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My Views on Kevin Warsh as Fed Chairman
I promised last week that I would give you my views about Kevin Warsh. I did so while clearly forgetting that I already have. Having heard more from him, though, I can put more meat on that bone.
I must first tell you that I have a natural tendency to want to believe that our monetary policy institutions can be saved, and so I want to believe that each new Chairperson has a chance. I was optimistic, for example, about Powell (and to be fair he was a definite improvement over Bernanke and Yellen!) even though in the end he turned out to be a fairly normal Fed Chair. I do give him credit for responding to the COVID spike a lot faster and further than I thought he would, especially since he claimed to believe the inflation was transitory. He didn’t do it right, but at least he wanted to.
My hopes, though, have generally proved to be unrequited. In my opinion, the Fed has been in a downward spiral since 1987 when Alan Greenspan took over. I once wrote a book called Maestro, My Ass! and I do not apologize for it. Although we look wistfully on the Greenspan days now, he started several trends in central banking that have been very destructive – the main one being his mission to make the institution’s deliberations and thought process very transparent. But at least he viewed inflation as the primary policy target.
This introduction is meant to point out that while I really want to believe that monetary policymakers eventually learn lessons and course-correct to doing things the right way, I’m no apologist for the Fed. You’ll want to remember this when my enthusiasm for Kevin Warsh comes out, below. Here is my framework – my basic views, expressed ad nauseum on this blog over the years, about central banking and the conduct of monetary policy:
- Monetary policy is best conducted with as little transparency as possible. It is not the Fed’s job to make the water always warm and inviting for investors so that they can lever up their returns without fear. Transparency breeds complacency and causes excess leverage in markets. As I said in ‘Maestro’: make people dig their own foxholes, and they will dig them deep enough.
- The Fed has a truly terrible forecasting record when it comes to inflation, especially. I do have to say that there are some signs of improvement on that score, so maybe the reason it has been so bad for so long is that for 25 years there was nothing to forecast since inflation was fairly low and fairly stable; now that it’s worth researching, maybe they’re learning. Some. But the fact remains that the forecasts are not even remotely good enough to base monetary policy on.
- Because economic data has huge error bars, and gets revised a lot, and forecasts have even larger error bars, it is nearly impossible to reject the null hypothesis that ‘nothing has changed’ with any given data point. It takes a long time and a lot of data to truly overcome the confidence hurdle. Since monetary policy is such an overpowering tool, it generally should be used very sparingly. The Fed should only rarely move rates away from neutral, and only when the cause to do so is undeniable. Yes, this means they will be late. But that’s okay – see point #1 – if people know that they can’t rely on the central bank to save them.
- One of the wisest things Greenspan ever said was that with respect to the dual mandate of price stability and long-term economic growth, the condition of “low and stable inflation” is the environment most apt to produce high long-term economic growth. In other words, the inflation-fighting mandate is primary, and the economic growth goal is secondary – and best achieved by means of achieving the first goal.
- Interest rates have no identifiable causal (lead) effect on inflation.
- Inflation expectations are a result of, not the cause of, inflation.
- The stock of money per unit of GDP is pretty much the only thing that matters for the price level in the long term. (Here is an article with a few of my favorite charts.)
- The implication of 4, 5, 6, and 7 is that the Fed should focus almost exclusively on maintaining money growth at a low, steady pace. This job is hard enough with the proliferation of alternate forms of money!
Now, let’s compare this to what Hopefully-Future-Chairman Warsh said in his confirmation testimony last week.
- Inflation is primary: “Congress tasked the Fed with the mission to ensure price stability, without excuse or equivocation, argument or anguish. Inflation is a choice, and the Fed must take responsibility for it.”
- The Fed should reduce forward guidance. I personally would say eliminate. I’m not entirely clear if Warsh’s desire to reduce forward guidance is because he doesn’t believe the Fed is good enough at forecasting to provide good guidance, because he thinks that too much transparency leads to overleveraged personal, corporate, and financial balance sheets, or because he doesn’t think that the Fed gains anything by trying to restrain inflation expectations. It doesn’t really matter. All three reasons are good. Any one of them is sufficient. If Warsh wants to reduce forward guidance, he’s on the right track.
- He thinks the FOMC should meet less frequently! I love that – again, I’m not sure if his instinct to do it is because he doesn’t think the Fed should be so active, or because he doesn’t think the data changes enough in a month and a half between meetings, or because he wants to be less transparent. Again, all three reasons are good.
- Warsh seems to be a believer in the notion that the rise of AI will pressure inflation downward. I do not share this view (see my article here and by podcast here), although I am a wild fan about Claude. I may be wrong. Warsh may be wrong. The important point here is that Warsh seems willing to wait for evidence, rather than conducting policy as if the Fed’s models about what could happen was in fact evidence. This is wisdom. I am absolutely content to be optimistic about the effect of AI right along with Warsh… as long as we don’t adjust policy on the basis of a guess.
- In general, Warsh seems to believe that the Fed should be less-active with respect to interest rates; he has also expressed an opinion that the Fed’s balance sheet should be smaller and is a general skeptic about relying on the balance sheet to adjust monetary policy. Unlike many at the Fed, he thinks the size of the balance sheet is related to the level of inflation and interest rates. He is absolutely correct about this and it may be fair to say that this is one of monetarists’ core objections to how monetary policy has been conducted since Bernanke. Warsh dissented on QE and LSAP (large-scale asset purchases) back during the Bernanke days. Shrink the balance sheet, and that will let you lower interest rates a little bit as inflation recedes. Absolutely. When the Fed shrinks its balance sheet – which was first expanded in an effort to stave off deflation; remember Bernanke’s helicopters? – it will reduce upward pressure on money growth and that will directly slacken upward pressure on inflation.
I don’t know if Warsh can pull off such a monumental pivot. Institutions resist change, and the Federal Reserve is a big institution. But it is a pivot worth making! If Warsh succeeds (and if I’ve correctly laid out his views), it will restore the Fed to at least its mid-1980s glory. Well, maybe “glory” is a bit strong…but this is one case in which going backwards would be a drastic improvement.
They’re Starting to Come Around on Rent Inflation
For a couple of years, I have been relentlessly defending my forward inflation forecasts against a sizeable group of people who looked at various high-frequency rent indicators and concluded that rents were going to be imminently in deflation. (For most of the last year many of those same people thought tariffs would be a large and immediate effect increasing inflation. Fortunately for them, being wrong on both counts, at least the errors offset somewhat.)
