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The Powell of Positive Thinking

Yes: Federal Reserve Chairman Powell was very hawkish at his Congressional testimony on Tuesday and Wednesday. He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. He additionally signaled that the peak probably will be higher than previously signaled (I’ve been saying and thinking 5% for a while, but it’s going to be higher), and even signaled the increasing likelihood of a return to 50bp hikes after the recent deceleration to 25bps.

This latter point, in my view, is the least likely since all of the reasons for the step down to 25bps remain valid: whether the peak is 5% or 6%, it is relatively nearby and the confidence that we should have that rates have not risen enough should therefore be decreasing rapidly. Moreover, since monetary policy works with a lag and there has been very little lag since the aggressive tightening campaign began, it would be reasonable to slow down or stop to assess the effect that prior hikes have had.

But here is the bigger point, and one that Powell did not broach. There is really not much evidence at all that the Fed’s hikes to date have affected inflation. It is completely an article of faith that they surely will, but this is not the same as saying that they have. Consider for a moment: in what way could we plausibly argue that rate hikes so far have been responsible for the decline in inflation? The decline in inflation has been entirely from the goods sector, and a good portion of that has been from used cars returning to a normal level (meaning, in line with the growth in money) after having overshot. How exactly has monetary policy driven down the prices of goods?

This is not to say that higher interest rates have not affected economic activity, and this (to me) is the real surprise: given the amount of leverage extant in the corporate world, it amazes me that we haven’t seen a more-serious retrenchment. Some of this is pent-up demand that still needs to be satisfied, for example in housing where significant rate hikes would normally dampen housing demand substantially and seems to have. However, there is a severe shortage of housing in the country and so construction continues (and home prices, while they have fallen slightly, show no signs of the collapse that so many have forecast). Higher rates are also rippling through the commercial MBS market, as many commercial landlords have inexplicably financed their projects with floating rate debt and where the cost of leverage can make or break the project.

Higher interest rates, on the other hand, tend to support residential rents, at least until unemployment eventually rises appreciably. I think perhaps that not many economists are landlords, but higher costs tend to not result in a desire to charge lower rents. On the commercial side, leases are for longer and turnover is more costly, but the average residential landlord these days is not facing a shortage of demand.

So where have rate hikes caused inflation to decline? Judging from the fact that Median CPI just set a new high, I think the answer is pretty plain: they haven’t. And yet, the Fed believes that if they keep hiking, inflation will fall into place. Where else can we more plainly see at work the maxim that “if a piece doesn’t fit, you’re not using a big enough hammer?” Or maybe, this is just a reflection of the notion that if you want something bad enough, the wanting itself will cause the thing to happen. [N.B. this is really more in line with the prescription from Napoleon Hill’s classic book “Think and Grow Rich”, but the title of Peale’s equally-classic “The Power of Positive Thinking” suggested a catchier title for this article. Consider it poetic license.]

Moreover, what we have seen is that higher interest rates have had the predicted effect on money velocity. Although I have elsewhere noted that part of the rebound in money velocity so far is due to the ‘spring force’ effect, there is substantial evidence that one of the main drivers of money velocity is the interest rate earned on non-cash balances. Enough so, in fact, that I wrote about the connection in June 2022 in a piece entitled “The Coming Rise in Money Velocity,” before the recent surge in velocity began. [I’d also call your attention to a recently-published article by Samuel Reynard of the Swiss National Bank, “Central bank balance sheet, money, and inflation,” where he incorporates money velocity into his adjusted money supply growth figure. Reynard is one of the last monetarists extant in central banking circles.]

Now, nothing that I have just written is going to deter Powell & Co from continuing to hike rates until demand is finally crushed and, according to their faith but in the absence of evidence to date, inflation will decelerate back to where they want it. But with long-term inflation breakevens priced at levels mirroring that faith, it is worth questioning whether there is some value in being apostate.

  1. Philippe
    March 8, 2023 at 5:15 pm

    Rates cuts were not so effective to stimulate inflation. What was were the forced savings and cash stimulus from he pandemic. Very naively then, could the symmetric measures be considered? As much as we all hate it, that would be increasing taxes, wouldn’t it?….

    • March 13, 2023 at 2:55 pm

      Well, if you increase taxes and don’t spend it – balance the budget – then yes…that would be anti-inflationary. Those seem like long odds against, though!

  2. Andrew Fately
    March 8, 2023 at 6:10 pm

    It must be a feature of government that officials choose to believe something that they think sounds good is in fact the best plan going forward regardless of a lack of evidence or physical constraints

  3. March 12, 2023 at 4:34 pm

    It’s all about tools available to the FED. They are charged with the objective of maintaining price stability. What else IS in their ‘tool box’ ?

  4. Andy H
    March 13, 2023 at 9:30 am

    Will events like the SVB bankruptcy impact upcoming fed decision making?

    This SVB bankruptcy also high lights that many banks have not increased interest rates on bank accounts and CDs but people and businesses see the opportunity to move to Treasuries with higher rates. So I have a perception that there is a big outflow of funds from the banks to the Treasury. Is there data to backup this perception?

    • March 13, 2023 at 2:54 pm

      Yes – deposits actually shrank recently for the first time in decades (maybe ever). But they normally slow when interest rates go up. That’s what higher velocity IS: lower demand for cash balances. Higher market interest rates make it less palatable to hold cash balances earning next to nothing. When rates are at zero, you aren’t losing anything holding a checking account balance. When rates are at 5%, you’re losing a lot. So yes, this is actually pretty normal. Well, not the fact that the bank examiners didn’t notice this was happening months and months ago. That seems new.

  1. April 1, 2023 at 9:55 am

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