Economists, the markets, and regular folk turned Fed watchers harbored two positive expectations for the central bank’s pivotal June 14 meeting. The first—that the behemoth of money would leave its benchmark rate unchanged after 10 consecutive hikes—proved correct, but brought cold comfort. Reason: The second widely held view of gentler times ahead, putting the odds of a July increase at just 50-50, and anticipating no further jumps thereafter, got crushed by the neo-hawkish stance adopted by Chairman Jerome Powell. The freshly issued, median forecast from the Open Market Committee now calls for a Fed funds rate of 5.6% by year end, suggesting two 25-basis-point increases to come. That’s a shocking downer from the OMC’s March prediction for the current 5% to 5.25% range to prevail at the close of 2023.
Powell and the OMC polling sent a stern message that inflation remains both dangerously high and stubbornly persistent. Though the CPI downshifted to a less-than-anticipated, and apparently moderate, advance of 4% in May, Powell stressed that the “core” number, excluding food and energy, stayed alarmingly elevated at 5.3%. To deepen the dilemma, the OMC, on average, sees the core rising at 3.9% when this year ends, well above the Fed’s 2% target, and higher than the March estimate of 3.6%. Powell also emphasized that the second principal factor determining the Fed’s actions besides the core CPI—the jobs market—“remains very tight,” and the OMC sees the employment picture staying hotter over the coming months than the quicker loosening foreseen in March.
Bottom line: Unless future data shows a cooling trend that the Fed deems a long shot, the central bank will keep ratcheting up the cost of borrowing to curb consumer spending, and ease the labor and wage pressures. As Powell put it on June 14, “The process of getting inflation under control has a long way to go.”
The Fed’s getting it totally wrong, two leading economists agree
Steve Hanke and Cam Harvey are leaders in two different schools of economics, but they lock arms in condemning Fed’s rear-guard attack on a mostly bygone problem. Hanke, professor of applied economics at Johns Hopkins University, is a hard-core monetarist who believes that the principal source of inflation is growth in the money supply, or M2, and that its trajectory should guide Fed policy. Harvey, a Duke University economist, focuses on the “yield curve.” He studies the spread between short- and long-term interest rates to predict where the economy is headed, and hence how the Fed should deploy its tools. But both Hanke and Harvey agree, by the measure each embraces, that inflation is already conquered, and by continuing the big squeeze, the Fed will likely drive the U.S. into an unnecessary, and possibly steep, recession.
Harvey could have been speaking for Hanke as well when he told Fortune, “The Fed should have stood down on all hikes in June, and all they did was move the pace of increases down. All the raises so far in 2023 were a major mistake, and an extra 50 basis points will do even more damage. The recession likely to hit later this year or in 2024 will be a wound self-inflicted by the Fed.”
For Hanke, the Fed’s looking in the rearview mirror by watching the wrong indicators
Hanke maintains that the Fed is fixated only on today’s data, chiefly core inflation and the state of the job market. But those are lagging indicators, he insists. And the central bank is not watching the money supply, the force that drives all economic activity, but which operates with a lag. The core CPI excludes food and energy costs because those categories can fluctuate widely from month to month. Hanke says that because the core CPI leaves out important commodity costs, it’s missing an excellent guide to where inflation is headed: “Commodity prices almost always rise sharply within one to nine months following a big increase in M2, and the money supply exploded as never before in 2020 and 2021. You take the jackrabbit stuff out of the index, and you take out the best leading indicators.” Prices for the likes of oil and farm produce aren’t sticky like rents or home prices, he notes. They’re highly sensitive to real-time changes in supply and demand. Commodities usually lead the way in an inflationary upsurge, as they did this time, rising much faster than the overall CPI in the early stages. But then they’re the first items to drop as inflation recedes.