This battle began in early 2023, shortly after the publication of new indices by the Federal Reserve Bank of Cleveland, supported by a paper entitled “Disentangling Rent Index Differences: Data, Methods, and Scope” by Adams, Lowenstein, and Verbrugge. Those authors parsed the BLS rent microdata to separate out the new tenants, and created a “New Tenant Repeat Rent” (NTRR) Index that supposedly served as a leading indicator of what all rents were going to do. Naturally, NTRR had peaked early and was heading down sharply, which reinforced the observation from things like Zillow, Apartment list, etc that new rents in the aftermath of the post-eviction-moratorium catch-up were declining.[1]
The San Francisco Fed also published a piece in mid-2023, entitled “Where is Shelter Inflation Headed,” by Kmetz, Louis, and Mondragon. Don’t get me wrong, I love it when people try to create better models of inflation processes. But this was another one that made just terrible forecasts, because (as in the former case) it was put together by econometricians who didn’t understand the actual underlying process and thought they could just torture the truth out of the data. They included this wonderful (and subsequently damning, because the Internet remembers everything) chart.
Accompanying that chart was the helpful clarifying statement, in case you didn’t get the import: “Our baseline forecast suggests that year-over-year shelter inflation will continue to slow through late 2024 and may even turn negative by mid-2024.”
In case you were curious, it didn’t turn negative; in mid-2024 it was a bit above 5%.
So back then is when I had to start defending a fairly simple premise: the behavior of landlords when they offer rents to new renters does not necessarily mirror what they offer to renewing renters. In fact, I could be even more strident – landlords could not offer lower rents to everyone, even if they offered them to new renters. That’s because a landlord needs to cover his costs or he won’t be a landlord for long. And in 2023, the costs for a landlord were still rising very rapidly – labor, energy, insurance, taxes, maintenance, and so on. My model – first presented in Enduring Investments’ Quarterly Inflation Outlook in August 2023 – suggested that rents were going to decelerate, but much more slowly than others were forecasting. I had them as low as 3% by mid-2024 before flattening out, and even that turned out to be too aggressive on the disinflation side.
By now, regular readers are familiar with this model and familiar with the fact that it still is calling for Rent of Primary Residence to hang around the current 3% level for quite a while yet. Want ‘em lower? Lower landlord costs.
But this article isn’t meant (only) to pat myself on the back. I also want to recognize when someone gets it right and the great inflation analysts at Barclays recently published an article entitled “Apples and oranges in the CPI basket: Why market rent gauges mislead on shelter,” by Millar, Sriram, Giannoni, and Johanson. It is marvelous article, and you have access to Barclays Live and care about this topic you should read it. While they don’t build a cost-plus model like I did, they got to many of the core reasons why looking at new-renter indices is bound to be misleading. My favorite charts from the piece are below (I also had these in my recent CPI report).
What my model does is tell you why that had to be the case: landlords can’t just lower rents on their whole renter base if their costs are increasing. The only exception to that would be if there had been significant overbuilding such that there was a surplus of apartments over the demand from renters. In some places, especially those currently experiencing a negative immigration shock, that may be the case (although those places happen to also be the ones experiencing large increases in insurance costs, so it’s not quite that easy). But nationwide, there is not a surfeit of apartments for rent. Ergo, no rent deflation. And it’s going to stay that way for a while.
One final note here, about the recent Trump announcement that the Administration desires less institutional ownership of single family homes and apartments. I say ‘desires,’ even though that isn’t how it was phrased, since there appears to be no obvious way that the Administration can force this. They are reportedly looking into whether antitrust regulations can be used to keep institutions from accumulating very large portfolios of shelter units, but this looks like (at best) a task for the legislature, not the executive. But let’s consider quickly what the effect would be if Trump got his way in this regard.[2] Institutions which own homes and apartments don’t hold them off the market. That would be terrible carry. They rent them, just as landlords do. If you forced institutions to divest single-family homes, it would simply move supply from the rental market to the owned-home market. That would probably drive home prices a little lower, relative to the prior baseline, but increase rent growth at the margin. This doesn’t seem productive!
[1] I talked about NTRR in a July 2023 episode of my podcast: Ep.74: Inflation Folk Remedies
[2] Honestly, I don’t think he really means to do this. Some amount of what the President says – especially the impossible things – are intended for consumption by voters. I could be wrong on this. Mr. Trump does have a way of making things happen that didn’t seem possible initially, but in this case there’s probably not much he can do and anyway it wouldn’t have a big impact anyway.
Inflation Guy’s CPI Summary (November 2025)
What better way to end this crazy year than with an economic data point that we don’t know how to really interpret? Happy New Year!
Recall that, thanks to the government shutdown, the BLS released September CPI (by recalling workers to calculate the number based on data already collected) but didn’t do any of the normal price-collection procedures for the prices that are normally collected by hand. That’s far less than 100% of the index, but it’s a lot and so the October CPI was not released at all. Which brings us to today, and the November CPI – where the data was mostly collected somewhat normally. However, the calculation procedures had to be adjusted in ways we don’t really know about. You’d think that the way you do this is that you figure out the value that equates to the price level you just measured, and just say ‘hey, that’s a two-month change’ but it isn’t quite that easy. And some very smart people think this could bias the CPI lower for a few months. Whatever they end up doing, the lack of an October number is still going to mess up all the feeds (e.g. from Bloomberg) and all of the scripts and spreadsheets based on those feeds.
The BLS said in a FAQ yesterday that “November 2025 indexes were calculated by comparing November 2025 prices with October 2025 prices…BLS could not collect October 2025 reference period survey data, so survey data were carried forward to October 2025 from September 2025 in accordance with normal procedures.” In other words, November will basically be a 2-month change. (Or so we thought: see below).
Looking back to the last real data we got, in September: recall CPI was weaker than expected, but a big part of that was because of what looked like a one-off in OER. But the breadth of the basket that was accelerating was increasing, which was not a good sign. Normally the OER question would have been answered last month but…oh well.
Coming into the month…we at least have market data!
There was a big drop in short inflation swaps and breakevens this month. A lot of that is due to the steady drop in gasoline prices (see chart below), but some of it may be because sharp-penciled people anticipated that the BLS adjustment for October’s missed data is going to bias the number lower.
And boy, did it. This number is absolute garbage.
