The Fed is completely backed into a corner, and no amount of Fed optimism or modern financial engineering will change that fact. It's time to act and honestly acknowledge what is really at stake for the economy.
The only sensible way forward at this point is for the Fed to meet the challenge head-on and use all of its “tightening” tools to fight inflation.
After over 13 years of reckless “easy money” policies and literally encouraging “moral hazard” through bailing out and backstopping markets for more than twice that long (the '87 crash, LTCM, dot com/911, the housing bubble burst, COVID), the Fed and federal government have reached the end of the “Great Moderation” period and ushered in a new era characterized by extremes, volatility, and a distinct lack of moderation.
We have come a long way since the end of the most extreme secular cycle in 1983, when then-Federal Reserve Chairman Paul Volcker finally succeeded in staving off persistent inflation by dispelling the misconception among market participants that easy monetary conditions would soon return (of course, this was a decision made in hindsight, as this fact was not yet known from Volcker's real-time perspective at the time).
An article published in Britain's Sunday Telegraph on July 10, 1983 captures the sentiment well: “In 1979, Mr. Volcker weaned the Fed away from its old habit of playing the financial game by Wall Street rules. The big change was a change in policy regarding the money supply. No longer did the Fed pounce every time Wall Street money markets slightly exceeded desired limits. The Fed's old tools for measuring the money supply, M1, M2, were revamped to improve statistical accuracy. The Fed's policy was to set desired growth rates for various aggregates and let market rates aim for their own levels.”
When asked at a congressional hearing in mid-1983 if he thought long-term interest rates would ever return to the 5% or 6% range (interest rates were nearly double at the time of the hearing), Volcker said: “I hope that those days are not gone forever. If we were confident of a long-term stable monetary environment, those kinds of interest rates would be quite normal. We all lived through the late 1960s and late 1970s, and it would be very difficult to get back to that environment.”
Fast forward to the modern era and the legacy of Maestro Helicopter Ben and dovish Yellen and Powell has taken its toll, instilling the exact opposite feeling in today's market participants.
Speculators, traders, bankers, financiers, business owners, and ordinary Americans are all astounded by the excesses of liquidity and have little faith that the easy monetary regime is actually over.
Watching business media pundits endlessly speculate about the next 25 or 50 basis point Fed rate hike and whether inflation may have already peaked given the Fed's recent actions seems ridiculous compared to the bitter battles against “public enemy number one” that continued throughout the 1970s and 1980s, when the federal government had the nation embroiled in a false and pointless battle to “contain inflation now.”
If the fact that 25 or 50 basis points seemed like a margin of error during the Volcker era wasn't bad enough, consider that this is happening against the backdrop of a Fed that has completed a regime change away from literal zero interest rates.
The market and all its participants are highly sensitive to interest rates and their expectations are extremely outlandish and childish, as a coddled monetary system becomes fragile and unable to accommodate even the economic conditions that seemed so favorable for most of modern history.
Moreover, there seems to be a certain distrust in this era, with many observers expressing a complete incredulity that the federal government would actually (or could) wage a legitimate fight against inflation, rather than, as some observers predict, choosing inflation to somehow get its way out of the problem in order to escape the consequences of its self-imposed, albeit enormous, debt liabilities.
“The Fed doesn't want to get caught in inflation, and would rather inflate its debt away…” one observer noted, “that has always been and remains the easiest and most preferred option for central banks,” while another noted, “Hyperinflation or default are both bad outcomes, of course, but hyperinflation is probably the option politicians and central bankers prefer because it takes longer to unfold and is harder to blame than outright default.”
Even astute macroeconomic observers believe that the Fed will abandon its tightening regime and return to an accommodative stance at the first sign of stress, but is this really a realistic scenario? Is the Fed such a weak institution that it could abdicate its primary responsibilities and collapse instantly, dooming the entire U.S. economy and millions of American households in particular, endangering the stability of society as a whole, and even threatening the realistic prospect of a final stage of hyperinflation?
Let us look at this brief passage from the Miami Herald of October 14, 1979, to gain a valuable realistic perspective on the costs of unanchored inflation, particularly in the American context.
Americans in the late 1970s learned that when inflation continued to run wild, every household, business, and institution, individually, struggled to cope with the disruptions caused by such extreme economic conditions, jeopardizing the stability of the entire economic system. This widespread instability and ultimately the economic hardship it caused was felt unequally, leading to a sense of injustice that spilled over into the social and political spheres, creating instability in the truest sense of the word.
The Fed will not allow this to happen again, given concerns about widespread systemic instability.
In 2008, as the economic crisis caused by the collapse of the national housing market was weighing heavily on the economy and causing hardships for households, businesses and institutions alike (albeit obviously from a deflationary perspective), the Fed panicked and not only took action but also overreacted to the situation, doing everything it could to mitigate the effects of that period and, in the Fed's view at the time, save the economic system from catastrophe.
Today, the situation will remain the same, as the Fed recognizes that inflation is unstable and persistent, and is maintaining a tight monetary stance to ensure systemic stability even as the pain of rising interest rates is widely felt.
Certainly, the pain will be felt most acutely by the federal government itself, as a significantly increased portion of the federal budget will be allocated to paying down the exorbitant national debt, leading to difficult decisions about national priorities.
However, it is important to note that the entire federal debt is not immediately refinanced at higher interest rates in line with the Fed's interest rate policy, but rather interest rates will increase over time as some existing debt matures and new debt is issued at the prevailing higher interest rates.
The federal government will have to make tough choices in the form of real spending cuts that will have a real, measurable impact on some households and businesses, but no matter how bad a new era of fiscal austerity may seem, it is surely a better option than the rapid and severe erosion of most Americans' living standards and retirement savings that would result from unchecked inflation.
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