December 9, 2022

The particular Fed’s Current Monetary Stance Will Lead to Stagflation, Not really Deflation

Mainstream analysts  seem convinced that global central banks are usually moving aggressively to tackle inflation, maybe even heading too far. After having believed until recently that the surge in prices was just transitionary, central banks demand now that they will restore price stability at almost any price. In September, the Fed raised its main rate of interest to […]#@@#@!!

Mainstream analysts   appear convinced that global central banks are moving aggressively to tackle inflation, probably even going too far.

After having believed until lately that the spike in prices was only transitionary, central banks insist now that they will restore price stability from almost any cost. In September, the Fed raised the main interest rate to a variety between 3 and 3 or more. 25 percent from close to absolutely no at the beginning of the year.

Several Federal Open Market Committee members predict that the target policy rate can reach 4. 25 percent this year and exceed 4. 5 percent in 2023. The Fed chairman also admitted in a hawkish posture that beating inflation would not be painless. But would the Fed’s monetary stance be enough to curb the high inflation price which stood above 8 percent for seven months? Or is  the Fed more likely to blink   rather than risk a severe economic recession? As  stagflation   has become a distinct possibility, the Fed’s disinflation scenario appears increasingly implausible.

Inflation Is Primarily a Monetary Phenomenon

The Fed must slow up the growth of the money supply below the growth within output in order to curb pumpiing. Otherwise, too much money is running after too few goods, driving up prices. The Fed should also keep inflation anticipations anchored, so that a lower demand designed for cash balances would not raise the speed at which money chases goods, undermining efforts in order to contain the growth in money aggregates. So far, the Fed has blamed the velocity of consumer price inflation on supply-side factors: the disruptions of supply chains during the pandemic, followed by the surge in energy costs due to the war in Ukraine.

This is just part of the story because money creation was the main operater of inflation all together. The supply shocks possess only exacerbated the circulation of printed money directly into consumer prices rather than in to real estate or financial resource bubbles. However , without an overabundance money supply relative to output, no supply shock could have led to a general increase in the price level. Indeed, graph one shows that since the global economic crisis the increase in M3 broad money outpaced real major domestic product (GDP) growth at a high rate plus recorded a peak during the pandemic. This growth gear is comparable to the one in the sixties and 1970s.

Graph 1: Wide money versus  real GDP growth

Macovei1
Source: FRED.

The increase in broad money has decelerated considerably, to 4. 3 % year over year within August 2022, but it still exceeds the increase in true GDP. The latter slumped because the US entered a specialized recession with negative development in both the first and second quarter of this year. This particular points to a  likely full-fledged recession forward , which normally need to reduce inflationary pressures. It is natural that the large expansion of fiduciary credit in recent years would be followed by a curative recession accompanied by deflation.

According to   Ludwig von Mises’s monetary theory of the business cycle, a drop within prices is unavoidable when the inflow of additional fiduciary media stops. Banks are usually refraining from further credit score expansion, either because they cautiously anticipate upcoming bankruptcies or outstanding debts are not paid back. Moreover, uncertainty makes both households and firms enhance their cash holdings, while distressed companies are liquidating inventories with fire-sale prices.

In principle, a recession could facilitate the Fed’s task of taming inflation and reduce the need for further significant interest rate hikes. But this is not consistent with the Fed’s  optimistic scenario   of an economic soft landing which may trigger another rest of monetary policy to be able to jumpstart the economy. Furthermore, a lasting increase in power prices, fiscal easing, along with a deanchoring of inflation expectations may turn the current recessionary environment into a prolonged stagflation period.

Stagflation Can Derail the Fed’s Benign Scenario

Stagflation in the 1970s   came as a surprise to most Keynesian economists since the combination of tepid growth plus rapidly rising prices was at odds with previous recessions. It also contradicted the famous Philips curve claiming a stable inverse relationship among inflation and unemployment. The particular “ popular” explanation of the high inflation in the 1972s was the tripling of oil prices following the two oil shocks in 1973 plus 1979.

In fact, the surge in pumpiing was caused by a Keynesian-style financial and monetary stimulus that fueled an unsustainable financial boom in the US in the sixties, as explained by  Thornton . This also forced the US to abandon the gold standard in 1971 and led to the fall of Bretton Woods. Like today, high inflation in america surging to 6. 4 percent in February 1970, predated the energy supply shock absorbers, which was mainly a symptom of excessive money printing. The particular increase in oil prices afflicted inflation differently in various countries, with prices increasing much faster in the US compared to Switzerland and Germany (graph 2), pointing to the key role played by monetary policy plus inflation expectations.