And that’s the cycle that’s now playing out. “It was fully predictable,” says Hanke. “At first, the overall CPI waxed much faster than the core because of the sensitivity of commodity prices; then it turned around as the money supply contracted, and the CPI is now falling much faster than the core.” The Fed’s mistake, he says, is to fix its gaze on core, when the decline in everything from oil to crops clamps a durable brake on inflation. “So the Fed looks at shelter, services, and other components that stay high for much longer. Taking out commodities makes it look like there’s more inflation in the system than there really is,” notes Hanke. Bolstering his take, he says, is the slowdown in the Producer Price index, which rose a puny 1.1% year over year in May. “That represents all energy, steel, and other inputs into the products people are buying,” he says, “and those prices are increasing at the slowest rate since December of 2020.”
The preoccupation over the plentiful jobs seeking scarce workers is a second lagging indicator, flashing a false sign blinding the Fed to the looming drop in inflation. “Before a downturn, companies don’t throw up their hands and start firing people, and stop offering new jobs,” observes Hanke. “They don’t let people go in anticipation of a recession, but only when they’re forced to by a big fall in sales and a squeeze in profit margins.”
For Hanke, the Fed’s continued hikes and quantitative tightening are so misguided because they’re causing a sharp contraction of M2—when M2 should actually be growing at around 6%, a number consistent with the Fed’s inflation target. “We haven’t seen this level of money supply contraction since 1937 and 1938,” says Hanke. In addition, he notes, demand for credit is falling because companies fear a downturn is coming, and the supply of credit is shrinking as banks cut back on lending as they lose deposits and regulation gets tougher. “Yet the Fed pursues that crazy policy of curbing credit, quantitative tightening, and imposing more stringent regulation. They’re using the wrong model. I have no confidence they’ll change anything,” concludes Hanke.
For Harvey, the yield curve is the key indicator—and it’s showing that more rate hikes spell disaster
Harvey views the yield curve as a “true north” compass charting the course of the economy. In all but highly unusual circumstances, yields on long-term Treasuries far exceed those on close-in maturities. But at present, the three-month T-bills are paying 5.2%, 1.5 points more than the 10-year at 3.7%. The steeply inverted slope, Harvey explains, raises two red flags. First, it portends a downturn. “The curve is eight for eight in forecasting recessions since 1968, and has never given a false signal,” he says. The threat of tough times ahead, of sinking or stagnant incomes, and less plentiful job openings, is already prompting consumers to hunker down by lifting what they save and curbing what they spend. The dour outlook also pushes companies to lower investment as they forecast flat or even falling sales for anything from appliances to autos. Hence, the yield curve predicts fast-falling demand en route to crush inflation.
Second, the downward-tilted yield curve spells trouble for banks. Their model relies on “borrowing short” and “lending long” via paying far lower rates on their savings and checking deposits than they garner on their corporate and consumer loans. But because the Fed made the mistake of holding rates so artificially low for so long, notes Harvey, the banks “stretched for yield” by issuing credit and buying bonds that, at the time, provided a decent spread over their cost of deposits. Then, the Fed’s 500-basis-point leap raised what customers can now collect on money market funds to around 4.5%, far more than banks can afford to pay on checking and savings. “The Fed turned the model that keeps banks healthy on its head,” says Harvey. “The Fed’s inverted curve is forcing deposits to leave the banks, lowering the amounts available for lending, helping ensure that a recession is right around the corner.”
Like Hanke, Harvey is convinced that jobs provide a lagging, misleading indicator. “The unemployment rate is always low before a recession,” he says—and employers rush to slash payrolls only when the deluge finally strikes. As a prime example of how the Fed places too much emphasis on lagging indicators, he highlights its current view of shelter. “The shelter component rose by 7.2% annualized in May, but we know it will come down because of the softening in the housing market,” he declares. Based on the CPI math, he sees July inflation falling to a number no more than a point above the Fed’s 2% target. “Hence, it makes no sense to strongly signal a rate hike in July,” says Harvey. “The inflation justification flies in the face of the real-time data. The Fed’s reasoning is inexplicable.”
It would be far better if the Fed relied on the forward-looking metrics advocated by these two sages than striving to conquer bygone threats in a crusade that’s taken the economy to the brink.
