The Folly Of Central Banking In One Country, Parts 1 & 2
BY BRYAN LUTZ
Guest post by David Stockman from his blog ContraCorner:
We ran across a positively awful post this AM, written by a fellow who is usually pretty sound on economic matters.
We are referring to Lance Roberts’ claim that inflation is about to roll-over sharply, and that therefore the Fed is committing a huge policy mistake by continuing to tighten at a rapid pace.
We think that’s totally wrong and beside the point but our purpose is not merely to correct Mr. Roberts.
He is just articulating a theme that will soon be a drumbeat on Wall Street based on a fundamentally erroneous Keynesian view of what central banks can and cannot do in today’s economic and financial environment.
In a word, they cannot remotely manage the price and output aggregates of their domestic economies, nor deliver reliably upon their macroeconomic targets for inflation and employment.
And as a practical matter that disability starts with Robert’s very typical claim that—like Milton Friedman and his progeny—he knows what the time lag is between change in interest rates and other monetary policy variables and the response of the macro-economy:
……the problem with this view is that the Fed is managing monetary policy based on lagging economic data.
To wit:
“As the Fed continues to hike rates, each hike takes roughly 9-months to work its way through the economic system. Therefore, the rate hikes from March 2020 won’t show up in the economic data until December…….
A few weeks back, therefore, Roberts predicted that the inflation rate would be back to the Fed’s 2.00% target by June 2023:
In August, the inflation will drop to 7.9% from 9% in June, and if we assume an average 0.2% monthly increase in the index, CPI will hit the Fed’s 2% target in June 2023.”
What has this man been smoking?
The month-over-month CPI increase in September—the first monthly test of his prediction—-was not 0.2%, but double that at 0.4%.
That means a continuation of the September monthly gain would result in a Y/Y headline CPI of about +5.0% by June 2023, not 2.0%.
Of course, we have no idea what the actual monthly gain will be over the next nine months, but we do think that:
1) As a mechanical matter, the embedded inflation in rents, wages and services in the CPI index is very powerful and will keep the Y/Y gains in the headline CPI well north of 6% during 2023 and beyond—meaning that the Fed is hopelessly behind the eight-ball on inflation.
2) Ultimately, the point of raising rates is not one of macroeconomic central planning in the sense of chopping down CPI rates or causing or evading a recession, but one of restoring integrity and rationality to the interest rate and financial asset markets, which have been hideously inflated for years by the Fed’s relentless money-pumping.
We will get to the first item in Part 2, but suffice it here to note that the latter is the more important point.
That’s because it illuminates why analysts like Roberts are on the wrong track when they make guesses about the time lag—which ranges from nine months to three years according to different experts—between the Fed’s interest rate manipulations and the resulting macroeconomic effects as measured by the CPI, GDP, U-3 and other crude metrics; and are even further from the mark when they assume that there is some kind of fixed Phillips curve trade-off between inflation and employment/GDP.
No, these relationships are all highly variable and unpredictable, meaning that the entire discussion of both matters is just plain nonsense in the context of an open economy.
That is to say, macroeconomic targeting such as 2.00% inflation and 3.5% unemployment is a fools errand in a $90 trillion global economy, where massive trade, capital and financial flows and huge labor and production cost differentials powerfully shape and drive domestic output and prices in any given country.
That is to say, monetary policy in one country doesn’t cut it.
That’s because global forces can easily overwhelm domestic impulses arising from central bank actions.
For instance, assume the central bank wants to slow-down aggregate demand in order to cool inflation.
Yet export gains on the global market caused by expansion abroad can easily offset housing production curtailments at home owing to higher mortgage rates induced by Fed policy.
Likewise, unpredictable international developments, such a soaring oil prices currently or deeply deflating durable goods prices like awhile back, can cause monetary policy lags to deviate substantially from historic observations.
And when it comes to the alleged trade-off between inflation and employment there is no way that shrinking or expanding trade balances do not impact short-run outcomes.
Yes, the Fed is the maximum leader of the central bank fraternity, but it should be obvious by now that it does not control near-term or even medium-term global economic trends.
Nor is it reasonable to believe that a mere 300 basis points of increase in the overnight money rate (from the aberrant starting point of zero) will predictably move the dial on international trade, commodity prices, labor costs or investment flows.
In a word, there is so much slippage in the monetary steering gear in today’s global economy that discretionary monetary policy and the macroeconomic policy targeting, which is its purpose, should not even be attempted.
To the contrary, it is long past time to go back to Carter Glass’ “bankers’ bank” notion.
The author of the Federal Reserve act provided that the Fed would operate strictly from the Discount Window, not the Open Market Desk, and that doing so it would passively supply reserves upon demands from the commercial banking system at a penalty rate above the free market rate of interest.
In that set up, the purpose of the central bank was to :
- Allow the gold standard to maintain the value of money at a fixed conversion rate.