Graph 2: Customer Price Index inflation within the  1970s

Macovei 2
Source: FRED.

The German and Swiss central banks understood that inflation was primarily a monetary trend and tried to control the growth in monetary aggregates to restrain inflation plus steer inflationary expectations. This particular became their monetary policy  nominal anchor   when the link to gold was severed. The Bundesbank hiked interest rates early and  ex post   real interest rates had been largely positive in Germany, whereas they had been bad in the US the entire period among August 1971 and October 1979. As a result, the development in the US broad money not only continued at a quick speed (graph 3) but was also accompanied by a deanchoring of pumpiing expectations as high inflation endured. Even if the increase in the US money supply was only slightly worse than in Indonesia, the deanchoring of pumpiing expectations pushed inflation higher in the US.

Graph 3: Broad cash (M3) in the  ALL OF US, Germany, and Switzerland

Macovei3
Source: SALLY.

Stagflation Red Flags

The particular 1970s experience underlines the key role played by inflation expectations in driving up prices. A sustained embrace prices reduces the requirement for cash holdings of a currency that is constantly dropping its purchasing power, reinforcing the inflationary spiral. Nowadays, we can already see an increase within inflation expectations of both professional forecasters (graph 4) and consumers (graph 5), which may amplify going forward.

Graph 4: Professional forecasters’  inflation projections

Macovei 4
Supply: Federal Reserve Bank Philadelphia.

Graph 5: Consumers’  pumpiing projections

Macovei 5
Source: New York Fed Survey of Consumer Expectations.

According to   Ludwig von Mises, the inflation caused by credit expansion differs from the one caused by direct monetization of government budget loss. The former is usually accompanied by deflation when the issuance of fiduciary media stops, whereas these is not, unless the government withdraws the additional quantity of money from the market.

The current spike in inflation is a mixture of a long-lasting credit boom, supplemented by good government budget handouts to both businesses and households during the pandemic. Fiscal profligacy has continued after the pandemic with a  huge forgiveness of student loans   and a  “ green” electoral investing package   which is  paradoxically designed to reduce inflation . Fiscal easing is likely to counteract deflationary pressures stemming from ending the credit expansion, as budget deficits have reached warlike levels peaking at nearly 15 percent of GDP in 2020.

Energy prices will most likely stay high as the war in Ukraine and the decoupling from your Russian economy continue, strengthened by the unabated green transition. This pushes governments to support the energy supply shock along with further rounds of monetized deficit spending to subsidize energy prices and boost public sector wages plus incomes. Growth of private wages has also accelerated in the tight labor market where anticipations of persistent pumpiing are taking hold (graph 6). Lately, both  the particular ECB   and  the IMF   expressed concerns that inflation has started to turn out to be “ self-reinforcing” due to governments’ fiscal packages and a boost in inflation expectations.

Graph 6: US nominal wages

Macovei 6
Source: FRED.

The particular Fed’s Monetary Stance Is simply too Lax

With prospects of stagflation materializing, the Fed’s current situation of monetary tightening is obviously too dovish. History shows that the US Great Inflation of the 1970s could only become ended by  walking interest rates into real good territory   for several years in order to reanchor inflation expectations. Inflation had accelerated to almost 12 percent whenever Volcker took over as Fed chief in November 1979.

At that time, the Fed rate was still fairly high, and the real price was only slightly undesirable at – 0. almost eight percent. Yet, with inflation accelerating above 14 % by mid-June 1980, Volcker raised the Fed rate up to 19 percent keep away from 1980. While he progressively reduced the policy rate over the next five years, the real rate was normally positive and exceeded 5 percent on average from 1981 in order to 1984, so that inflation lowered below 4 percent (graph 7).

The rate tightening also triggered a steep economic recession within 1981– 82 and the wiping out of the savings and loan industry. With current harmful real rate rates exceeding – 5 percent and  voices   already calling for a softening from the Fed’s stance in the new recessionary environment, the US will most likely end up with stagflation rather than reduced inflation.  

The financial sector could throw some sand in to the printing machine by being extra cautious and tightening financing conditions more than the Given. Indeed, the spread between your 30 Year fixed mortgage rate and the Federal money rate increased from typically 275 basis points within 2020 to 385 basis points in the first 9 months of 2022, but the financial sector tightening composed only partly for the Fed’s too lax monetary position.

Graph 7: Federal Funds price and inflation

Macovei 7
Source: FRED.

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