There are going to be two eras going forward: pre-shutdown inflation data and post-shutdown inflation data. Much like when there are large one-offs in the data, as in Japan years ago when there was an increase in the national sales tax rate, the year-over-year data for the next year are going to look artificially low. The BLS never adjusts the NSA data ex-post. If it’s wrong, it stays wrong. We can really hope that this doesn’t affect seasonal adjustments when the BLS calculates the new factors for next year, because that would mean next October’s CPI is going to be massively biased upwards.
Because what it looks like is that for many series the BLS didn’t calculate a two-month change based on the current price level – it looks like, especially for housing, they assumed October’s change was zero so that the two-month change reported for this month was actually a one-month change spread over two months. For example, even with the low Owners’ Equivalent Rent print in September, the y/y figure was 3.76%, so about 0.31% per month. The BLS tells us that the two-month change in OER was +0.27%. That looks more than a little suspicious to me.
Largely from that effect, core services inflation dropped from 3.5% y/y to 3.0% y/y in just two months. Riiiiight.
If in fact these two-month changes are all (or mostly) one-month changes, then the data makes a lot more sense. Either way, it’s hard to believe that the y/y change in Health Insurance dropped from 4.2% y/y to 0.57% y/y, thanks to a -2.86% decline in November from September. Yes, the Health Insurance category does not directly measure the cost of health insurance policies, and October is often when the new estimation from the BLS goes into effect, but a monthly -1.43% pre month decline for the next 12 months in Health Insurance is implausible.
Ergo, I’m not going to show most of my usual charts. This is garbage all the way down. Now, in my database instead of having a blank for October as the BLS does (for many but not all series. Seriously this is going to completely mess up any spreadsheet based on pulling data from Bloomberg), I am going to assume the price level adjusted smoothly over those two months – that is, I interpolated between September and November. That’s naïve, but it’s necessary to assume something and that’s better than assuming no change for October!
I have no idea what this will do to Median. If the Cleveland Fed follows the BLS lead, they’ll report a blank for October and a Median of something like 0.24% for the two-month period (that’s what I calculate), but it’s also garbage because garbage-in, garbage-out.
Really, this is a low point for inflation people and a low point honestly for Inflation Guy. I expected more from the BLS. I spend a lot of time defending these guys (heck, I just wrote a column on “Why Hedonic Adjustment in the CPI Shouldn’t Tick You Off”) because the staff involved in calculating the CPI are solid non-partisan professionals (aka pointy-head types) who really are trying to get as close to the ‘right’ answer as actual data allows. I can’t say that’s true in this case. Now, maybe when we get more data we will discover that the economy has abruptly shifted into something like price stability on the way to outright deflation, and it just happened to have a major inflection in October when no one was looking. But to me, it just looks like bad data.
Policymakers still gotta make policy, even if garbage data is all they have. But the correct response to not knowing what’s happening is not to assume you know what’s really happening and act accordingly – the right approach to extremely wide error bars is to do nothing. The correct approach for the Fed is to do nothing until they have another 3-6 months of data and can start getting some confidence about current trends again. That’s not the world we live in. In this world, the Fed will recognize that the inflation data is squirrelly so their behavioral response will be to ignore it and in the policy context that means that they’ll make policy for a while here based solely on the labor market. Get ready for much more market volatility around the Payrolls report again! To me, that looks like it’s likely to be an ease in two of the next three meetings, before the FOMC needs to recognize that the new inflation data is still showing 3-4% inflation. It’s possible that the Committee could take a pause while they wait for the incoming Fed Chair in May. But the inflation data will not be an impediment to an ease, and will no longer be a strong argument for holding the line if growth data looks weak.
I may be being overgenerous here. It’s also possible this will reinforce the FOMC members’ priors since many of them were utterly convinced that inflation was going to drop significantly due to housing. This, in the presence of bad data, would be a pure error. But the result is the same: an easier Fed than is healthy for the monetary system right now.
There are lots of reasons to think that yields further out the curve will stay stable or rise. But yields at the short end should probably reflect easier money going forward.
Sorry I couldn’t be more help. Here’s looking forward to 2026!
Does Crypto Expand the Money Supply?
We live in interesting times, and let’s face it: mostly, in a good way. It doesn’t have to stay that way, naturally, and it won’t stay that way naturally.
This has always been the weak spot in any system that insists on centralized management of certain functions. Of course, that’s the fundamental flaw and conceit of socialism: it relies on the active intercession of omniscient beings to order activities better than the masses of private actors can. Usually, “better” means “less volatile” to the policymakers who set up the committees of omniscient beings (personally, I would say “better” means “less fragile,” which is the opposite of “less volatile”).
The best argument for using the collective wisdom of the anointed few is to prevent the tragedy of the commons, where individuals making private decisions can impact the use of public goods. And that brings us to money.
I think it is a fascinating question whether ‘money’ is a public good, which should be regulated and controlled. Or is a particular currency, such as the US Dollar, the public good which should be regulated and controlled? The argument the Federal Reserve would make is that, absent the control of the Federal Open Market Committee, the money supply would grow or shrink in dangerous and random ways. Or at least, that would be the argument they would make, if they cared about the stock of money any more.
There is no plausible argument in my mind that “interest rates”, which is what the Fed now works to control, is a public good that is better managed by the Smart Guys. So, weirdly, the Fed now manages something which they don’t have any knowledge about that should supersede private market actors (rates), but does not purport to manage something they could plausibly argue is a common good that no one directly controls (money).
** Separate question: are the Cognoscenti at the Fed any good at it? Chairman Powell said yesterday that the Fed is likely to stop running down its balance sheet soon. With the balance sheet still at 22% of GDP, compared with the pre-GFC normal of about 6% – see chart – “Until the job is done” has apparently become “until it’s time for my smoke break, and then you’re on your own.” What’s the matter with kids today?
So the answer to this ‘separate question’, as inflation remains at the highest level of this millennium and is now headed higher, is “of course they’re not. Why are we even asking that question?”
I actually want to go slightly further. The Fed no longer tries to control the money supply, which at least they might have an argument for doing, in preference to managing interest rates against the market-clearing actions of private actors. But over time (and accompanied by the whining and moaning of central bankers), the concept of money has gotten squishier and squishier. One of the reasons that central bankers want to control crypto is that they fear the power of money loose in the wild (ironically, given that they stopped worrying about money a long time ago), untamed by the Anointed Stewards of Money.
