Nothing Is Forever
If you need to put your money in a safe and secure place and you want it to earn interest, Treasury bonds are safer than putting it in any bank as a deposit or putting it anywhere else, because they are backed by the full faith and credit of the United States Government.
US Rep. Jim Cooper (D)
Since the Federal Reserve started to tighten monetary policy to fight high consumer price inflation, politicians have criticized it. Especially the left, progressive wing of President Biden’s Democratic Party repeatedly called for a slower tightening because, in their view, the Fed is paying too little attention to the labor market.
It has become routine for them to publish an open letter before FOMC meetings, so the group around Senator Elizabeth Warren published another one. Even though the calls for a pause remained unheard, it might be that Powell will face even more criticism from politicians, especially from Democrats, in the coming months.
Elizabeth Warren is arguably the group’s loudest voice and is a sharp critic of Powell. From the open letter:
While we do not question the Fed’s policy independence, we believe that continuing to raise interest rates would be an abandonment of the Fed’s dual mandate to achieve both maximum employment and price stability and show little regard for the small businesses and working families that will get caught in the wreckage.
In times when the Fed is following a tighter stance on monetary policy, it is not unusual to receive criticisms from politicians. Although the Fed is independent on paper, additional public pressure can influence its monetary policy decisions. For example, Arthur Burns pivoted in 1974 because of high public pressure and lowered interest rates after the hiking cycle (criticized as too aggressive by many economists) threw America into the worst recession in forty years. As we know today, inflation returned with a vengeance and started to rise two years later until it reached a peak of 14.76% in 1980.
Although geopolitical events undoubtedly played a role in how inflation developed, the primary reason CPI started to increase was an expansionary fiscal and too loose monetary policy in the 1960s. Under President Lynden B. Johnson, government expenditures increased, on the one hand, to fund his Great Society, on the other hand, to finance the Vietnam War. Additionally, the government cut taxes. The attention turned to chair Bill Martin and his Fed.
Martin and other FOMC members saw warnings of a pick up of inflation and raised rates, which made Johnson furious. He saw his political goals in danger and wanted to push Martin and the Fed to push back, but Martin did not back down. In the end, Johnson had to give in, but the dispute did worsen the relationship between Martin and him in the coming years.
The rate hike (and those that followed) was insufficient to keep inflation from rising. Although the Fed more-or-less raised the interest rates throughout the second half of the decade, fiscal spending also increased. While inflation remained close to 1 % in the first years of the 60s, after the dispute between Martin and Johnson, it steadily increased to about 6 %.
One can spot some parallels between then and now. Today, the Fed is tightening while the US government plans to spend more. Astonishingly, Biden’s plans sound like a modern version of Johnson’s Great Society. However, one must add here that political commentators noted that the budget proposal should be understood as a political statement, not a serious proposal that could pass the House of Representatives.
President Biden on Thursday proposed a $6.8 trillion budget that sought to increase spending on the military and a wide range of new social programs
Regardless, lessons from the 60s are long forgotten in political circles. Suppose the fiscal policy remains expansionary despite interest rate hikes from the central bank. In that case, it dampens its effect because, in theory, higher rates should be an incentive to reduce consumption and increase savings.
Similarly, if households do not cut back on consumption and start to finance their spending through credit to make up for their real wage loss, it keeps inflation elevated. Because of all the stimulus programs during the pandemic, households accumulated savings. They thus managed to continue to finance their consumption, although average credit card interest rates in the US have risen to 20 %.
It’s no wonder, then, that as the US economy continues to send mixed signals, consumers are doing the same. According to the results of our latest US Consumer Pulse Survey, they’re worried about rising prices and job security, yet they’re optimistic and still spending. They’re switching to less expensive brands to save money, but they’re also willing to splurge on certain goods and services.
McKinsey Consumer Pulse Survey [emphasis added]
The fact that unemployment remains at record lows contributes to the fact that spending remains strong. Although, according to McKinsey, the consumption growth rate is falling, most households continue to have a strong balance sheet, despite becoming more selective in their purchases.
As a result, it is not surprising that US CPI remained more-or-less unchanged from the prior month; only headline CPI came in 0.1 % lower than expected, at 4.9 %. Inflation will remain sticky as long as the government and households continue to spend. For the Fed, the more challenging part of their inflation fight is still in front of them. Since the 1980s, it took advanced economies ten years on average to bring inflation back to the 2 %-target whenever it rose above 5 %
Consumer price inflation will not go down substantially if the economy is not slowing down rapidly at some point, in my opinion. The stimulus payments are still making their way through various sectors of the economy. According to economist Ludwig Straub, transfer payments elevate demand and prices until the money lands in the hands of wealthy actors who do not use it for consumption, a Trickling Up Effect, as he calls it. According to a study by Straub, Rognlie, and Auclert, the whole process takes about five years, which means the effects of the covid stimulus could be felt for more years.
