“Inflation is going to be a little more sustained than what people are looking for. Also it’s much harder than people think to achieve a soft landing……
I suspect they’re going to need more increases in interest rates than the market is now judging.“
Chairman Powell’s speech
Fed Chairman Jerome Powell’s remarks to the Brookings Institution, Wednesday 30th November, addressed two key questions:
- What does the Fed expect inflation to do in the months ahead?
- How is Fed monetary policy likely to respond?
Where is inflation headed?
“Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”
Powell focuses on core PCE inflation — which excludes food and energy, over which the Fed has little control — as this gives a “more accurate indication of where overall inflation is headed”. Core PCE is divided into three categories: (a) Core Goods; (b) Housing Services; and (c) Non-Housing Services.
Core Goods inflation is falling as supply chain issues are resolved and energy prices decline.
Housing Services is rising but tends to lag actual rental increases by 6 to 9 months. Rents were growing at between 16% and 18% in mid-2021 when PCE housing services inflation was still below 4% which means that core PCE inflation in 2021 was understated by a sizable margin. Housing services inflation is expected to fall “sometime next year” as lower rental renewals begin to feed into the index.
Non-Housing Services — the largest of the three categories — “may be the most important category for understanding the future evolution of core inflation” and, by inference, the evolution of broad inflation.
This spending category covers a wide range of services from health care and education to haircuts and hospitality…..Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.
In short, if you want to understand the future of inflation, look at the labor market.
Demand for labor far exceeds the supply, with job openings at 10.3 million in October far above unemployment at 6.1 million.
The primary causes of the current tight labor market are: (a) a large number of workers taking early retirement; and (b) a surge in deaths during the pandemic.
The Fed believes that there is still some way to go:
So far, we have seen only tentative signs of moderation of labor demand. With slower GDP growth this year, job gains have stepped down from more than 450,000 per month over the first seven months of the year to about 290,000 per month over the past three months. But this job growth remains far in excess of the pace needed to accommodate population growth over time — about 100,000 per month by many estimates…..
Wage growth, too, shows only tentative signs of returning to balance.
Today’s ADP data warns of a manufacturing and construction slow-down but growth in services employment and overall earnings:
Private businesses in the US created 127K jobs in November of 2022, the least since January of 2021, and well below market forecasts of 200K. The slowdown was led by the manufacturing sector (-100K jobs) and interest rate-sensitive sectors like construction (-2K), professional/business services (-77K); financial activities (-34K); and information (-25K). The goods sector shed 86K jobs. On the other hand, consumer-facing segments were bright spots. The services-providing sector created 213K jobs, led by leisure/hospitality (224K); trade/transportation/utilities (62K); education/health (55K). Meanwhile, annual pay was up 7.6%. “The data suggest that Fed tightening is having an impact on job creation and pay gains. In addition, companies are no longer in hyper-replacement mode. Fewer people are quitting and the post-pandemic recovery is stabilizing”, said Nela Richardson, chief economist, ADP. (Monex)
Fed monetary policy
Powell continues, hinting at a moderation in the rate of increases:
Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.
The Fed is deliberately feeding optimism on Wall Street, but we are unclear as to their motive. Possibly it is an attempt to manage long-term Treasury yields. Keeping LT yields low would most likely raise earnings multiples for stocks and lower mortgage rates for home buyers, slowing the decline in asset values.
More likely, as Wolf Richter points out, a buoyant stock market gives the Fed political cover for further rate hikes. Plunging asset prices would ramp up political pressure on the Fed to cut interest rates, whereas market gains take the heat off the Fed, giving them further leeway to hike interest rates.
Conclusion
Fed policy is likely to be determined by two factors:
- moderation of core PCE inflation to below the Fed’s 2% target; and
- a significant rise in unemployment and/or fall in job openings. Powell describes this as “restoration of balance between supply and demand in the labor market.”
They are likely to continue hiking rates, but at a slower pace of 50 basis points, at least for the next two meetings.
Thereafter, we expect them to raise rates at a slower rate or, alternatively, pause and wait for the impact of past hikes to feed through into the broader economy. It could take 6 to 9 months to see the full effect of past hikes.
Unless something drastic happens, the Fed is unlikely to cut rates. Powell concludes (emphasis added):
It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.