- Enable the banking system to stay liquid owing to the ebb and flow of central bank reserves driven not by monetary central planners domiciled at the Fed, but by the ebb and flow of private commerce and the resulting demand for bank credit on main street and reserves at the Discount Window.
- Permit the private economy of producers, workers, consumers, investors, savers and speculators to determine the level of GDP, employment and the countless other ingredients of the aggregate economy, meaning that these aggregates would be de facto outcomes on the free market, not a priori targets for action by the state and its central banking branch.
Needless to say, politicians and statists had no use for Carter Glass’ “banker’s bank” because it cut them out of the action. Capitalist prosperity was to be the peoples’ enterprise, not a gift of the state.
Under that sound money regime, inflation didn’t happen because money was as good as gold.
At the same time, the state didn’t have any dog in the hunt at all when it came to macroeconomic variables like the unemployment rate, real GDP growth, housing starts, CapEx levels and all the rest.
It is only when the central banks plunged into the macro-economic management and targeting business with reckless abandon after Nixon severed the link with gold in August 1971 that today’s hyperactive central banking regime materialized.
Moreover, that occurred even as goods and services inflation became endemic without the link to gold.
Accordingly, central bankers soon found themselves shuttling from pillar-to-post as between inflation rates and unemployment/GDP growth rates, thereby generating, in turn, all of today’s central banker witch-craftery about policy impact lag times and Phillips Curve trade-offs.
Moreover, when price stability—at least notionally viewed as near zero percent inflation in the early fiat period—was arbitrarily redefined by Bernanke in 2012 as 2.00% per annum and no less, and only to be measured by the shortest inflation ruler in town, the PCE deflator, the inherent instability of the Keynesian central banking regime became well nigh insuperable.
But the starting point of wisdom is to recall that it wasn’t always this way. As we will show in Part 2, there was virtually no net inflation in the 1920s, and the purchasing power of the dollar in the spring of 1946 was identical to what it had been 45 years earlier in Q1 2021.
PART 2
For want of doubt, the chart below indexes to a base of Q2 1921 the gain in both real GDP (purple line) and consumer prices (black line) through Q3 1929.
It leaves nothing to the imagination: During that eight year period, the CPI rose by a minuscule 0.24% per annum, even as real GDP expanded at a 6.1% annual rate between 1921 and 1929.
So much for the Keynesian Phillips Curve!
Under a regime of reasonably sound money, low taxes, fiscal surpluses and minimal state intervention, there was no such thing as a trade-off between inflation and employment/growth.
On a cumulative basis, the real economy grew by 62% and the price level was flat as a board.
Indeed, the price level between 1921 and mid-1946 did not increase at all on a net basis.
That is, there was zero cumulative inflation over 45 years, yet the US economy ended up 207% larger in real terms!
So when it comes to assessing Fed policy the last thing we should be looking at is economist’s witchcraftery about “policy lags” and inflation/employment trade-off.
Those are an inherent product of the rotten central banking regime which brought the world to the brink of today’s impending economic maelstrom.
This gets us to the heart of the matter with respect to the Fed’s current interest-raising campaign.
The real reason it must persist is not owing to precisely where the CPI and PCE deflator indices stand today or might possibly post in nine months.
Rather, the necessity for getting the Fed’s heavy thumbs off the interest rate scales is that real interest rates are absurdly negative and have been for years and years, as shown be the chart below.
That fact alone is the actual source of the inflation, even if it did originally manifest itself more in financial asset inflation than the goods and services indices.
Accordingly, the Fed’s job is to allow the free market to discover the correct, sustainable and economic price for debt and other financial assets, and then get out of the way.
That is to say, once the financial markets are free to price debt, stocks, real estate and derivatives according to supply and demand, not as dictated by the Fed’s fallible econometric models, inflation will take care of itself.
There is no need whatsoever for the central bank to plunge into the actual main street economy and target the aggregates or to stubbornly pursue arbitrary Humphrey-Hawkins type “goals” for the PCE deflator, U-3 unemployment etc.
To be sure, the level of distortion in financial markets and the main street economy is extremely severe and endemic after decades of Keynesian money-printing.
But it would appear from the chart below that the appropriate real rate for the 10-year UST, which is the fulcrum security for the entire global financial system, is 3-4%. That was the level the market settled at when Volcker’s inflation purge was completed by early 1986.
Accordingly, as long as inflation remains in the current 5-8% zone, depending upon which flawed general price index you are using, it is possible that the free market would push the benchmark UST rate to 10% or higher in nominal terms.
But so be it.
There will be no real solution to today’s “stagflation” until the distorting effects of massive increases in sub-economic debt and cheap-money fueled speculation are purged from the system.
Yes, allowing short-term rates as well as the 10-year benchmark to find their own level on the free market would likely result in a hair-curling recession.