The question is, does crypto expand the money supply? For the purposes of this question, let’s ignore the official definitions of money, M1, M2, M3, etc and just focus on ‘spendable balances.’
If you give me a dollar, in exchange for something that feels like a dollar and that you can spend (say, a stablecoin like USDC), have we increased the money supply? The answer depends on what I do with that dollar. If it is deployed to a vault, then obviously the number of ‘dollarish’ units in circulation haven’t changed. You have minted $1000 USDC, but there are now $1000 USD that are sequestered in a vault and not spendable. The amount of spendable money hasn’t changed. If instead that $1000 goes to buy a Treasury bill from the government, then it is going to the government to spend. Normally, buying Treasuries doesn’t change the amount of spendable dollars, because in buying a Tbill I am deferring my decision to spend (instead, I hold securities) and delegating that decision to spend to the government. I exchange my future spending for the government’s current spending, and in the future that transaction is reversed when the Tbill matures. Some people think that means that Treasury issuance increases inflation because it increases money, but it doesn’t. The Treasury bill is just a token representing my deferral of spending into the future.
But if I was able to buy that Tbill because I issued a USDC token, which you can spend, and then gave the fiat money I received from you to the government in exchange for a Tbill, then I have doubled the number of spendable dollars in circulation: $1000 in the form of USDC, and $1000 in the form of dollars sent to the Treasury which will be spent. Essentially, what has happened is zero-reserve banking. If I were a bank and you deposited $1000, I could lend out only, say, $900 of that (“fractional reserve banking) and in principle the Fed can control that multiplier by changing the reserve requirement.[1] But now you’ve deposited $1000 and I am lending 100% of that to the government. Stablecoin manufacturers in this way are basically banks issuing their own currencies. Now, a lot of that money is going abroad, but it looks like money to me.
Worse are the vaporware crypto issuers who simply create supply out of thin air. If people accept bitcoin as money, rather than as a speculative chip to trade around, then I have created money with no reserves whatsoever, and no limit on how much ‘money’ I can so create.
If this is true, then the irony is that crypto – which was inspired originally by the desire to remove money from the ministrations of the Very Smart Bankers who could ruin money by creating too much of it – could be the very tool that creates the inflation its originators wanted to protect against. In that kind of world, I really don’t understand the use of a nominally-anchored stablecoin. If the overall money supply growth is unbounded and now essentially uncontrollable (once the size of the crypto world gets sufficiently big), then holding something that is pegged to the sinking ship seems counterintuitive to me.
While I didn’t start this article with the intention of pointing out that our USDi coin is a raft rather than an anchor (like stablecoins), it does seem to be relevant here to mention that you can now mint USDi directly from our website: https://usdicoin.com/coin . And, while the increase of USDi will contribute to the overall money supply – at least it has a built-in defense!
[1] …but it doesn’t really work like that any more. The Fed still has a dial to turn that limits how much lending can happen on a given depository base but it isn’t as clean as it was when there was a simple reserve requirement. This is well beyond the point of this article.
The Fault, Dear Brutus, is in R*
I want to say something briefly about the “neutral rate of interest,” which has recently become grist for financial television because of new Trump-appointed Fed Governor Stephen Miran’s speech a couple of days ago in which he opined that the neutral rate of interest is much lower than the Fed believes it is, and that therefore the Fed funds target should be more like 2%-2.25% right now instead of 4.25%.
Cue the usual media clowns screaming that this is evidence of how Trump appointees do not properly respect the academic work of their presumed betters.
If that was all this is, then I would wholeheartedly support Miran’s suggestion. Most of the academic work in monetary finance is just plain wrong, or worse it’s the wrong answer to the wrong question being asked. And that’s what we have here. Anyone who thinks that Miran is an economic-denialist should read the speech. It is mostly a well-reasoned argument about all the reasons that the neutral rate may be lower now than it has been in the past. And I applaud him when he comments “I don’t want to imply more precision than I think it possible in economics.” Indeed, if we were to be honest about the degree of precision with which we measure the economy in real time and the precision of the models (even assuming they’re parameterized properly, which is questionable), the Fed would almost never be able to decisively reject the null hypothesis that nothing important has changed and therefore no rate change is required!
I can’t say that I agree with Miran’s argument though. Not because it’s wrong, but because it’s completely irrelevant.
Sometimes I think that geeks with their models is just another form of ‘boys with their toys.’ And that is what is happening here. The “neutral rate of interest” is a concept that is cousin to NAIRU, the non-accelerating-inflation rate of unemployment. The neutral rate, often called ‘r-star’ r* (which is your clue that we’re arguing about models), is the theoretical interest rate that represents perfect balance, where the economy will neither tend to generate inflation, nor tend to generate unemployment. Like I said, it’s just like NAIRU which is a level of unemployment below which inflation accelerates. And they have something else in common: they are totally unobservable.
Now, lots of things are unobservable. For example, gravity is unobservable. Yet we have a very precise estimate of the gravitational constant[1] because we can make lots of really precise measurements and work it out. Economists would love for you to think that what they’re doing with r* is similar to calibrating our estimate of the gravitational constant. It’s not remotely similar, for (at least) two enormous reasons:
- Measuring the gravitational constant is only possible because we know (as much as anything can be known) what the formula is that we are calibrating. Fg=Gm1m2/r2. So all we have to do is measure the masses, measure the distance between the centers of gravity, and infer the force from something else.[2] Then we can back into G, the gravitational constant. Here’s the thing. The theory of how interest rates affect inflation and growth, despite being ensconced in literally-weighty economics tomes, is just a theory. Actually, several different theories. And, by the way, a theory with a terrible record of actually working. To calibrate r*, the hand-waving that is being done is ‘assume that interest rates affect the economy through a James and Bartles equilibrium…’ or something like that. It is an assumption that we shouldn’t accept. And if we don’t accept it, calibrating r* is just masturbation via mathematics.[3]
- With the gravitational constant, every subsequent measurement and experiment confirms the original measurement. Every use of the model and the constant in real life, say by sending a spacecraft slingshotting around Jupiter to visit Pluto, works with ridiculous precision. On the other hand, r* has approximately a zero percent success rate in forecasting actual outcomes with anything like useful precision, and every person who measures r* gets something totally different. And r* – if it is even a real thing, which I don’t think it is – evidently moves all the time, and no one knows how. Which is Miran’s point, but the upshot is really that monetary economists should stop pretending that they know what they’re doing.
