With Limited Tools and More Limited Economic Bogey Men, the Fed Makes it Worse

“The present danger, however, is not so much that current and planned moves [by global central banks] will fail eventually to quell inflation… It is that they collectively go too far and drive the world economy into an unnecessarily harsh contraction. Just as central banks ... misread the factors driving inflation when it was rising in 2021, they may also be underestimating the speed with which inflation could fall as their economies slow.” 

 Maurice Obstfeld, former chief economist at the International Monetary Fund and former chair of the economics department at UC Berkeley

Home sales in my neck of the woods, Los Angeles, are down 28%. Mortgage rates, which were well under 3% at the beginning of the year, are now averaging 6.7%. The prime rate, the interest rate paid by banks’ best customers, just hit 6.25%. Most of us, when we borrow, can expect to pay several points above that, and credit card interest is soaring above 20% way too often. There is almost no way to increase interest rates by .75% (which Wall St calls 75 basis points) three times in a few months without impacting employment. And Wall Street is not exactly happy about that set of increases either, as the above CNBC headline bumper suggests.

The Federal Reserve has a few basic tools at its disposal. For example, it can increase M1 money supply (colloquially called “printing money”), it can control the rate at which the Fed lends to banks (the “Fed rate” which is the subject noted above), it can buy debt instruments that are putting a drag on financial institution (“quantitative easing”), they can define liquidity requirements and internal banking regulations, etc. Sounds like a whole lot of control, and while that is true, when they face a monolithic problem (like “inflation”) that they themselves ignored for too long, their hands are tied, their tools mostly relegated to manipulating interest rates.

Although the members of the Federal Reserve Board are presidential appointees, confirmed by the Senate, they are not under either presidential or congressional control once appointed. The current head of the Fed, Chairman Jerome Powell, was appointed by both Donald Trump and Joe Biden. His full term is fourteen years. So, if there is a popular groundswell against Fed policies, there is no direct way for those policies to be vetoed by our federally elected representatives. This allows the Fed to impose unpopular policies, suffering for the masses on occasion, and there is no realistic popular recourse to reverse those decisions. 

By choosing a label, focusing on a problem through that chosen lens, the Fed tends to react in very traditional ways. For example, “inflation” is traditionally countered by higher interest rates to cool down the economy. But if the hotness of the economy is only a partial explanation, a simplistic rate hike just might be the wrong signal, especially if that rate hike is implemented too quickly and at rates that are too high… to create policies without waiting to see the impact of the last rate hike on the economy. That impact might not kick in for a year or more.

We all believe that an inflation rate of 8% of more is too high (it’s 10% in the Eurozone!)… but the Fed has zero control over one of the most significant contributing factors, the impact of Putin’s war against Ukraine on the global cost of fossil fuels and foodstuffs. But as Michael Hiltzik points out in his September 29th OpEd in the LA Times, the Fed just might be making a bad situation so much worse: “We have a term for the intentional infliction of pain on others: cruelty. So what are we to make of the Federal Reserve Board?

“The Fed, in statements associated with its campaign to bring down inflation, has referred to the challenge of bringing about a ‘soft landing’ — that is, reducing inflation without significantly slowing the economy or even provoking a recession… Asked at his Sept. 21 news conference about the consequences of the Fed’s efforts at ‘restoring price stability,’ Fed Chairman Jerome H. Powell replied that ‘no one knows whether this process will lead to a recession or if so, how significant that recession would be.’…

“As Powell observed, the question is how to do so without imposing the pain of the process on those least able to shoulder it — job holders, especially those with lower-income jobs who might be the first to be fired in a recession… What may be more pertinent to the current economic situation is whether the Fed’s rate increases thus far this year have already achieved a good part of its goal. The answer to that is: We don’t know.

“That’s why a growing chorus of economic experts is saying that the danger of the Fed’s policy is no longer that it won’t move aggressively enough to cool price increases, but that it is moving too aggressively… Their argument is that the Fed, like other central banks that have followed its lead in raising rates, has not given its prior rate increases time to take effect… The consequences of overshooting the inflation mark could be dire.

“We reported this summer on the alarming notion, increasingly popular among economic policy wonks, that inflation could not be brought down without an increase in unemployment along with a slowdown in wage growth… Its most uncompromising iteration came from former Treasury Secretary Lawrence H. Summers, who told a London audience that “we need five years of unemployment above 5% to contain inflation — in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.” (The U.S. unemployment rate, as measured in August , was 3.7%.)

“Powell appears to have accepted this general idea, if not Summers’ specific figures. ‘We’re never going to say that there are too many people working,’ he said Sept. 21. ‘We have got to get inflation behind us. I wish there were a painless way to do that — there isn’t.’… The Fed’s current tightening is the fastest since the early 1980s, observes Kathy Jones, an interest rate expert at Charles Schwab & Co…. ‘The rapid pace of tightening raises the risks of a more significant downturn in the economy in the near term,’ Jones wrote after the last rate increase. ‘Monetary policy works with a lag. Changes in interest rates today can take a year or more to have a significant impact on the economy. Since this has been the fastest rate hiking cycle in decades, a lot of tightening has already taken place and may have yet to work its way through the economy.’” Even as the Fed announced its most recent rate hike, inflation was already cooling. How many unemployed workers will pay for the Fed’s sins?

I’m Peter Dekom, and an over-anxious Federal Reserve, knowing it waited too long to act, seems to be voting to cause the very recession they are trying to avoid.