Trouble for the Curve: Recession vs. Inflation Is the Fed’s Hobson’s Choice

Commentary The yield curve measures the difference between short-term borrowings, or “short” money, and “long” money, borrowed on longer terms. The Fed typically affects interest rates by setting the overnight borrowing rate for member banks. Open Market Operations, its second principal means of moving rates,  affects cash in the economy by selling Treasurys to pull money out of the economy and thus raise interest rates.  To lower rates, the Fed buys Treasurys to add money to the economy.  Finally, the Fed can raise or lower member banks’ reserve ratio, the amount of money a bank must keep on deposit at the Federal Reserve to affect the money supply. But all those Federal Reserve measures typically affect just shorter-term rates; longer-term rates tend to be more market dependent. And there’s the rub. In a healthy economy, long money comes with a higher interest rate than short money because the lender’s money is outstanding for a longer time and, thus, is subject to higher risk that the creditor may default on its debt.  Moreover, in a healthy economy, savings are invested in businesses, real estate, research, innovation, training, etc. But when businesses and entrepreneurs lose confidence in the future growth of the economy, they take their excess cash and invest it where it will be safe and virtually risk-free;  they put their money in Treasurys.  Greater demand translates to lower long-term interest rates that are required to attract investors. The risk for the economy is that the return on the longer-term rate will go to less than the shorter-term rate.  This phenomenon, known as an inverted yield curve, has predicted every declared recession since 1976. That brings us to the Federal Reserve’s decision Wednesday to raise rates a quarter-point to one-half of one percent. As of Friday’s close, the difference in the rate of return between the two-year Treasury note and the 10 year was just 17/100ths of a percentage point, what financial professionals call 17 basis points, or “bps”. That’s the lowest since March 16, 2020, when the full scope of the pandemic was coming into view and businesses started to close down. 2020 inflation But in 2020, inflation, as measured by the Consumer Price Index, was below 2 percent.  For 2021, inflation ran at 7 percent; it appears to be increasing, at least among the public.  The Michigan Consumer Sentiment Survey is at its highest point since 2008. All this sets up what is called “stagflation”, a portmanteau from the 1970s to describe the onset of economic stagnation, where the economy slows and there is simultaneous inflation. The insidious thing about stagflation is that the inflation complements the economic stagnation and vice-versa. They feed on each other.  That’s what makes it so hard to break, absent the kind of hard recession that Fed Chair Paul Volcker was willing to invoke in the 1980s to stop it. There is a simple rule in Economics: the amount of money (“M”) and the number of times the money turns over in trade in the economy, what economists call its “velocity”, equals the prices (“P”) of goods multiplied by the quantity(“Q”) of goods.  These relationships, known as the “Quantity Theory of Money”,  are summarized by this formula: MV=PQ In a booming economy, the money supply (M) will expand and the velocity of money, V, will increase to equal the output (Q) and/or prices (P) of the economy. But when the output of the economy (Q) is slowing, the velocity of money—its turnover —(V) also slows. If the money supply (M) remains constant, then prices (P) must necessarily increase. This is why Milton Friedman, the Nobel award-winning economist, said in 1963, “Inflation is always and everywhere a monetary phenomenon.” In context, Friedman said there is no instance in history where inflation happened when the money supply had not expanded in the years before inflation occurred. While his comment was doubted at the outset, most mainstream economists accept the principle now. Currently, the velocity of money is at nearly its lowest point on record. But our production—as measured by our GDP—is up only about $2.4 trillion since 2019. By the same token, M2—the amount of money in the economy—has increased by about $7 trillion and is at a record high. So how should policymakers hope to restrain this inflation? Well, a quarter-point hike in the short-term rate isn’t likely to affect inflation much at all. And that was likely a choice by the Fed, because—in truth—the Fed is as much a political organization as any other instrument of government. “Inflation”, while harming mostly lower and middle-income people, also affects the owners of assets: stocks, bonds, real estate, cryptos, artworks, NFTs, etc. which have all mostly appreciated in value in this inflation. Breaking the back of inflation would affect the values of those assets and we can very much anticipate the Fed is hesitant to do so, not in an off-year election year that will decide the control o

Trouble for the Curve: Recession vs. Inflation Is the Fed’s Hobson’s Choice

Commentary

The yield curve measures the difference between short-term borrowings, or “short” money, and “long” money, borrowed on longer terms.

The Fed typically affects interest rates by setting the overnight borrowing rate for member banks. Open Market Operations, its second principal means of moving rates,  affects cash in the economy by selling Treasurys to pull money out of the economy and thus raise interest rates.  To lower rates, the Fed buys Treasurys to add money to the economy.  Finally, the Fed can raise or lower member banks’ reserve ratio, the amount of money a bank must keep on deposit at the Federal Reserve to affect the money supply.

But all those Federal Reserve measures typically affect just shorter-term rates; longer-term rates tend to be more market dependent.

And there’s the rub.