In short, we are arguing about an unmeasurable mental construct that has no useful track record of success, and we are using that mental construct to argue about whether policy rates should be at 2% or 4%. Actually, even worse, Miran says that the market rate he looks at is the 5y, 5y forward real interest rate extracted from TIPS. The Fed has nothing to do with that rate. But if that’s what he is looking at why are we arguing about overnight rates?
I should say that if there is such a thing as a ‘neutral rate’ that neither stimulates nor dampens output and inflation, I would prefer to get there by first principles. It makes sense to me that the neutral long-term real rate should be something like the long-run real growth rate of the economy. And if that’s true, then Miran is probably at least directionally accurate because as our working population levels off and shrinks, the economy’s natural growth rate declines (unless productivity conveniently surges) since output is just the product of the number of hours worked times the output per hour. But I can’t imagine that the economy ‘cares’ (if I may anthropomorphize the economy) about a 1% change in the long-run real or nominal interest rate, at least on any time scale that a monetary policymaker can operate at.
The best answer here is that whether Miran is right or not, the Fed should just pick a level of interest rates…I’m good with 3-4% at the short end…and then change its meeting schedule to once every other year.
[1] Which may in fact not be constant, but that’s a topic for someone else’s blog.
[2] In the first experiment to measure gravity, which yours truly replicated for a science fair project in high school, Henry Cavendish in 1797 figured the force in this equation by measuring the torsion force exerted by the string from which his two-mass barbell was suspended, with one of those masses attracted to another nearby mass.
[3] Yeah, I said it.
The Fate of FAIT was Fated
Growth in the US is ebbing, and it is likely only the AI boom that is keeping us from recording a small recession. Unemployment is still rising, although slowly, and credit delinquencies are rising. Because the services sector and the goods sector are still asynchronous – a holdover from the COVID period – we haven’t seen an aggregate contraction, but it will happen eventually. That doesn’t concern me. Recessions happen. It is only worrisome because equity markets are so ‘fully valued’ that an adjustment to a recession could be rough. On the other hand, all signs point to the Federal Reserve starting to ease, and this may support stocks. I would go so far as to say that investors are counting on that.
That is a rather ordinary problem. The bigger problem has not yet been realized by equity markets, but as we look at long maturities on the yield curve we see that yields are near the highs of the year even with the Fed expected to ease. That is not normal. When the Fed eases the curve tends to steepen, because however long the period of lower short rates, it will be a larger proportion of a shorter-maturity instrument. But long rates still decline in that case, normally.
You can insert your favorite story here, about how foreign investors hate Trump, or people are worried about inflation, or the credit profile of the United States. My preferred explanation (see “The Twin Deficits – One Out of Two IS Bad”) is that if you reduce the trade deficit sharply but do not reduce the budget deficit equally sharply, then the balance must be made up by domestic savers and that implies a higher rate of interest.
There’s also some reason to be wary of the turn higher in inflation, even though that was entirely foreseen (see “Ep. 145: Beware the Coming Inflation Bounce”) and a good part due to base effects. There are, though, some signs of underlying secular rather than cyclical pressures on prices. For example thanks partly to AI electricity prices started accelerating higher in 2021 but unlike other parts of the CPI have continued to rise. The CPI for Electricity stands 35% above the level of year-end 2020, and well beyond the long-term trend. Beef prices are 41% higher and still rising.
Of course, there are always prices that are rising but there are two reasons I am more concerned about this now. The first is that the money supply has returned to a positive and rising growth rate and is at a level inconsistent with long-term price stability even before the Fed renews its easing campaign.
Five percent was once a nice level for M2 growth, when demographics and globalization were following winds. Now they are headwinds and we need to be lower. Still, I wouldn’t get panicky about 5%. Get to 8% and I’ll be more concerned. But the reason that might happen concerns changes happening at the central bank.
What gets the headlines is the continual pressure that the Trump Administration is putting on Fed Chairman Powell and others on the Federal Reserve Board, several of whom are jockeying to be dovish enough to be selected as the next Fed Chair. But the much more important development was the 5-year review of the Fed’s operating framework, which Powell discussed at his Jackson Hole speech. The significance of this was seeming lost on most investors, although 10-year breakevens have gradually risen and are up at 2.42%, and other than in the post-COVID surge they’ve not been much higher than that since 2012 or so.
These are 10-year breakevens, so this isn’t a tariff effect. What’s going on here? Not much, yet, but…there is the change in the Fed’s framework, which I think is important.
Five years ago, the Fed abandoned a specific inflation target in favor of “Flexible Average Inflation Targeting”, or FAIT, which basically said “we are targeting 2% inflation, but only over time. So when inflation is too low for a while, then it’s okay to let it run hot for a while later.” At the time, this was a clear sign that monetarists – who don’t necessarily believe there is a tradeoff between inflation and growth like the Keynesians do – were losing the battle. More flexibility to respond to inflation ‘tactically’ is not something that we needed, and it wasn’t clear how that would be a helpful change anyway.
But the current 5-year framework adjustment is worse. It basically abandoned the good part of FAIT, which was any kind of soft commitment to be hawkish in the future if necessary. In Powell’s words – and I’m not making this up – “…we returned to a framework of flexible inflation targeting and eliminated the ‘makeup’ strategy.”
Yep, that’s what he said.
There is a lot more in Powell’s explanation, but most of it all leans in the same direction. For all my historical criticism of former Chairman Greenspan, he deserves credit for this: he used to say that achieving low and stable inflation was key to achieving maximum stable employment over time. Thus, inflation was primary, not secondary, in achieving the dual mandate. Now, the Fed ostensibly wants to target a low level of inflation…because that’s what central banks are supposed to do…but recognizes that sometimes they’ll want to emphasize lower rates to help Employment – and the important part is that as I just noted, they won’t ‘make up’ for running too much liquidity now by running less liquidity later. Does anyone want to take the other side of the bet that the Fed will have an easier time lowering rates and keeping them low, than raising them and keeping them high? Accordingly, the long-term inflation outlook just got worse. I don’t think we are returning to the 1970s, but we aren’t returning to 2% any time soon – and the Fed is okay with that!
FAIT was never a very good idea, and I didn’t think it would survive the first time inflation ran too high and dictated an extended period of very tight money. It didn’t. I didn’t think they’d actively make it worse, and maybe the joke’s on me. They always make it worse.
