The Great Jerome of Washington

Partha Chakraborty-

Partha Chakraborty

“Do you ever wait for the longest day of the year and then miss it? I always wait for the longest day of the year and then miss it!” Daisy Buchanan in The Great Gatsby.

Flapper queen Daisy Buchanan in “The Great Gatsby” never had to worry about inflation. If she did, her record would be no worse than the Great Jerome (Powell) of Washington, currently the Fed Chair. Or Janet Yellen. Or Paul Krugman. And many others. Just like the sunshine that Daisy missed, signs of inflation were all there. Regular readers will remember last year in October we rued about the pervasive and persistent nature of inflation arising out of supply chain issues in Dude you’re not having a Dell for Christmas. One month later in November, we wondered aloud about recession in Face up or fess up to the R-word. Half a year on, inflation is at a multi-decade high, Fed increased rates twice, and the majority of practitioners are predicting a recession by 2023. Time to take stock.

This time around, I am preparing for a period of economic hurt as payback for past sins.

US inflation may already be near its historical peak. In 1983, BLS (Bureau of Labor Statistics) switched how they calculate CPI. Authors Marijn Bolhuis, Judd Cramer, and Larry Summers found that the peak core inflation rate of 13.6% in June, 1980 would be 9.1% using the new method, today’s figures are close. There are signs that US economy has already cooled down significantly, even if Fed has not raised rates by much. Demand for residential real estate has decreased, and construction of new homes is slowing. There is weakness in commodities pricing – reflecting continued lockdowns in China, war in Ukraine and a general global economic malaise. Brent crude dipped below $100 a barrel recently for the first time since late April. Copper, traditionally a good gauge of economic pressures building up, is down by over 20 percent this year. If these trends continue and are reflected more broadly in prices, there will be little need for Fed tightening further than what the market has already baked in. The economy is much less energy-intensive than in 1980, households and businesses’ balance-sheets are mostly strong. Risks in the financial system appear manageable. The Fed has earned quite a credibility in recent decades, which might explain a new-found haste to raise the rates after missing inflation for two years. With all that in mind, many economists predict that the Fed will indeed be successful in dampening inflation without driving into deep depression.

Fixed Income (Bond) markets typically act as a good bellwether. Very recently, there is a slight easing of pressure on bond prices showing some confidence in the Fed’s capacity to curb inflation. The Fed will most likely hike rates by 75bp rate in July. Bond markets are expecting Fed rates of 3.25% – 3.75% in early 2023 with a possible rate cut later that year.

Mission accomplished? Not quite.

Larry Summers was prescient in his call for a looming inflationary pressure, way back in 2020. As he observed, whenever inflation is over 4% with unemployment below 4% America has suffered a recession within two years, every single time. US economy has crossed both markers. By Dr. Summers’ calculations nominal rates need to hit 5.5%, not 3.75% nor even 4.25%, to make any dent – he posits “a substantially greater probability that we’ll need higher rates than the Fed now envisions or the market now predicts”. The same numbers that put current numbers closer to 1980’s peak also imply that the Fed may have to deploy equally draconian measures to combat it. Then Fed Chair Paul Volcker brought a hike of effective rates north of 18% precipitating in a recession that last to the end of 1982. At the very least similar efforts will have debilitating impact on US government accounts.

Currently, interest expense is about USD 666 billion, increasing by USD 111 billion for each 3% rise, resulting in a USD 750+ Billion per year expense even if the Fed raises rates to the low end of forecasts, likely over USD 1 Trillion. For comparison, US 1 Trillion is a bigger number than we spend on defense and Medicare combined today; it will be more damaging when tax receipts shrink and Treasury’s capacity to raise new debt essentially goes to naught.

What complicates the picture are two realities not discussed widely – a. Self-fulfilling prophecy and b. shift in Beveridge Curve.

Professional participants and forecasters generally accept long-term normalized inflation at Fed’s 2% target, consumers increasingly do not. Consumers are expecting inflations over 5%, as do firms exposed to surging commodity prices. Median inflation expectations almost doubled from 2.3% in 2021 to 4.2% now. 4 in 10 consumers now think Fed’s inflation target is over 10%. A self-fulfilling prophecy kicks in – if you think you will face higher prices on one side of the ledger, you will demand higher prices on the other side, starting a never-ending vortex. To counter a similar problem, we needed “inflation nutter” like Paul Volcker who made it his mission to break the chain, no matter what the cost. He did, for a price.

We do not see the same conviction at the Fed today.

Beveridge curve formalizes an intuitive relationship between vacancies and unemployment rate, viz., the more vacancies there are, the lower the unemployment rate. Research indicates that since the onset of the pandemic the curve has shifted outwards, implying, it now takes more vacancies to get to the same unemployment rate. During COVID, workers moved away from population centers to escape outbreaks, now they are hard pressed to return. Ease of remote work made more people less compatible when companies demand more in-person work. People’s new fondness of takeout killed low-skill jobs at restaurants. Families are still not back to both adults searching for jobs as childcare remains spotty. In short, US economy lost its capacity to match the right people with the right job, resulting in over ten million unfilled jobs with less than five million people looking for jobs.

An easy corollary is the upward pressure on wages, especially for jobs requiring special skill and physical presence. Airlines, just back from the graveyards after decimation of pleasure travel during the pandemic, are having to jack up compensation by almost 20% in some cases. Part of that is reflected in 37%+ increase in US domestic airfare on average. The story repeats.  Research suggests that for vacancies to return to their 2019 level, the unemployment rate would rise to more than 6% – a rise of half a percentage point in a three-month average unemployment rate above its low over the preceding 12 months predicts a recession. “Sahm Rule” observes that every time it has occurred since 1950, it has either coincided with, or has shortly been followed by, a downturn.

Shift in Beveridge curve is recent and Sahm Rule is only observed in the rear-view mirror. The jury is still out for sure, though I get no comfort.

We could go ad-infinitum as to what went wrong. Successive US administrations borrowed about USD 5.9 Trillion over 16 months and introduced newly printed money in the economy- that’s a whole lot of money chasing a supply of goods that was constricted by the pandemic in the first place. It resulted in asset inflation – stocks, houses, durable goods – and that is only starting to correct for real. As supply of these assets gets limited people are turning to consumption – the same amount of “new” money is still stirring the pot, resulting in higher prices, even without any supply chain issues or the Ukraine War. Elementary, Dear Watson.

Given where we are, we also need a new Volcker in our midst – somebody who will clearly enunciate and execute a break from inflationary tendencies.  This means we are in for a lot of hurts. Better get used to it.