The European Central Bank is facing a similar problem. While most eurozone countries preferred subsidies for businesses to keep their workers (the German Kurzarbeit-model) instead of direct stimulus payments to households, the situation changed due to the war between Russia and Ukraine. Many countries implemented transfer payment schemes, price caps, or price breaks to dampen the effects of inflation on households.
However, these measures helped to keep demand and price inflation elevated, so the dampening effect of the transfers evaporated quickly. Additionally, price breaks and price caps stopped/slowed price increases where they were implemented, but as a result, prices increased in other areas of the economy. In Spain, consumer price inflation is the lowest in the eurozone due to a wide range of market interventions. Still, core inflation is only slightly below core inflation for the eurozone as a whole.
So, eyes were on the ECB and its governing council last Thursday. While most economists expected an interest rate increase of 25 basis points, there were still some good arguments that would have supported a 50 basis point hike. Ultimately, the ECB decided to raise rates by 25 basis points.
At the press conference, President Lagarde justified the decision by referring to the ECB Bank Lending Survey published in the same week, which showed that loan demand strongly decreased across the board, especially for business loans.
Yet, one should not forget that at the same time, European bank earnings have been robust in the first quarter. Unicredit, for example, reported the highest revenues in over ten years. Further, an ECB study found that interest rate hikes substantially affect inflation more than lower asset purchases.
Despite all that, the ECB did not raise interest rates by 50 basis points. Apart from Largarde’s mention of the ECB Bank Lending Survey, a further improvement on the energy front might have also played a role. Within the statement, Lagarde noted that governments should consider scaling back on fiscal stimulus.
Currently, that seems unlikely. For example, a discussion broke loose in Austria about further measures to dampen food inflation. Again, the proposals vary from price controls to a lower value-added tax on food, which only postpones or shifts price increases to other areas. Even though the ECB probably should know better, if we think back to the Draghi era when the ECB kept financial conditions favorable for countries that only took advantage of them and kept spending instead of consolidating their budget. As we all know, nothing is as permanent as a temporary government program.
Remember when European economic data surprised on the upside while US data disappointed a few weeks ago? That effect has now turned around. Maybe the ECB governing council was aware of the significant drop in German Factory Orders the day after the meeting. Compared to the prior month, orders fell more than 10 %. Interestingly, the same flip of economic surprises was observable just before the GFC accelerated.
European retailers are also struggling under lower volume sales, and if one assumes that ECB policy will stay restrictive for longer, headwinds will only increase. In theory, lower rates support consumption, while rising rates dampen consumption. Still, Chart 4 shows that Draghi’s low-interest rate policy and QE could not support consumption sustainably because they did not spur real economic lending.
Madame Lagarde was very engaged in ensuring that the ECB would not pause and continue to tighten monetary policy. However, she did not reveal how far the ECB wanted to increase interest rates. Still, she stated that the ECB is not seeing enough effects of monetary tightening on the economy that is in line with inflation returning to two percent.
I suspect that, given what Lagarde said during the press conference, the ECB will hike interest rates by another 25 basis points at the next meeting, which will bring the Main Refinancing Operations Announcement Rate to 4 %. Most banks expect an ECB terminal rate of 4 %, meaning two more 25 basis point increases would follow. Market participants share that view and expect the terminal rate to be reached in September before the ECB eases slightly into Q4, but much less than what the market expects from the Fed.
However, I think that these expectations are wrong or, put differently, too optimistic. In my view, the most probable scenario is that economic activity will halt in the third or fourth quarter due to unforeseen factors, consumption will drop, and unemployment will rise in Europe and the US.
In that case, I expect that both central banks will throw their fight against inflation under the bus and slash interest rates while government spending rises even faster. Under that scenario, inflation will most likely drop near or below 2 %, but only temporarily, as the fiscal and monetary reaction will push up inflation in 2024.
Another scenario would be that consumer price inflation bottoms somewhere between 4 and 3 %, and economic activity remains slightly expansionary. At the same time, eurozone countries continue to keep spending elevated to dampen the effects of inflation, only to cause elevated inflation for longer.
The scenario currently is the least probable one would be a sudden financial meltdown. Although hearing ‘financial meltdown’ probably makes you think of the US regional banking sector, I believe that it would be either European or Asian banks that get hit at first. Hence, it is not wrong to pay some attention to it.
In that case, governments will not have another choice than to bail out the banks, another result of zero-percent interest rates in the 2010s, which caused the profitability of European banks to melt like ice under the sun. Then, debt to GDP levels of eurozone countries might come into market participant’s focus again. However, currently, European government bond spreads show no sign of stress.
What one can say for sure is that if interest rates are kept high for a more extended period, consumers have to cut back on spending at some point when their financial cushion is gone. In that case, and if governments continue to increase spending, it might not take long until investors demand a higher yield on government bonds.
I gave my heart, my blood,
Nothing is forever (but eternity)
I gave my heart, my blood,
Nothing is forever (but eternity)Caliban - Nothing Is Forever
I wish you a splendid weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity and are no investment advice)
Untangling the multiple issues that currently exist remains so difficult. Thanks for some cogent ideas