The Twin Deficits – One Out of Two IS Bad
From time to time on this blog, I circle back to the question of the balance of deficits. In my mind, as our economy goes through whatever the “Trump Transition” is, the biggest risk to the bond markets is not from some fear about whether the Treasury will default or whether the US dollar will cease to be the world’s currency of choice for reserves (neither of which I think is going to happen any time soon) but that large secular changes in the balances of savings and dollar demand could lead to outsized moves in interest rates.
First, let me remind you that the deficits are all intertwined. When the US Federal Government runs a deficit and borrows money, they have to get it from people/entities that have saved that money. One place that the government bond salesmen know they can turn to is non-US investors, who are in possession of those dollars because the US runs a large trade deficit with most other countries. When we run a trade deficit, it means we are importing more stuff than we are exporting or, equivalently, we are exporting more dollars than we are importing. Those dollars are pretty useless except to buy things that are dollar-denominated. By construction, we know that the new owners of dollars aren’t buying goods, because if they did there wouldn’t be a deficit; the main other thing they buy are securities or real property.
So if you don’t want other countries buying US stocks, buildings, and farmland, run a big trade surplus and they won’t have the dollars to do it.
It’s a good thing they have all of those dollars, because the Federal government needs them! The federal deficit needs to be funded by those foreign dollars, or by domestic savings (banks, individuals, companies, e.g.), or by the central bank buying up those bonds. And that’s pretty much it. Over time, the trade balance plus the budget balance plus the central bank balance plus private savings equals zero, more or less. During COVID, the massive expansion of the federal deficit was only possible because the Fed bought about the same number of bonds as the government sold. Had they not, interest rates would have risen precipitously because private savers would have had to be induced to put those dollars into bonds.
(Or, the government would give incentives for banks to hold more govvies, say by exempting them from the SLR. Not that such a thing would ever happen!)
Let’s pivot this then back to the Trump Transition. The stated goal of the Administration was to lower the trade deficit a lot, lower the budget deficit a lot, and lower interest rates. That all makes sense and is internally consistent. It could happen that way, if all of it happens that way.
What if, though, the President’s team makes more progress on one front than on the other? Early returns on the tariff front seem to imply that the US will face a smaller trade deficit going forward. Now, the latest spike higher (smaller deficit) here is at least partly and maybe mostly due to a ‘payback’ of the pre-tariff front-running that led to massive deficits in the prior three months. But it should not surprise us that increasing tariffs should cause the trade deficit to decline. That is, after all, sort of the point.
If we concede that the trade deficit is actually heading back towards some better semblance of balance, then that’s plank 1 of the Trump agenda. That will supply fewer dollars to cover the federal budget deficit, though. As long as the federal budget gets into something closer to balance…
That was the promise of DOGE, and of the revenues from tariffs. The latter will indeed be yuge, and will help balancing the budget. Or it would, if we weren’t about to run an even bigger deficit with the Big Beautiful Bill soon passing into law. The trailing-twelve-month budget deficit is just less than $2 trillion, which was a number we never even sniffed prior to COVID. So that’s the demand for savings: the feds look like they’re going to keep on spending more than they take in.
Unlike during COVID, too, the Fed is now letting its balance sheet shrink. No help there.
Now, there is also a movement in Congress to pass legislation preventing the Fed from paying interest on the reserves that banks hold at the Fed. For decades, the way the Fed managed the money supply was to adjust the quantity of reserves, which rationed credit and caused the price of credit (interest rates) to move as well. But it was the rationing of credit, not changing the price, that affected the money supply. Beginning with the Global Financial Crisis, the Fed flooded extra reserves into the system, forcibly deleveraging banks (look at that chart above again) – but, since that would also crush bank earnings, they started paying interest on reserves (IOR). Since, if banks were not being paid to hold reserves, they would hold as little as they could, the Fed had to pay interest or the excess of reserves in the overnight market would cause interest rates to always be zero. So the Fed started to manage the price of credit, rather than its quantity. The central bank fully intends to always hold way more in securities and therefore force way more reserves into the banks, going forward – but has gradually been reducing its portfolio securities. As I said, no help there.
If Congress succeeds in preventing the payment of IOR – and the politics on this looks good since the Fed now runs operating deficits, so that it is basically paying banks interest with taxpayer dollars (see chart below…Fed remits to the Treasury have dried up completely), then as I said above banks will try to hold fewer reserves and overnight interest rates will drop as banks compete to lend their excess reserves at anything above zero, unless (a) the fed increases the reserves banks are required to hold (really unlikely) or (b) the fed makes reserves scarce so some banks will have to buy them and some will sell them (the old way) (also really unlikely). In neither case does the Fed expand the balance sheet as a first intention, so unless we get another crisis the expansion of the Fed balance sheet is unlikely in my view.
So that leaves private savings. If the trade deficit declines and the budget balance doesn’t move significantly towards balance, then interest rates will have to rise, potentially a lot. I think the President’s stated plan makes very good economic sense. I just wonder if it’s going to be derailed by the desire to keep the Federal spend going.
Growth. Does. Not. Cause. Inflation.
I am constantly amazed at certain articles of faith among the economics community. In my line of expertise, one of the most amazing to me is the absolute conviction with which the economics community believes that if the economy grows too fast, inflation will result and if it grows too slowly, disinflation or deflation will result. That this conviction is so strongly held is especially incredible, since there is essentially no evidence for that belief.
Theory says it is so. Growing too fast puts too much pressure on land, labor, and capital, which causes their prices to rise and therefore the price of the output. I mean, obviously.
Except that it doesn’t seem to have ever happened that way, at least for a long, long time.
Heck, let’s just take recent experience. In the last twenty years, we have had two global economic crises. The upheaval in 2008 was the largest since at least the Great Depression. The economic contraction in 2020 made the Global Financial Crisis look like a piker. So obviously, if we look at inflation it must have massively slowed down in those events, right?
Hmmm. Now, I’ve showed the Core CPI price level against GDP. If you squint, you can see a small deceleration in core CPI in 2010: it actually reached only +0.6% y/y at one point. We never even reached deflation, despite the fact that the GFC was triggered by housing and housing is by far the largest component of CPI. I don’t need to say anything about the COVID period because it is so recent. Core inflation vaulted higher, and continued to do so long after economic output had been fully restored to its prior level.
The other wonderful counterexample I like to show is the 1970s.
