E-piphany

People are worried about rising interest rates at the long end of the curve. “The Fed should raise interest rates,” they say, “to bring interest rates down.”

Just a quick rationality check there: read the sentence a couple of times.

I know you’ve been told that long interest rates go down when the Fed has ‘credibility,’ and they can only have credibility if they raise rates. That’s double-poppycock. First, because when the Fed raises interest rates, interest rates go up even at the long end of the curve. Don’t believe me? Here’s the 30-year bond yield, plotted against the Fed funds rate. I want you to find for me the place where the Fed tightened and yields fell. Go ahead, I’ll wait.

Now, I’m not saying that yields never go down when the Fed is hiking, or vice versa. It’s just very rare. And yields move around for lots of reasons, so sometimes Fed funds and long yields move in the opposite direction for spurious reasons. But it is super clear that the main driver of long interest rates is short interest rates.

I said it’s double-poppycock. The second way is because the notion that the Fed (or new Fed Chairman Warsh) will only have credibility if it raises rates is actually an embedded double-poppycock. First, because the Fed doesn’t have any credibility and hasn’t for years…unless you meant in the macro (but important) sense that people believe the Fed will ride to the rescue during a calamity. They don’t have any credibility as inflation fighters, because (a) until recently they hadn’t had to fight inflation for 35 years, so there was little opportunity to build inflation-fighting credibility and (b) the one time they did, they screwed it up so bad that they’re still fighting the inflation they created, five years later. The second of the embedded double-poppycocks is that raising rates is just the wrong thing to do, because raising rates without reducing money growth causes velocity to rise and inflation to accelerate.

Warsh has been pretty clear that to fight inflation, the Fed needs to shrink the balance sheet and slow money growth, and they can do that while lowering interest rates. I have no idea why people think that means he wants to raise interest rates, or needs to. But these are the same people who are seeing headline inflation jump because of rising gasoline prices and then tell you it makes it more likely the Fed is going to tighten.

Poppycock. Actually, double-poppycock. First, because rising gasoline prices affect mainly headline inflation and the Fed doesn’t even focus on headline inflation; second, because rising energy prices tend to slow growth, and historically the Fed has erred when they didn’t ease into a growth shock.

Now, having said all of that…there are currently some bad signs for inflation that the Fed should address by shrinking the balance sheet as quickly as they can. It was disheartening to head Chairman Warsh utter the poppycock (just one) about the system needing ‘ample reserves.’ The system did just fine for generations when the Fed had an extremely skinny balance sheet. The bigger problem now is that interest rates have risen enough that even if the Fed sold all of the bonds in the portfolio, it couldn’t drain nearly as much as they added by buying those bonds back when they were goosing things in 2020.

But here is the thing that I don’t hear people talking about, at least in the context of inflation and monetary policy:

The economy is just not slowing down very much…maybe it is just beginning to?…despite tighter financial conditions from higher interest rates and a supply shock from higher energy prices. Yeah, the 30y bond is at 5.2%. Where is that having an impact on growth? Higher rates mean less cash-out refinancing to help sustain consumption, a greater propensity to save (which is after all why market interest rates rise, to induce savings because other sources of dollars aren’t keeping up with the demand for dollars), and a stronger dollar which weakens foreign demand for our goods. Higher energy prices are, to be sure, a zero-sum game financially when we are mostly self-sufficient in energy, but historically higher energy prices have slowed ex-energy growth.

The fact that this isn’t happening, and that equities are not appreciably declining despite higher interest rates, is concerning because it suggests – to me at least – that there is too much liquidity in the system. M2 is rising at 5.5% y/y, and that’s too fast in the current environment (as I’ve pointed out before). It’s rising at a 7.2% annualized rate over the last 6 months.

And that’s happening partly because the Fed has been growing the balance sheet, not shrinking it.

It doesn’t feel like that is enough to explain the bulletproof economy, so it may be that there’s shadow liquidity from (for example) the growth of stablecoins. Now, economic growth is not a bad thing in itself, and growth doesn’t cause inflation. But if the amount of money growth is accelerating, and the benefit from holding non-cash balances is increasing (tending to raise velocity), and that’s enough to keep the economy pushing right through an energy shock and the higher cost of money…then to me that says it’s going to be hard to keep it from leaking into prices. The Fed does not need to hike rates – that would only make things worse. The Fed needs to take stern action on the balance sheet, though, and soon.