That’s because current levels of output and employment are the product of chronically falsified interest rates and bloated financial asset prices, and are not sustainable in an environment of noninflationary money.
But even 10% or more unemployment and a 5% shrinkage of real GDP would be worth the cost of ending the Fed’s money-pumping regime.
After all, there would be no humanitarian crisis, notwithstanding the predictable outcries from Washington politicians of both parties.
That’s because a massive automatic shock-absorber system is already in place in the form of unemployment insurance, food stamps, Medicaid, housing subsidies and the rest of the Welfare State nine-yards.
Without any new legislation at all, the existing “Safety Net” could easily supply $600 billion of transfer benefits to 20 million unemployed (12% U-3 rate) at $30,000 per person.
That is to say, a sound money driven purge of the current financial and economic rot would not trigger a downward spiral into an economic black-hole of depression.
To the contrary, while the bad debts and other speculative excesses were being liquidated the most vulnerable part of the work-force would be supported via transfer payments, thereby paving the way for a natural free market recovery as businesses and households re-engaged in economic activity on the basis of honest financial asset prices.
Indeed, as Jim Grant has thoroughly documented, that’s exactly what happened in during the 1921 depression, which purged the wartime inflation and investment excesses.
Shortly thereafter the US economy came bounding back with nary a dollar of monetary or fiscal “stimulus” to help it along.
Of course, according to the Keynesians what would be “lost” even then is the purported “potential GDP” that would be foregone during the purge.
But so what?
Potential GDP is just an academic artifice that has been used to justify the central bank’s goosing of aggregate demand on the grounds that actual, tangible output is held to be falling short of an arbitrary target.
It amounts to an macroeconomic bathtub that is never filled to the brim, thereby providing statists with an excuse for monetary and fiscal policy intervention.
In fact, of course, “stimulus” induced GDP today is just output pulled forward in time—wealth stolen from the future at the cost of permanently higher debts.
So, yes, that kind of lost potential GDP is very worth sacrificing to fix the money.
Likewise, another consequence of the needed purge would be the sharp shrinkage of the phony “wealth” that has been generated by years of egregious money printing.
As it happened, when Greenspan took the helm at the Fed in August 1987, nominal GDP (red area) stood at $4.8 trillion and financial assets (blue area) held by households totaled $12.8 trillion.
Accordingly, the ratio of financial assets to GDP stood at 2.66X, and there was no earthly risen for it to rise in the decades ahead.
Indeed, the reduction of real GDP and productivity growth by upwards of 50% during the succeeding decades implied, if anything, that the ratio of financial assets to national income should go down, reflecting the worsening fundamental economic trends.
Needless to say, the opposite occurred.
At the end of 2021, household financial assets had soared by more than 9X and now stood at 4.84X GDP.
Yet that was inflation–financial asset inflation–pure and simple.
And it is destined to devolve into Ross Perot’s famous “sucking sound to the south”.
At the end of the day, the core evil of Keynesian central banking is that it amounts to the worst kind of socialism.
That is, a form of monetary central planning that ends up showering the 1% and 5% with massive asset windfalls, even as the main street masses ultimately end up in today’s pickle: Namely, suffering from raging stagflation, even as the Fed prepares to push them into the next cycle of recession.
In the meanwhile, it becomes ever more evident that central bank interest rate pegging and inflation/unemployment targeting is one of the greatest follies ever undertaken by the state.
For instance, in just the last 10 months the Fed heads have proven in spades that they do not know where the aggregate economy is going, nor what levels they are going to peg interest rates at in order to achieve their dubious goals:
In the US, the Fed’s own dot plot at the end of last year showed a peak rate of 2.1%.
By March this year, that estimate had climbed to 2.8%, which was subsequently lifted to 3.8% and then to 4.6% last month.
The markets, meanwhile, are pricing in a rate circa 5%.
Just one year ago, had someone mentioned a 5% Fed funds rate, they would probably have been laughed out of the room.
No, they should be laughed out of the room even now.
Not in a million years would free market interest rates have behaved they way the 2-year and 10-year Treasury yields have performed during the last decade.
The plunges and surges are nothing more than the ship-of-fools at the Eccles Building trying to manage a $22 trillion economy with policy tools that are not remotely fit for purpose.
Indeed, when it comes to setting interest rates and financial asset prices, the only thing fit for purpose is the free market.
It’s about time we tried it.
In any event, the draw-down of stock and bond values on US markets has already reached $18 trillion, or more than double the draw-down which occurred during the 2008-2009 financial crisis.
But with more than $100 trillion of egregiously inflated financial assets still standing in harm’s way, the reckoning is just getting started.
And, no, the money-printers are in no position to come riding to the rescue as they did in the winter of 2008-2009.
Keynesian monetary central planning has now generated the mother-of-all financial bubbles and no longer has the means to keep it afloat.
Thank heavens!
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