Notice there are several flat points here, where GDP was steady-to-lower and the price level kept on truckin’ (that’s a 1970s reference, kids). Notice that since I’m using core CPI, you can’t even say ‘well, the OPEC embargo caused energy prices to spike and that also slowed the economy.’ Yes, it did, but shouldn’t that slowing of the economy have taken pressure off of other non-energy prices? Well, it didn’t. Inflation was robust during the 1970s, despite growth that lurched forward and back in fits and starts.
Those are fun, visual aids but sometimes our eyes can deceive us and hide or exaggerate a relationship that is statistically present (or not). So here I did the economist thing and ran scatterplots at different lags. Each of these shows the y/y change in GDP on the x-axis (quarterly observations, since 1960 until 2024), and y/y changes in Core CPI on the y-axis. Chart A shows the y/y changes contemporaneously (1965Q1 vs 1965Q1, e.g.). Chart B lags the inflation one quarter, so we see if this year’s growth affected this year’s inflation but lagged a little bit. Chart C lags the inflation one year, so we see if this year’s growth affects the coming year’s inflation. And Chart D lags the inflation two years, so we see if this past year’s growth affects next year’s inflation.
The correlation coefficients, for your reference: -0.18, -0.13, 0.03, 0.14. That’s thin gruel on which to make a strong argument about growth causing inflation, in my mind.
Now, I’ve run these regressions since 1960 since the core CPI index only goes back to 1957. The same regressions with headline inflation show coefficients of -0.11, -0.05, 0.10, and 0.11. I’m actually surprised they’re not any better, because energy prices should be correlated with growth and flatter the relationship. The OPEC embargo does hurt that relationship, but even if we just run these regressions since 1980 the correlations between growth and headline inflation are just 0.13, 0.19, 0.16, and -0.09.
So where do we get the idea that growth causes inflation?
Well, if I look at GDP growth versus headline inflation, from 1929 until 1960, and I exclude 1946 when industry relaxed from its war footing and war-time price controls were removed, then I can coax a really nice correlation of 0.73.
Indeed, if you look at the correlation between 1929 and 1945, it becomes a whopping 0.88. That’s science, baby – fitting the data to the story! But now I think we get to the heart of the matter because something else momentous happened in 1948 and that was the publication of the first edition of the most-used textbook in history: Paul Samuelson’s Economics. It is no surprise, perhaps, that generations of economists learned this ‘fact’ based on a correlation of 0.88…that has been falling ever since.
Since that time, the correlation between core inflation and growth has been low, and sometimes even negative, over very long periods. If there is any causal relationship, it is completely swamped in exceptions. Decades-long exceptions. It is time to give up this idea. One unfortunate consequence of that is that the way the Federal Reserve operates is as if there is one dial it can turn and that is ‘the dial that increases growth until inflation gets hot, then decreases growth.’ The problem is that isn’t one dial, it’s two. In general, I think the Fed should keep its hands off the growth dial, but if it wanted to meddle on rare occasions it would do so by manipulating medium-term interest rates. To control inflation, it needs to moderate the growth of the money supply. Frankly, in my opinion the FOMC should simply focus on the latter mission and let growth, and markets, take care of themselves. They’re not good at any of these missions anyway.
Inflation Guy’s CPI Summary (October 2024)
I said two months ago that I didn’t think the Fed should ease, but they would anyway. And they did, by cutting overnight rates 50bps. Then last month I said “Getting rates back to neutral, around 4% or so, is not a bad idea as long as quantitative tightening continues. It isn’t the best idea, but it’s not a disaster. But this raises the stakes for the next FOMC meeting… I suspect 25bps is the only choice they can make which will make almost everybody equally unhappy. There’s more data to come before that meeting, but the FOMC’s path has narrowed considerably as inflation remains sticky.” And the Fed, on cue, cut rates 25bps.
But the Fed is getting into an uncomfortable position now, because inflation looks like it has leveled off. As I have said for a while it likely would.
We will get to that. First let’s look at the number.
The economists’ consensus has been drifting higher in recent days, as data on used cars was suggesting that component would be an add in October. Consensus going in was for +0.21% headline (SA) and +0.28% on core. The actual numbers were +0.24%/+0.28%, so pretty close to the consensus with y/y headline inflation at 2.58% and y/y core at 3.30%. It doesn’t seem to me, though, that the chart of core CPI for the last year is particularly soothing. More and more it appears that May-June-July were the outliers, and we are hanging out around 0.3% per month on core inflation.
Also, my early estimate for median inflation is 0.296% m/m, leaving y/y basically unchanged at 4.09%.
Used Cars was indeed high, at +2.7% m/m. But the real problem with Used Cars isn’t this month. The real problem is that for two and a half years Used Cars has provided steady disinflation as the COVID spike (caused because new cars were not being produced as quickly thanks to supply chain problems, but the deluge of money meant that people had lots to spend and wanted cars dammit) ebbed…but that game appears to be about over.
So if you want to get inflation lower from here, it’s going to be a challenge to get it from core goods, which was steady y/y at -1% this month but only because Apparel had a large decline. Core goods is likely to head back to small deflation or small inflation (with the dollar’s recent strength, small deflation is the better guess), but higher from here. We have known this for a while. The heavy lifting is going to have to come from shelter, or supercore, going forward.
So as for shelter…OER was +0.33% m/m in September but +0.40% m/m in October. Primary Rents were +0.28% last month and +0.30% this month. The y/y disinflation is continuing, but still no sign of the hard deflation we were promised.
The good news here for 2025 is that if Trump’s plan for mass deportations happens, and if “mass” means millions, then some of the pressure on shelter that developed over the last few years as ten million additional heads needed roofs over them will abate. Then maybe we can get shelter inflation lower. There is a modest additional “if” part, though, and that is “if landlord costs can stop increasing.” Our bottom-up landlord-cost-driven model has primary rents eventually converging just south of 4%. Better, but still not great.
So that leaves supercore, which unfortunately ticked higher this month.
The problem there also remains the same. Stop me if you’ve heard this one, but wages are moving only slowly downward, and supercore is where the wage/price feedback is the strongest. The red line below is Bloomberg’s calculation of supercore and the other line is the Atlanta Fed wage growth tracker. And the problem is that median wages don’t tend to move drastically differently than median inflation, which as we have discussed is proving sticky.
If core goods is no longer declining, and shelter isn’t doing the heavy lifting of deflation, and if core-services-ex-shelter (supercore) is leveling off…then gosh, that looks a lot like high-3s-low-4s village.
