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Is a recession coming? Yes, if the Fed keeps ignoring the metric that matters most says a prominent Johns Hopkins economist

April 21, 2022, 11:00 PM UTC

A prestigious chorus of experts now forecast that a U.S. recession is practically a sure thing. In an April 14 interview, former Treasury Secretary Larry Summers declared, “There has never been a moment when inflation was above 4% and unemployment below 5% when we didn’t have a recession within two years.” Summers chided the Fed for suggesting that a “soft landing” is likely, advising its leaders to level with the public by issuing a far more realistic, and rocky, view for the road ahead. Summers put the odds of a recession at “quite possibly at two-thirds or more.” A couple of weeks earlier, Bill Dudley, who headed the New York Fed from 2009 to 2018, gave an even gloomier assessment in a Bloomberg oped, warning that “the Fed has made a recession inevitable.” For Dudley, the central bank misfired by keeping monetary policy so loose, for so long, that “cooling things off” will require a tightening cycle so severe that it’s bound to send the economy from a boom to a tailspin.

Even the most usually dovish of the Fed braintrust are turning hawkish. Governor Lael Brainard and Minneapolis Fed chief Neel Kashkari, among other traditional progressives, are calling for big, fast increases in the Fed Funds rate and a rapid shrinkage in the central bank’s balance sheet, tough measures that frequently trigger steep downturns.

A year ago, a prominent economist used the orthodox quantity theory of money to predict what the Fed and almost all of his peers missed: That an inflationary explosion was close at hand. He even hit the mark by predicting that prices would be roaring at 6% and as much as 9% by the close of 2021. He’s Steve Hanke, a hardcore monetarist and professor of applied economics at Johns Hopkins University. Hanke made the prescient call on inflation in a July 2021 oped in the Wall Street Journal co-authored with his Johns Hopkins colleague and the former Invesco chief economist John Greenwood. Now Hanke agrees with Summers and Dudley that the we’re facing a high probability of a recession. But he reaches that conclusion for very different reasons.

Hanke asserts that the Fed could avoid tanking the economy by simply following the playbook that has on occasion worked in past periods of leap in inflation. “The real problem isn’t that a flight to safety is impossible, it’s the Fed’s policies,” Hanke told Fortune. Added the veteran amateur pilot: “The Fed’s like a pilot that’s ignoring the altimeter that shows the plane’s altitude. It needs to stop flying blind to achieve the soft landing that Chairman Powell is promising.” Hanke thinks the Fed can still avert that dreaded crash landing—but it must exercise precision to hit the right targets, something it is currently not doing.

What caused the jump in inflation

For Hanke, the “altimeter” that always and solely determines the rate of inflation is the level and trajectory of the money supply. That’s the crucial yardstick the Fed’s shunned to get us into this mess, and the one it must follow to get us out. For Hanke, it was the Fed’s money printing marshaled to fund the blowout in deficits that spawned today’s price pressures. “High fiscal deficits don’t in themselves cause inflation,” he explains. “If the citizens buy the bonds, they transfer their spending power to the government, but inflation wouldn’t go up. Instead, it’s the Fed that’s been buying the bonds with printed money. It was like a helicopter dumping new dollars across America.” The extra trillions in outlays aimed at combating the COVID crisis spawned the deficits. The Fed then “monetized” over 90% those extra fiscal shortfalls by creating dollars, and in the process, fattened the money supply. Indeed, the Fed piled an incredible $3.8 trillion of newly-issued Treasuries on its balance sheet since February of 2020, almost tripling its holdings.

In pursuing that policy of Quantitative Easing, the Fed swelled the money supply, or M2, by close to a cumulative 41% in just over two years. “That’s an unprecedented increase,” Hanke notes. He likes to compare how that green tide lifts inflation, to the buildup of water in a bathtub. “If the faucet is wide open as in the past two years, the water enters much faster than it can drain out,” he says. “That’s been happening since February of 2020.” The rising water level, or the excess money supply, drains via two valves. The first is “real” growth in GDP as the economy produces more goods and services. The second is “demand for money,” as peoples’ holdings in cash, checking and money market accounts rise along with their incomes.

The two exit valves, he says, will drain only part of that accumulation––and leave a glut that will overflow the tub as extra inflation. “There’s a lag of 12 to 24 months before a huge buildup in the money supply turns into inflation,” he says. “That’s what I saw in mid-2021 that led me to call big price increases by the end of the year. But the Fed ignored that signal completely.” Hence, Hanke notes that whatever the Fed’s course of action now, he predicts the U.S. will be stuck with inflation of 6% or more this year, through all of 2023, and perhaps into the early months of 2024, as the excess keeps draining out of the the monetary’s bathtub’s overflow valve.

