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Anatomy of a Monetary Policy Error

Well, it isn’t as if no one warned that monetary policymakers were eventually going to get painted into a corner. Long before the Covid crisis, there were many voices warning that the Fed’s tendency to ease aggressively, but to find excuses to tighten slowly, would eventually get them into trouble. And here we are.

The Federal Reserve, prior to the Ukraine/Russia war, had started to talk hawkishly about raising interest rates; that talk, combined with 40-year highs in core inflation, persuaded Wall Street economists that the Fed would raise interest rates by more than 200bps this year.

That was never going to happen, even if Russia had not invaded Ukraine. Not since the early 1980s has there been a tightening cycle of at least 200bps over 10 months that also ended with the overnight rate above where the 10-year rate had been at the beginning of that period. So the calls for 200bps of tightening with the 10-year rate under 2% was always an incredibly aggressive call. Moreover, those cycles where it did happen occurred in an era when the Fed Chairman didn’t go in front of the cameras every meeting to explain why the Fed was ‘trying to increase unemployment’ – and, in fact, back in those days almost no one outside of the financial community paid much attention to the Fed at all. Plus financial leverage, ancient source of dramatic accidents, was much lower then. So my operating assumption has always been that the Fed would probably tighten about 3 times this year, pausing in between each hike…or maybe hiking 4 times and then easing once. Especially since the Fed no longer controls the marginal reserve dollar (there being copious excess reserves), the effect of monetary policy moves is less clear…and this also mitigates in favor of taking time to assess the effect of policy moves by watching the economy evolve. Ergo, this tightening cycle was always destined to be late and halting, and focused on interest rates rather than on money supply. Such a trajectory already qualifies as a ‘mistake’ when inflation is threatening 8%.

But now there’s even more room for error. Because the skyrocketing energy prices trigger another mistaken belief at the Fed, which enhances the desire to tighten even slower/later.

The Fed thinks that rapid energy price increases have this effect on the economy: rapid increases in energy prices tends to cause slow growth or recession as those increases consume discretionary income and leave less for non-energy purchases. And recession causes a decrease in pressure on other resources, such as labor. Which, in turn, leads to lower pressure on core inflation. Since energy prices are mean-reverting (at least, the rate of change is!), the central bank is “supposed” to ignore inflation that is caused by energy price increases, since if they tighten according to some Taylor-Rule-like dictum then they’ll tighten into a recession and increase the amplitude of the business cycle. Ergo, the Russian invasion of Ukraine means that the Fed should tighten less.

However, that’s not the way this works.

Rapid increases in energy prices do in fact tend to cause recession. But inflation is not caused by too little economic slack, and disinflation is not caused by too much slack. Inflation is caused by money growth, period, and M2 money growth is currently above 12%. It is true that an increase in energy prices would lead to a decline in non-energy discretionary spending, which would limit core inflation, if money growth was low. But if money growth is high, the increase in energy prices just rearranges the relative price changes because there is plenty of money to go around. It doesn’t change the overall impact of the rapid money growth. (Small caveat: a scary recession would increase the demand for precautionary cash balances, lowering money velocity…but people are already holding such precautionary balances so it’s hard to see how that could be a large effect from this level). Ergo, when the Fed slows down its tightening campaign because of the way they believe inflation works, and especially if they decide to not shrink the balance sheet – because “higher long-term rates would be bad in a recession” – they won’t have any real effect on growth but they’ll be accommodating a much higher level of inflation.

And just like that, you have it. The genesis of a really colossal monetary policy error. Get ready.

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