As an aside: I have been saying ‘high 3s, low 4s’ would be where inflation settles in…and I’ve been saying that for a couple of years. Even I am a little amazed that I haven’t had to tweak that forecast much, other than to allow that we might briefly dip below that if housing followed the dip-and-bounce that our model had. I don’t want to put on false humility, because I was saying that inflation would stay sticky and too high long before anyone else was saying that, and I had the correct reasons and I think I’ve guided readers and clients well. But getting the landing spot right, that far in advance, also clearly involved some luck. I am saying that partly to keep the Fates on my side. But you should also know that someday, it might turn out that ‘high 3s, low 4s’ needs to be adjusted. And I’ll still consider this a pretty good call!
The Fed’s actions can clearly affect that eventual equilibrium level, but it doesn’t look like they are yet taking this seriously. The game isn’t over and there will be more CPI reports and more after that. But for now, this looks like a policy error – or worse, a blatant attempt to influence the election – and unless something unexpected happens with prices it looks like the Fed is going to have to choose between the right policy move (which means continuing tight policy) that appears to be political, or continuing to loosen policy so as to not appear to be political, and temporarily surrendering on inflation. I suspect that the FOMC will vote to keep rates steady at the next meeting.
By the way, if you care about the crypto space at all and haven’t read my column on stablecoins, you should, and you should be sure to circulate it. The column is here.
Inflation Guy’s CPI Summary (August 2024)
Let me start with the punch line, which I think will not be a very common take: this report does not stop the Fed from easing 50bps next week, and honestly doesn’t really even hurt the chances very much.
The inflation swaps market was pricing in 0.05% on an NSA basis, roughly 0.13% on a SA basis. Actually, that market was better offered, with traders either expecting a weaker number or wanting to hedge that possibility more than the chance of a stronger number. Economists gathered around a consensus of 0.16% for headline, and 0.20% on core CPI. The actual print was +0.19% m/m on CPI, and +0.28% on core CPI, bringing the y/y numbers to 2.59% and 3.27% respectively. It was the worst monthly core print since April, and the initial market response was predictably poor.
My early estimate of Median CPI for the month is +0.26% m/m, bringing the y/y median to 4.16%. (Sharp-eyed readers will note that neither headline, nor core, nor median CPI are at the Fed’s target).
Interestingly…at least, if you’re the kind of square who finds the CPI interesting…the y/y changes in Core Goods (-1.9%) and Core Services (+4.9%) were steady. That’s the first time in a while we’ve seen that.
Wow, right? A rounded +0.3% on core CPI takes the Fed out or at least puts them on a 25bps cut, right? Well, not so fast. The monthly change in Owners Equivalent Rent immediately jumps out at you (at least, if you’re the kind of square who looks at these things deeply) as +0.495% m/m. That’s the largest m/m change since February, and it hasn’t been appreciably higher on a regular basis since early last year.
That looks a little quirky, especially following the recent dip. And it looks suspiciously like a one-month-lagged chart of the m/m changes in Primary rents, which dipped a few months ago before paying it back last month.
That looks to me like some weird seasonal wrinkle. The y/y shelter figures are still declining. But, if you look carefully, you can see that the rate of improvement is slowing. And maybe my math isn’t so good but it doesn’t look like these are converging on deflation.
The rents data are therefore both the good news and the bad news. The good news is that in this month’s CPI, it was a miss higher only because OER had the quirky jump. I’ll get into more of the number in just a second, after sharing the bad news: there is nothing in the trajectory of rents to suggest that the operating theory of many forecasters for a long time – that rents would soon be in deflation – is going to happen. Heck, as I keep pointing out the trajectory of rents is higher than my bottom-up rents model, which suggested we should be bottoming out around 2.4% y/y right about now. And my forecast was on the very high side of what people were saying.
But let’s get beyond rents. The ‘big sticky’ is always important to watch, but outside of rents things looked pretty good this month. There were some outliers on both sides (Lodging Away from Home +1.75% m/m, Airfares +3.9% m/m after 5 straight declines; Car/Truck Rental -1.5% and Used Cars -1% m/m), but core CPI ex-shelter declined to only +1.72% y/y. The list of monthly categories shows a long list of categories whose price fell m/m: jewelry, car/truck rental, used cars, energy services, miscellaneous personal goods, personal care products, household furnishings and operations, medical care commodities, medical care services, recreation, communication, and a few others. Not that we are headed for deflation, but look at this distribution of y/y price changes. I haven’t shown this for a few months.
Again, this doesn’t look like something that screams deflation, but the far right tails are all moving left. There’s still a cluster around 4-5%, which shouldn’t be surprising since Median CPI is at about 4.2%. Do also notice that there aren’t a lot of categories showing deflation on a y/y basis, but if you take out shelter from this you get something that looks more disinflationary: a mode around 4-5%, but tails to the downside. In inflationary periods, the tails stretch to the upside, and we had that for a while; but the signature of the overall distribution is encouraging.
The conclusion, as I said up top, is that if the Fed was leaning towards cutting rates 50bps next week this is not a number that should change their collective mind very much. Unless the Fed cares only about the top line numbers, this isn’t an alarming report. It isn’t the lovely deflationary print that bond bulls wanted, but that wasn’t really in the cards. We’re arguing over a couple of hundredths in the monthly core print, and that is entirely attributable – still – to shelter. In fact, there are signs of broadening disinflation. To be clear, I personally do not think the FOMC should stop quantitative tightening and there’s no hurry to cut rates. The fight against inflation is not only unfinished, it won’t be finished for quite a while…and an ease now will just make it harder later. But that’s what I would do. What I am saying is that the Fed is not likely to change course on the basis of this number.
The y/y figures for headline CPI are going to keep dropping for a few months here, partly on base effects and partly because energy prices are very weak. A perfectly reasonable trajectory for monetary policy (if you think that rates ought to at least be eased back to neutral in the 3-4% range) would be 25bps next week, and then larger cuts in a few months when the headline inflation number is lower and the unemployment rate is higher. The only problem with that approach is that an acceleration in the pace of easing later may look like concern, which is why some FOMC members favor getting out of the gate quickly. As I said, there’s nothing here that should stop that.
But median inflation is still headed for ‘high 3s, low 4s,’ with a potential dip into the low 3s before a reacceleration. The hard work on inflation is still ahead, and it is going to get harder now that we are in a recession.
