Get Real
Well, that’s another Fed week in the books and much of talk focused on the idea of the real fed funds rate, or the monetary policy rate set by the central bank adjusted for inflation. And, given that the Fed uses core PCE as its primary inflation target, it’s probably best to adjust the funds rate by that measure. Take the upper end of the fed funds target range of 5.5% and subtract 2.9% for core PCE and you’re left with a real rate of 2.6%.
Folks arguing that the Fed should cut rates point to this 2.6% as being too high to achieve the “soft landing” in the economy markets have already come to price in. That may be so but, at the same time, it may be difficult to argue the 2.6% is enough to sustainably bring inflation back down to the Fed’s 2% target, which seemed to be the subtext of Jerome Powell’s latest press conference.
Suggesting he was still not confident of achieving the Fed’s goal, he dismissed talk of a March rate cut, much to the dismay of investors. However, it may help to put that 2.6% real rate into some sort of context. Powell for months now has suggested that he is wary of making the same mistake the Fed made a half century ago of declaring victory over inflation too soon. So it should be noted that even the ignominious Arthur Burns raised the real fed funds rate well above 5% in the course of making that fateful mistake.
His successor, Paul Volcker, was charged with remedying the issue and ended up taking it over 10% in finally accomplishing that feat. So you might argue that, if Powell would prefer to avoid being the next Arthur Burns, he should not shy away from a real monetary rate that is less than half of that Burns unsuccessfully utilized.
For this reason, I find it a bit strange to hear people complain that the real fed funds rate is now too high or too restrictive. History suggests that Powell has not yet even met the Arthur Burns standard, let alone the Paul Volcker one. And this may have important implications for the sustainability of the current inflation problem.
Recession Watch
While current monetary policy may not be restrictive enough to sustainably bring inflation back to the Fed’s target, it may still be enough to cause a recession. This week we got that latest reading from the Dallas Fed on manufacturing activity in the region which showed another steep decline. The average of five regional Fed indexes now shows a drop to levels only seen during recession.
It’s interesting to note that one of the components showing the steepest decline in Dallas was the outlook for hiring. This adds to a growing list of similar readings such as the significant decline in the household survey of employment and the persistent drop in the hires level from the Jolts report. Adding to the list, according to Challenger, Gray & Christmas, January saw, “the second-highest layoff total and the lowest planned hiring level for the month of January in data going back to 2009.”
It should not come as much of a surprise then to see that workers have lost confidence in the outlook for their own employers. Bloomberg reports that amid the growing number of layoffs and concomitant decline in hiring, “US workers are more downbeat about the prospects for their employers than at any time in nearly a decade.”
Of course, employees are also consumers whom comprise the majority of economic activity. Layoffs thus mean less spending and a slower economy. But fear of being laid off can also have a similar effect. And if these employees losing confidence in their employers begin to spend less, putting more pressure on corporate revenues, layoffs may become even more likely. This is why once labor trends turn south, the vicious economic cycle it creates can make a recession inevitable.
Last, but certainly not least, there is also the issue of the credit cycle and the renewed problems on regional bank balance sheets. Even if what is going on at New York Community Bank, which saw its stock price halved this week, is not a systemic issue, it is representative of a bigger problem for its peers which is likely to put a damper on credit creation for quite some time.
Facing significant losses in their commercial real estate loan portfolios, these banks are unlikely to generously extend credit in any capacity until those issues are resolved somehow. Because we are nowhere near a resolution in that regard, credit is unlikely to flow in a way going forward that would be supportive of economic activity which clearly appears to be decelerating. And slowing economic activity amid a weakening labor market and tight credit conditions is just the recipe for recession.
Get Real, Part Deux
With the federal deficit already gaping, a recession could be the catalyst for a real fiscal crisis. For the past year or so I have been tracking the growing list of those warning of a “debt spiral.” We can now add former Treasury Secretary Robert Rubin and author of The Black Swan, Nassim Taleb. This week, Taleb told an audience at a Universa Investments event,
So long as you have Congress keep extending the debt limit and doing deals because they’re afraid of the consequences of doing the right thing, that’s the political structure of the political system, eventually you’re going to have a debt spiral. And a debt spiral is like a death spiral.
Taleb later explained that what he meant by a “debt spiral” is a situation in which the cost of servicing the debt grows such that it overwhelms all other spending. New debt much be issued simply to service existing debt and so the total debt pile begins to grow exponentially. The point at which a growing debt problem becomes this sort of a crisis is, of course, not knowable in advance. However, it’s not outrageous to suggest it could be closer than most appreciate.
“As budget deficits surge toward the stratosphere, Congress will soon have to get serious about savings proposals. Yet reforming Social Security and Medicare—the leading drivers of long-term deficits—remains a political nonstarter,” writes Brian Riedl in the Wall Street Journal. Cutting defense is also untenable given the geopolitical environment and no other spending items are significant enough to make a debt in the overall budget.
On the revenue side, he points out, “It’s farcical, however, to suggest that the tax-the-rich pot of gold is large enough to rein in our deficits and finance new spending programs. Seizing every dollar of income earned over $500,000 wouldn’t balance the budget. Liquidating every dollar of billionaire wealth would fund the federal government for only nine months.” If the problem seems untenable, that’s because it is. If nothing changes, a debt spiral is inevitable and it appears as if nothing is going to change any time soon.
So it’s more than a little strange that the bond market has, all of a sudden, become so complacent about all of this. But, as Robert Rubin points out, according to Bloomberg, “The danger is that when markets are ‘out of sync with reality,’ they can then ‘correct savagely’ — as happened when Greek bond premiums over German ones soared during the euro crisis.” That’s quite a warning coming from the former keeper of the nation’s coffers.
Of course, the Fed wouldn’t hesitate to step in and intervene in the bond market in such a scenario even if it meant abandoning the inflation side of its mandate. In fact, it has taught the treasury, congress and investors alike, through its past actions, that it would do so immediately and forcefully. In fact, this moral hazard created by the Fed makes any proactive policies to address the debt problem far less likely and thus a debt spiral far more so.
Perhaps some are starting to see the same writing on the wall that Taleb and Rubin are so dramatically pointing to. Demand for gold hit a new record last year and is poised to set a new one this year, according to the World Gold Council. Investor demand, specifically, is expected to grow at an “accelerated pace” this year given the expected path of monetary policy. Considering its intersection with profligate fiscal policy, they may soon need to upgrade “accelerated pace” to “exponential pace.”