In a healthy economy, long money comes with a higher interest rate than short money because the lender’s money is outstanding for a longer time and, thus, is subject to higher risk that the creditor may default on its debt.  Moreover, in a healthy economy, savings are invested in businesses, real estate, research, innovation, training, etc.

But when businesses and entrepreneurs lose confidence in the future growth of the economy, they take their excess cash and invest it where it will be safe and virtually risk-free;  they put their money in Treasurys.  Greater demand translates to lower long-term interest rates that are required to attract investors.

The risk for the economy is that the return on the longer-term rate will go to less than the shorter-term rate.  This phenomenon, known as an inverted yield curve, has predicted every declared recession since 1976.

That brings us to the Federal Reserve’s decision Wednesday to raise rates a quarter-point to one-half of one percent.

As of Friday’s close, the difference in the rate of return between the two-year Treasury note and the 10 year was just 17/100ths of a percentage point, what financial professionals call 17 basis points, or “bps”. That’s the lowest since March 16, 2020, when the full scope of the pandemic was coming into view and businesses started to close down.

2020 inflation
2020 inflation

But in 2020, inflation, as measured by the Consumer Price Index, was below 2 percent.  For 2021, inflation ran at 7 percent; it appears to be increasing, at least among the public.  The Michigan Consumer Sentiment Survey is at its highest point since 2008.

All this sets up what is called “stagflation”, a portmanteau from the 1970s to describe the onset of economic stagnation, where the economy slows and there is simultaneous inflation.

The insidious thing about stagflation is that the inflation complements the economic stagnation and vice-versa. They feed on each other.  That’s what makes it so hard to break, absent the kind of hard recession that Fed Chair Paul Volcker was willing to invoke in the 1980s to stop it.

There is a simple rule in Economics: the amount of money (“M”) and the number of times the money turns over in trade in the economy, what economists call its “velocity”, equals the prices (“P”) of goods multiplied by the quantity(“Q”) of goods.  These relationships, known as the “Quantity Theory of Money”,  are summarized by this formula:

MV=PQ

In a booming economy, the money supply (M) will expand and the velocity of money, V, will increase to equal the output (Q) and/or prices (P) of the economy.

But when the output of the economy (Q) is slowing, the velocity of money—its turnover —(V) also slows. If the money supply (M) remains constant, then prices (P) must necessarily increase.

This is why Milton Friedman, the Nobel award-winning economist, said in 1963, “Inflation is always and everywhere a monetary phenomenon.” In context, Friedman said there is no instance in history where inflation happened when the money supply had not expanded in the years before inflation occurred. While his comment was doubted at the outset, most mainstream economists accept the principle now.

Currently, the velocity of money is at nearly its lowest point on record.

But our production—as measured by our GDP—is up only about $2.4 trillion since 2019.

By the same token, M2—the amount of money in the economy—has increased by about $7 trillion and is at a record high.

So how should policymakers hope to restrain this inflation?

Well, a quarter-point hike in the short-term rate isn’t likely to affect inflation much at all. And that was likely a choice by the Fed, because—in truth—the Fed is as much a political organization as any other instrument of government.

“Inflation”, while harming mostly lower and middle-income people, also affects the owners of assets: stocks, bonds, real estate, cryptos, artworks, NFTs, etc. which have all mostly appreciated in value in this inflation. Breaking the back of inflation would affect the values of those assets and we can very much anticipate the Fed is hesitant to do so, not in an off-year election year that will decide the control of Congress.

A better choice for the Fed would be to adopt a policy of yield curve control, by selling off the Treasury and mortgage assets it has acquired during the pandemic.  The Fed has said they will stop making purchases of those assets but has yet to indicate whether—or when—they will start selling them. Selling the assets would draw off excess money from the economy and raise long-term rates. Those higher long term rates would permit the Fed more leeway to raise its traditional shorter-term rates more rapidly and to a greater degree without risking a yield curve inversion and recession.

But raising long-term rates would tend to hinder job creation (labor participation is still significantly below pre-pandemic levels) and would, as well, reduce the value of the aforementioned assets.

But inflation can also be affected by fiscal policy, the policies and actions of government. Following the MV=PQ formula, greater productivity leading to a greater quantity of goods (Q) could be affected by lessening regulation, improving infrastructure, and adopting other industrial policy that tends to enhance productivity, such as applied research. Adding oil and gas to the global  market from our own production would help, too.

Inflation is insidious; a veritable cancer on society that robs people of their futures and cripples their present. Paul Volcker knew that and crushed it in the 1980s.  Chairman Jerome Powell and his colleagues should follow his predecessor’s lead. And President Joe Biden and Congress should lend a hand with fiscal policy. Now.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.


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J.G. Collins is managing director of the Stuyvesant Square Consultancy, a strategic advisory, market survey, and consulting firm in New York City. His writings on economics, trade, politics and public policy have appeared in Forbes, the New York Post, Crain’s New York Business, The Hill, The American Conservative, and other publications.