In his speech at Jackson Hole, Wyo., on Aug. 25, Fed Chair Jerome Powell declared that today’s inflation “remains too high” and that the central bank is “prepared to raise rates further if appropriate.” Though virtually every press report characterized the chair’s comments as “hawkish,” analysts, pundits—and the markets—found it reassuring that Powell stuck to his “wait and see,” “we’ll be data dependent” script and didn’t suggest an even tougher tilt.
That stance left open the possibility that the Fed won’t lift its benchmark beyond the current 5.25% to 5.50% target range at the September and November meetings. Indeed, according to trading of Fed funds futures on the Chicago Mercantile Exchange, the probability of a hike for September remained practically unchanged from pre-speech levels at 19%, and the odds of a November rise dipped a bit to around 45%.
Powell strongly implied that, at the very least, the Fed would maintain the current 5.25% to 5.50% range for an extended period. But he didn’t say that further increases are anything like a sure thing. The stock market took Powell’s comments in stride, registering modest gains in the hours following the speech.
What Powell didn’t say: Fed policy is already supertight
Powell stated, “We see the current stance of policy as restrictive, putting downward pressure on economic activity, hiring, and inflation.” He added that the task of taming what he views as a still excessively rapid pace for consumer prices has “a long way to go.” But according to two top economists, each viewing the picture from a different perspective, the central bank is already squeezing the economy far too hard, and the “long way to go” concept is wrongheaded, because at the current clip, inflation’s already running near the Fed’s target.
Steve Hanke, professor of applied economics at Johns Hopkins and renowned as the global “money doctor,” focuses on trends in the money supply, as defined by the broad gauge M2. “The growth or decline in the money supply is what determines the price level, and it’s M2’s gigantic growth that caused the inflationary outbreak. Now, it’s a severe contraction in M2 that will hammer the economy,” he told Fortune. Hanke points out that as of July, M2 had fallen 3.7% from its level in July of 2022. The two sources of that shrinkage: the Fed’s quantitative tightening (QT) campaign, in which it’s reducing its holdings of bonds and hence draining consumer savings, and a falloff in bank lending, traditionally the biggest source of M2. “In July, we had the first year-over-year fall in commercial bank credit in many years,” says Hanke.
For Hanke, we haven’t yet witnessed the damage from the crushing combination of declining lending by banks and QT that curbs Americans’ spending power. But it’s coming. “The lag between falling M2 and a recession is between six and 18 months,” he says. “And the delay this time will be towards the end of that range.” He notes that the downward trend in M2 will drive inflation to somewhere near the Fed’s 2% goal by year-end. But the Fed is still doubling down what he calls “an ultra-tight monetary policy. Because of that misguided policy, we’re sleepwalking our way to a recession,” says Hanke.
Will Luther believes that excessively high ‘real rates’ could cause a steep downturn
In his speech, Powell cited “positive real rates” as a major reason why Fed policy is currently “restrictive.” But for Will Luther of Florida Atlantic University, the central bank has lifted this crucial metric—arguably the best gauge of tightness in monetary policy—to excessive heights. “In June and July, both the ‘core’ CPI [consumer price index] and the ‘core’ PCE [personal consumption expenditures price index], the latter being the Fed’s preferred measure, increased by less than 2%,” says Luther. “Yet Powell talks about having a ‘long way to go.’ Those numbers show he’s already there.” For Luther, the Fed is acting like a driver whose goal is reducing the car’s speed from 60 mph to 20 mph; the driver gradually slows to 20 mph, “then keeps hitting the brakes because the average speed’s been too high at 45 mph over the last three miles! He should just keep cruising at current speed.”
The “real” rate that Powell’s talking about, and that he apparently doesn’t see as too high, is the difference between the 5.25% to 5.50% Fed funds number and current inflation. And as we just saw, prices month over month are now waxing at just 2%. Hence, the real Fed funds rate is running at 3.25% to 3.50%. “That’s much too restrictive,” says Luther. “A real rate of 1.5% to 2.0% is sufficient to restrain inflation.” The mistake of making credit far more expensive than necessary will pound business investment and consumer spending, and likely force the U.S. into an unnecessary recession.
Powell’s explanation that persistently high, and perhaps even accelerating, economic growth, justifies keeping policy extremely tight in the face of falling prices, doesn’t fly with Luther. “On the contrary, the economy is still recovering from the blow of the pandemic,” he says. “We still have a lot of growth potential in catching up to the pre-2019 trajectory. We’re viewing a supply side recovery. It’s not inflationary at all, because it’s driven by increased productivity.” In fact, the growth spurt is disinflationary because the U.S. is raising production of goods and services faster than the rise in prices.
The markets, and America’s consumers, shouldn’t be reassured at all by Powell’s wait-and-see stance. As Hanke and Luther both say, the Fed’s hitting the brakes too hard. Inflation’s pretty much in the rearview mirror, and the Fed’s now steering onto the shoulder, and towards a recession.