P.S. The Dow rallied 700 points by the close, after Powell’s speech (WSJ). That increases the probability of at least one more 75 basis point hike at the next meeting.
Fed hikes now, pain comes later
Fed Chairman Jerome Powell announced a 75 basis point increase in the Fed funds target rate at his post-FOMC press conference today:
“Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. Restoring price stability will likely require maintaining a restrictive stance of policy for some time.”
The target range is now 3.75% to 4.0%.
Commenting on today’s announcement, Michael Contopoulos from Richard Bernstein says little has changed:
“Nothing really changed today, the Fed has been hawkish since Jackson Hole. It doesn’t matter how high rates go, what matters is that the Fed is going to be restrictive and they’re going to bring down long-term growth…..The end game is not cutting rates, at least any time soon, the end game is to slow growth and slow the economy.” (CNBC)
Chris Brightman from Research Affiliates, co-manager several PIMCO funds, offers a useful rule-of-thumb as to how far the Fed will need to hike. The unemployment rate has to rise by 1.0% for every 1.0% intended drop in core inflation.
Core inflation is close to 6.0% at present, if we take the average of core CPI (purple), growth in average hourly earnings (pink), and core PCE index (gray). To achieve the Fed’s 2.0% inflation target, using the above rule-of-thumb, would require a 4.0% increase in the unemployment rate.
That means an unemployment rate of 7.5% (red line below), making a recession almost certain.
The recent 10-year/3-month Treasury yield inversion also warns of a recession in 2023.
Conclusion
We expect the Fed to hike the funds rate to between 5.0% and 6.0% — the futures market reflects a peak of 5.1% in May ’23 — then a pause to assess the impact on the labor market. Employment tends to lag monetary policy by 6 to 12 months, so the results of recent rate hikes are only likely to show in 2023. The recent inversion of 10-year and 3-month Treasury yields also warns of a recession next year.
The unemployment rate will most likely need to rise to 7.5% to bring inflation back within the Fed’s target range. That would cause a deep recession, especially if the Fed holds rates high for an extended period as they have indicated.
Uncertainty still surrounds whether the Fed will be able to execute its stated plan. A sharp rise in unemployment or bond market collapse could cause an early Fed pivot as the Treasury yield curve and Fed fund futures still expect.
Important recession warning
We have had a number of major indicators warning of a bear market over the year, with the S&P 500 falling by more than 20%, completing a Dow Theory reversal, and 100-day Momentum holding below zero.
On the recession front, GDP recorded two quarters of negative growth — a useful rule of thumb recession measure. The middle of the Treasury yield curve also inverted — with the 10-year yield falling below the 2-year — warning of a recession ahead.
But unemployment (3.5%) is the lowest since the 1960s and the NBER has not moved to confirm a recession.
The front-end of the yield curve also remained positive, failing to confirm the signal from the 10-year/2-year negative spread.
Until now, that is.
On Tuesday, the 10-year/3-month Treasury spread turned negative, confirming the earlier 10Y/2Y recession warning.
Why is that important?
Because a negative 10-year/3-month spread has preceded every recession since 1960. One possible exception is 1966 (orange circle below). The 10Y/3M inverted, the Dow fell by 25%, and the NBER confirmed a recession but later changed their mind and airbrushed the recession out of the record. All-in-all, the 10Y/3M is our most reliable recession indicator, with a 100% track record in our view, over the past sixty years.
Conclusion
Our most reliable recession indicator, a negative 10-year/3-month Treasury yield differential, now confirms the recession warning from other indicators. But the signal is often early and it could take 6 to 12 months for the actual recession to arrive.
After their recent track record, expectations that the Fed will manufacture a soft landing are the triumph of hope over experience.
Employment is a lagging indicator and often only falls during the recession. Inflation likewise lags monetary policy by up to 6 months, before the full impact is clear. We expect the Fed to continue hiking, waiting for employment and inflation to fall, until the lagged impact of past rate hikes comes into view. Instead of cutting interest rates to soften the impact, the Fed has indicated they will hold rates high for longer. If so, we are likely to experience a severe recession.
Our strategy is to invest in cash in the short-term and limit exposure to equities, other than precious metals, critical materials, and defensive stocks.
Bond market: No place to hide
Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.
Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.
The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.
Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.
Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.
Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.
A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.
Conclusion
We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.
Will a recession kill inflation?
There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.
A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.
Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.
In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.
A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.
Conclusion
We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:
(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).
An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.
A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.
The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.
Acknowledgements
Alfonso Peccatiello for his analysis of CPI and recessions.
CPI shock upsets markets
The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.
The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.
Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.
Fueled by strong growth in average hourly earnings.
But it is not only services that present a problem.
Food prices are growing above 10% p.a. — signaling hardship for low income-earners.
The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.
CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).
The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.
The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.
Conclusion
Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.
Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.
The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.
We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).
Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.
Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.
The best short-term haven is cash.
CPI dips but rate hikes likely to continue
CPI dipped to 8.5% for the 12 months to July. But this still leaves the Fed way behind the curve, with a real Fed funds rate of -6.0% (8.5%-2.5%).
Monthly CPI figures, however, show a sharp slowdown, with CPI falling 0.01% in July (-0.14% annualized rate).
The primary cause is energy prices, which fell 4.53% in July (-54.7% annualized rate).
Food CPI continues to climb, up 1.06%for July (12.75% annualized rate).
CPI Shelter, heavily weighted at 32.1% of the total CPI basket, remains a major source of upward pressure on CPI. The Shelter index tends to lag home prices by up to 12 months and the Case-Shiller 20-City Composite Home Price Index grew at 20.8% for the 12 months to May.
The Rents component of CPI shelter shows a similar lag, a long way behind the Zillow rent index which is up 14.8% over the 12 months to June.
Wages & consumer expectations
Consumer expectations for inflation were unchanged, at 5.3% in June.
While average hourly wage rates moderated slightly, growing 6.2% in the 12 months to July.
Upward pressure on wages is likely to continue for as long as job openings exceed unemployment, with a current shortfall of 5 million workers.
The Fed
The real Fed funds rate (FFR adjusted for CPI) rose to a weak -6.0% after the latest rate hike, still lower than any previous trough in the past sixty years. Real FFR (red below) should be positive when unemployment (blue) is below 5%. Past lows, circled on the chart below, were in response to high unemployment — when the economy had spare capacity. We now have the opposite, with a tight labor market, and negative real rates are likely to give rise to high inflation.
Conclusion
Some are calling this “peak inflation” but the decline in CPI growth is due to a large monthly drop in energy prices. Food and shelter costs are still rising.
The energy crisis is not over, with Winter approaching in Europe while gas storage levels are at record lows and Russia is restricting pipeline flows in an attempt to create division within the European Union. Energy prices are likely to remain volatile.
The Fed is way behind the curve, with a real Fed funds rate of -6.0%. We expect them to continue hiking interest rates despite the recent fall in energy prices.
According to Larry Summers and Olivier Blanchard, the Fed will only be able to bring inflation down when unemployment is well above 5%. The danger is if the Fed is forced to halt rate hikes before it has tamed underlying inflation. We are then likely to end up with both low growth and high inflation.
Our strategy remains defensive: overweight Gold, critical materials, defensive stocks which enjoy strong pricing power, and cash.
Acknowledgements
- Hat tip to Wolf Richter for the CPI Rent/Zillow chart.
Jay Powell is selling but the bond market isn’t buying
Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:
June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.
“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.
Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”
He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.
The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.
But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.
The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.
You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.
CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.
Taming inflation in the 1980s
Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.
In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.
The Federal deficit was 2.5% of GDP. Now it’s 12%.
Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.
Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.
Pricking the bubble
Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.
So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.
Housing starts and permits are both declining.
Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.
The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.
Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).
If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.
That’s just the start.
“Inflation is always and everywhere a monetary phenomenon”
Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.
The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.
The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of inflationary consequences.
All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.
Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.
Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.
But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.
The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.
An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.
Conclusion
Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.
Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.
Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.
But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.
The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.
Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:
“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”
Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.
Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.
Larry Summers: Fed needs same disinflation as under Volcker
Larry Summers highlights a paper from the NBER regarding measurement of CPI since the 1980s. Changes in how cost of housing is measured have lowered core CPI relative to the methodology used prior to the early 1980s (blue line below). Applying the current methodology (red line) retrospectively suggests that comparable core CPI is closer to the Volcker era.
Summers continues:
“New paper shows past and present CPI inflation are more similar than official data suggests. When correcting for change in how housing inflation is measured, we find a return to target core inflation will require the same disinflation as achieved under Volcker.”