For Hanke, the solution is slowing the money supply to a golden growth rate of around 6% a year. At that pace, the amount of water entering should fill the tub just enough so that the Fed hits its inflation target of 2%. Back of the envelope, says Hanke, 2% of that money supply growth fuels real economic expansion, 2% goes to accommodate the increase in the demand for money, and 2% is left in the tub to eventually flow through the inflation overflow valve. But it’s not clear that will happen, because the Fed isn’t watching the money supply at all. Here’s strong evidence: Even now, long after the Fed killed the “transitory” label and declared inflation a major problem last November, M2 is growing year over year at an 11% clip, almost double the ideal rate of 6%. For Hanke, the Fed should fight inflation by tuning its instruments to steer the money supply on the correct course. Instead, the Fed pledges to push its levers without regard to M2, which for Hanke is the equivalent of flying without a gauge, not knowing whether you’re motoring over the clouds or skimming the ground.

The two sources of inflation

As Hanke points out, the jump in the money supply that’s causing all this pricing pressure has two sources. The first is the Fed itself. Its hand in monetizing the deficits that funded the spending blowout accounts for the biggest portion of the hangover we’re experiencing today. It’s the fount the Fed now targets by shrinking its balance sheet. The central bank ended its quantitative easing or QE campaign of amassing Treasuries with newly-minted money in March. The markets are expecting the Fed to start letting Treasuries run off as they mature and also reduce their holdings of mortgage backed securities starting in May, marking a shift to QT or Quantitative Tightening. “There’s no question that shrinking the balance sheet is a predictable instrument for lowering the Fed’s contribution to the money supply,” says Hanke. The problem is whether the central bank gets the pace correct, and they could get it extremely wrong if they’re not watching the money supply reading.

The second source is the commercial banks. The more dollars they lend, the faster M2 increases, and banks have been extending big volumes of new home, refi, and credit card loans in these flush times. Put simply, the more dollars banks channel to borrowers, the faster the money supply expands.

The Fed’s strategy of sharply raising the Fed Funds rate is aimed at the second source––curbing credit furnished by banks. But Hanke fears that over-reliance on lifting rates is where the trouble lies. “There’s no clear linkage between an increase in the Fed Funds rate and changes in the growth rate of the money supply provided by banks,” he notes. “Most people think that raising the Fed Fund rate automatically indicates a tightening of monetary policy. But that’s not necessarily the case. You don’t know if the Fed’s tightened until you look at the money supply numbers.” (Read: the altimeter.) He notes the current strong demand for credit is clouding the picture. Companies have high margins and want to expand, he observes. Consumer balance sheets are in good shape. Even after a few hikes, adds Hanke, many categories of interest rates could remain below the level of inflation, making the likes of new mortgages still a bargain. In that instance, the money supply could keep growing even in the face of Fed rate increases.

Is a recession coming?

Hanke is convinced of one thing: to avoid a recession the Fed must follow the money supply, something that will require an exquisitely fine maneuvering of both levers the Fed has control over (QE and interest rates). It’s vital to keep the money supply growing, because all the times the U.S. has achieved a soft landing, he says, have occurred when the money supply kept waxing. “Even in the cases where the Fed raised rates as in 1965, 1984, and 1994-5, the economy didn’t suffer a swoon because money supply growth supported sufficient buying power,” he says. By contrast, all recessions are characterized by sharp declines in M2––Hanke cites the examples of 1973, 1988-1989, and 1999-2000. There are two ways he thinks the Fed could go wrong: One, they become so panicked by the scary monthly inflation numbers that they overdo it by raising rates too high or shrinking the balance sheet too rapidly so that they hammer the money supply, crashing the economy. Second, if the Biden Administration figures that a recession will be even more damaging in the coming elections than rampant inflation, they could keep whispering to Powell, who could keep the money supply goosed. In that case it’ll take much longer than two years for the fabled tub to drain the excess from past mistakes.

The right course, he says, is adjusting the various levers to achieve the ideal 6% growth rate in the money supply that assures the Fed’s 2% target. For example, if despite big increases in the Fed Funds rate, bank lending keeps going gangbusters, it might be necessary to hasten the runoff in the balance sheet that throttles back M2. Or if rate increases greatly diminish credit and shrink M2 more rapidly than expected, the Fed could slow or pause the decline in its balance sheet to ensure the policy mix that hits the 6% goal.

However, in Congressional testimony, Powell has explicitly stated that the status of money supply has little or no effect on the course of the economy, a position that makes Hanke skeptical that he’ll get the delicate balance right. Hanke compares the central bank to a hapless flyer of yore, Douglas “Wrong Way” Corrigan. In 1938, Corrigan made a celebrated transcontinental flight from Long Beach to New York. Then, instead of cruising back to California as planned, he took off east instead of west, landing apparently to his own amazement, in Ireland. Corrigan blamed heavy cloud cover for winging 2500 miles the wrong way. The misadventure earned him an immortal nickname revived by Hanke to characterize what he calls the “Wrong Way Fed,” the pilot that’s ignoring the one, crucial gauge needed to bring our economy to a smooth, safe landing.

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