The “7% solution” on interest rates could come back to haunt the Federal Reserve
A trader watches Federal Reserve Chairman Jerome Powell speak on a screen on the floor of the New York Stock Exchange (NYSE), November 2, 2022.
Brendan McDermid | Reuters
St. Louis Federal Reserve Chairman James Bullard suggested on Thursday that the central bank may need to raise short-term interest rates as high as 7% to ensure inflation subsides.
Once again, Bullard and other Fed officials argue that the central bank cannot repeat the policy mistakes of the 1970s.
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Former U.S. Treasury Secretary Larry Summers and others have also backed this view, putting increasing pressure on the Fed to fix a problem that has no unique historical analog.
Bullard noted that policy would turn tight with the fed funds rate somewhere between 5% and 7%, and it may well have to stay there before the Fed can declare inflation dead.
His “7% solution” is, in my opinion, complete and utter nonsense.
A rate hike of up to three percentage points from the Fed’s current target range of 3.75% to 4% would ensure a very deep recession. This would ensure that something breaks somewhere, risking a systemic market or economic event that would shake financial markets or the economy to its very essence.
That, in turn, would force the Fed to “pivot,” lowering rates to avoid the kind of systemic risk that can quickly turn global and disastrous.
Signs of easing inflationary pressures
First and foremost, inflation begins to decline. It is the case that it is its headline or core consumer prices or other measures of inflation more closely watched by the Fed.
The last four months of the headline consumer price index, if annualized, implies that consumer prices will return to just above 2% by next year, well ahead of the timeframe predicted by the Fed.
Energy prices slump further as crude oil fell Thursday to its lowest level since January.
Some Wall Street firms are predicting a 15% to 20% drop in home prices in 2023 as mortgage applications, pending home sales, new and existing home sales and purchase cancellations all indicate a very deep recession in residential real estate.
The economy has rarely, if ever, avoided a general recession after housing activity collapsed.
The increasingly steep inversion of the yield curve is perhaps even more revealing.
The three-month treasury bill is now yielding almost half a percentage point more than the 10-year note.
Former New York Fed economist Arturo Estrella, whom I often quote and who did fundamental research on the predictive powers of this particular spread, says that unless the curve steepens so much in the coming weeks when the 10-year note will fetch more than the three-month note, a recession in 2023 is a certainty.
There is almost no scenario over the next two weeks that would suggest a steeper yield curve by any observable measure.
The question now becomes, how wide and deep will next year’s recession be?
This leads me to argue that not only Jim Bullard, but almost every panel of voting Fed officials suffers from some sort of mass delusion.
A radically different era from the 1970s
This economy has nothing to do with that of the 1970s. Making a policy mistake that is far too restrictive, rather than too easy, is the critical mistake the Fed is risking.
If the Fed were to raise rates to 7%, well above an inflation rate that could drop to 3% or lower, next year would be historically tight. This would risk creating a deeper problem than the one the Fed is trying to solve and the central bank is desperately trying to avoid repeating.
Compared to the 1970s, the energy intensity of the economy is radically different, as is the composition of the labor market.
When the United States came off the gold standard, suffered two major oil shocks, and felt the ill effects of poor policy decisions, greater sensitivity to energy price changes, and greater unionization of the labor have created fertile ground for spiraling wages and prices. fears today.
These fears continue to guide current policy decisions despite the noticeable improvement in the inflation data itself, expectations of future inflationary pressures, slowing consumer demand, and a decided shift in financial market concerns from the inflation to recession.
The conditions that created inflation a generation ago simply do not exist today. This makes comparisons with the many and varied factors that pushed inflation up from 1964 to 1980 a gross error in judgment.
Supply chain disruptions have eased, as evidenced by the plummeting cost of shipping containers from China to the US West Coast
Stocks of unsold goods continue to hurt retailers nationwide as Target demonstrated earlier this week. Meanwhile, even economically sensitive companies like FedEx are cutting worker hours and employment ahead of the typically busy holiday delivery season, a sign of a weakening economy and easing pressures on commodity prices. consumer goods.
The Fed’s current stance on policy is one of fear and not at all forward-looking.
By simply trying to avoid the mistakes of the past, the power plant is embarking on a mistake that will affect our future.
You can’t drive a car by looking in the rearview mirror, and you can’t drive an economy using outdated comparisons.
If short rates rise to 7%, this solution will be much more painful than the current problem it hopes to solve.
I remain deeply intrigued by the political judgment of this Federal Reserve.
He seems to have abandoned his faith in the so-called “reaction function” of the markets and instead focuses solely on the ghosts of past inflation.
As the holiday season approaches, it may be incumbent on the Fed to take a more charitable view of the economy. If the central bankers don’t, not only will they take away the punch bowl, but it will be nearly impossible to refill once the party comes to a screeching halt.
— Ron Insana is a CNBC contributor and senior adviser at Schroders.