Raghuram Rajan, former central banker and current professor of finance at the University of Chicago, asks the primary question of the day in the Financial Times:
“Why is the US Federal Reserve finding it so hard to convince the market that it means business when it comes to not cutting rates?”
“The December meeting minutes stated clearly, ‘No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.'”
But, the Federal Reserve cannot seem to get this point across to the investment community.
Mr. Rajan treats the subject historically and goes back through several regimes of monetary policy to examine how the Fed has approached policy efforts in order to keep inflation under control or get inflation under control.
Mr. Rajan reluctantly comes to the conclusion that “central banks can’t win when it comes to credibility on inflation.”
Mr. Rajan explains that there always seems to be a loose end or two in whatever the Federal Reserve is trying to do that prohibits it from attaining the monetary stance it would like to achieve.
For example, the Fed’s current frameworks, adopted in 2020, embedded “inflation tolerance within them”:
“A key element of the Fed’s new framework was that it would no longer be pre-emptive in heading off inflation. The old mantra, that if you are staring inflation in the eyeballs it is already too late, was abandoned.”
“While none of this was particularly effective in moving inflation higher, it may have emboldened the government to spend more, knowing the central bank would not raise interest rates quickly.”
“When the pandemic hit, there were few constraints on government spending which, together with the war in Ukraine, pushed us back into a high-inflation regime.”
“But central banks again find themselves with the wrong kind of credibility — namely the assumption that they will tolerate inflation.”
“No wonder markets continue to price in Fed cuts, even as the Fed insists it will not turn accommodative until inflation is tamed.”
Federal Government Expenditures
Look at what has happened to government expenditures since 2020.
Once the pandemic period appeared, the Federal Government has assumed that it can do just about anything it wants to do because of the apparent fragility of the economy.
And, this appears to be true, regardless of whether or not the Federal Reserve is fighting off inflation.
The Federal Reserve really began its “battle” in March 2022.
Look at what has happened to Federal Government expenditures in 2022. Note that we only have the accounting for three quarters in this past year.
In Quarter I, 2022, the Federal Government spent $5,9 trillion: in Quarter III, 2022 the Federal Government spent $6.1 trillion.
Furthermore, the Federal Debt rose substantially during this period.
Here are the Federal budget deficits during this period of time.
Here is the picture of the increasing Federal debt during this period.
It is obvious that once the focus of the Federal government became protecting the public from the economic consequences of the Covid-19 pandemic, all caution was thrown to the wind.
The Federal Reserve may have thrown its attention to the battle against inflation in 2022, but, the Federal government kept up its spending from early in 2020 through the end of 2022.
And, there is no indication that the Federal government will back off from its excessive spending in 2023 or beyond.
The Federal Reserve says nothing about the U.S. fiscal situation.
The financial markets say nothing about the U.S. fiscal situation.
Yet, how can the Federal Reserve win its battle against inflation if the Federal government is continually bumping up spending and adding massive amounts of debt to what it owes the world?
No wonder the investment community doesn’t believe the Fed when its leaders say they are going to maintain their tight monetary policy until it hurts.
Mr. Rajan has drawn us a very clear picture.
Ever since the end of the Great Recession, the Federal Reserve has attempted to construct a “new” approach to monetary policy, one that would achieve economic growth with a minimum of inflation.
So, Ben Bernanke gave us a policy of “quantitative easing” where the Fed bought regular amounts of securities so as to keep supplying the economy with “expected” amounts of new funds.
Ms. Yellen asked us to accept a little more inflation so as to gain a little more economic growth.
Mr. Powell, at first, kept on with the quantitative easing, again looking for pumping up the economic growth rate a little bit more.
Then, the pandemic hit, and all caution was thrown overboard.
Now, higher rates of inflation are a concern, so Mr. Powell has moved to another policy approach.
Yet, government spending and government deficits, continue to dominate the horizon.
And, here we are in the investment world, bewildered by what we are to focus on and what we are to expect from those people leading us through this exercise.
The investment community seems to have doubts about the actions of the Federal Reserve.
Maybe the investment community has some reasons why this doubt is justified. Maybe.