whereby, collectively, market participants seemingly are always willing to take the optimism of the growth phase of expansionary market environment a few steps too far and ultimately have to suffer a major set-back when the system rebalances.

Further, at the height of every the “boom phase”, there are always some activities that, in retrospect, were obviously completely frivolous speculation fueled by the blinding fever dream of fast and easy riches.

Finally, the average speculator and other naïve participants always seems to struggle to recognize when the boom is over leading them to inaction, until they are faced with incontrovertible evidence of the emerging “bust phase” after which, they race for the exists like so many scalded monkeys.

By 2007, the “Housing Bubble” had reached a level that was so clearly an overshoot, that any sensible observer with just basic “rule of thumb” analysis could forecast that trouble wasn’t far off.

Today, we have an “Everything Bubble” marred with numerous frivolous speculations together with a Fed finally willing to stimulate a “prick” providing the risk of a major reversion.

Given all the obvious headwinds, one has to wonder at what point will come the “Minsky Moment”, namely the sudden collapse of asset values as market participants finally reach a collective panic in the face of the mounting evidence that a major downturn is inevitable. 

While there is no way to truly know, let’s see if we can gain any insight in tracking today’s evolution of panic by comparing the current trends in the S&P 500 against the course taken in 2007.

The following data visualization (click for larger view) shows the S&P 500 from the buildup and peak of 2007 bubble overlaid and aligned with the peak of this cycle providing a simple comparison of how a panic can evolve.  Again, history never repeats exactly but this visualization can provide a rough point of comparison and some valuable overall perspective.

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Now and Then – A ‘Tightwad’ at the Fed

While the current administration struggles to figure out their position on inflation, forcing Treasury Secretary and former Federal Reserve Chair Janet Yellen into an uncomfortable “mea culpa” and current Fed Char Jerome Powell into a pointless public relations photo op, let’s take a look back at our last major inflationary crisis as a point of comparison with my commentary in bold italics.

In October of 1980, a headline read “’Tightwad’ Volcker puts economy through the wringer” with the author detailing some of the Federal Reserve Chair Paul Volcker personal habits and opining that his handiwork had brought interest rates up to a level not seen since Confederate troops threatened to march on Washington.  Further, it was noted by Business Week that “Shattered confidence in the Carter Administration left the president no choice but to select a man who would be instantly hailed as the savior of the dollar, even though that meant bringing in a Fed chairman far more conservative than Carter would have preferred.”  

By contrast, today, the Biden administration is just beginning to recognize how far they are behind the curve.  When Jimmy Carter nominated Volcker, it was an admission of defeat while today Biden is just beginning to recognize that a fight is on.

In March of 1981, another headline reads “L.A. bank raises prime to 17.5” with the author indicating that various banks were bringing their prime lending rates up by 0.5% as a result of “sharp” increases in the Federal Funds Rate and detailing that “Last week, federal funds were trading as low as 13 percent, but the rate jumped above 15 percent this week.”  Further it was noted by a Security Pacific (the L.A. bank) spokesman that “The federal funds rate has gone up 200 basis points and CD rates about 100 basis points,”

The Federal Funds rate jumping by 200 basis points over the course of a few weeks offers a truly comical contrast to today’s endless worry and handwringing over the Feds prospect of going 25 or 50 bps at the next meeting.  Clearly, we are more attuned to and afraid of the impact that increasing interest rates will have on our asset prices likely as a result of being essentially less resilient and more fearful overall.

Another March of 1981 headline reads “Volcker Hopes for Stable Interest” within which Fed Chair Paul Volcker is quoted as saying “1981 could be a really rotten year” for the economy indicating further that “The risk of high interest rates, is there” and further still that “we won’t have a rapid recovery like last year’s.”

Clearly, the early 80s were a very different time.  We now find ourselves in an era where a slight wrong choice of words by even just a random member of the FOMC sends world markets reeling. 

Finally, a July of 1981 headline reads “Volcker cools inflation with high rates” within which it is detailed that “The painful readjustments are taking place, as you can hear everywhere from would-be home sellers and buyers in a market almost wiped out by high interest rates, and from small-business people unable to maintain adequate inventories because it costs them 23 percent for money” and concludes “Some of the complaints [about the Feds course of action] will be frivolous.  Some will be self-serving.  And some will come from those who wonder if the chairman knows what he is doing, or whether he is practicing economic bloodletting.”

After two years with a Federal Reserve engaged in a pitched battle with inflation pushing the U.S. into one recession and on the brink of a second (that was to materialize later that year), there was significant uncertainty about the path forward as notable pain was being felt by households and firms. 

Fighting persistent monetary inflation is not just a simple nominal policy course correction; it is a fundamental process of tightening the monetary system by severely contracting the money supply and thoroughly disabusing all market participants of any ideas that the old easy-money regime will ever return.

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