Perhaps the Fed Should Exercise Some Patience in Extinguishing the Inflation Fire It Set

The Federal Reserve reminds me of a fire chief who moonlights as an arsonist. The Fed aids and abets in the setting of inflationary fires and then runs to extinguish them. In this commentary I will argue that the Fed’s response to the COVID-19 pandemic and the unprovoked invasion of Ukraine by Russia exacerbated and prolonged the inflationary impulses of these events. Furthermore, I will hypothesize that the Fed is going to pursue a more restricitve policy longer than necessary to extinguish the inflationary fire it helped set, the result of which will be a deeper-than-necessary recession. The Fed is not malicious. Rather, it is ignorant. At his semi-annual appearance before the Senate Financial Services Committee on March 7, Fed Chairman Powell stated that the Fed does not know what the level of the “neutral” federal funds is now and that the neutral level is not constant through time. Yet, the Fed persists in conducting its monetary policy by setting the level of the federal funds rate, not knowing whether the level set is above or below the neutral level of federal funds rate.

When it became obvious to all that there was COVID-19 pandemic in March 2020, real production of goods and services in the US and in many other regions of the world collapsed as business shutdowns occurred. This represented a negative supply shock. If nominal aggregate demand remained the same in the face of this negative supply shock, higher prices would result. The changes in the sum of depository institution credit (loans and securities on the books of these institutions) plus the monetary base (the sum of currency in circulation and reserves held at the Fed by depository institutions) are postively correlated with changes in nominal aggregate demand. Let’s call the sum of depository institution credit plus the monetary base “thin-air” credit because both are created, figuarively, out of thin air. By this, I mean that the extension of thin-air credit does not necessitate anyone cutting back on their current spending in order to extend this credit. You can think of the creators of thin-air credit, the Fed and depository institutions, as legal counterfeiters. Plotted in Chart 1 are the annualized percent changes in quarterly observations of thin-air credit (the blue bars) and the annualized percent changes in the quarterly observations of output produced by the business sector (the red bars).

In Q1:2020 and Q2:2020, real business output contracted at annualized rates of 6.33% and 13.1%, respectively. At the same time, thin-air credit grew at annualized rates of 40.4% and 17.0%, respectively. I cannot fault the Fed for flooding the financial system with liquidity in Q1:2020 as the financial markets seized up. However, instead of beginning to drain this massive infusion of thin-air credit in Q2:2020, the Fed allowed thin-air credit to grow at an excessive rate in Q2:2020. This massive increase in thin-air credit in the first half of 2020 in the face of an unprecedented post-WWII rate of contraction in business production lit, with a lag, the inflationary fires that have raged in 2021 and 2022.

I emphasized “lag” in the previous sentence because empirically there is a lag between changes in thin-air credit and changes in consumer inflation rates. The following three charts document these lags. Plotted in all three of the charts are year-over-year percent changes in thin-air credit (the blue bars). Also plotted in all three charts are the year-over-year percent changes in various measures of the Personal Consumption Expenditure (PCE) chain price index (the red lines). Plotted in Chart 2 are quarterly observations of the all-items PCE price index; in Chart 3, the PCE, excluding food and energy components; and in Chart 4, the Fed’s new favorite measure, the PCE for services, excluding food, energy and hosuing components. The thin-air credit observations were advanced by the number of quarters that resulted in the highest positve correlation with the inflation measure. For example, in Chart 2, percent changes in thin-air credit are advanced by six quarters, which resulted in a correlation coeffecient of 0.74 (the figure in the upper left-hand corner of the chart). This suggests that the percent change in thin-air credit in the current quarter has its largest impact on the all-items PCE price index six quarters in the future. So the thin-air percent changes that appear in 2023 and 2024 are implict forecasts of PCE inflation rates in those quarters. Notice that the slower trending in growth of thin-air credit implies that the trend in PCE inflation also will be trending lower.

So, depending on the definition of PCE price inflation chosen, the lags between percent changes in thin-air credit and PCE price inflation range between five and seven quarters. If the time period for observations were expanded, the lags might change. But what is consistent, regardless of the time period chosen, is that there is a relatively long lag between percent changes in thin-air credit and PCE price inflation and that there is a relatively high correlation between percent changes in thin-air credit and future PCE price inflation. I realize that it would take political courage for the Fed to trust that the rate of consumer price inflation would be on a steady downward trend five to seven quarters in the future.

Let’s take a look at the behavior of a narrower definition of thin-air credit through February 2023. This definition includes, along the monetary base, the credit on the books of commercial banks. So the credit on the books of saving banks and credit unions is excluded. But because bank credit accounts for the bulk of thin-air credit, this narrower definition of thin-air credit is close enough for Fed work. As shown in Chart 5, in the three months ended February 2023, this narrower definition of thin-air credit grew at an annualized rate of just 2.1%. If the Fed continues to raise the federal funds rate and continues to allow its securities holdings to run off, growth in thin-air credit would be expected to continue at historically low rates or even contract. In price-adjusted terms, the thin-air credit is declining, which, with a shorter lag than with consumer inflation, has negative implications for the behavior of real aggregate demand.

Based on the history of the relationship between percent changes in thin-air credit and different favorite “flavors” of consumer inflation, a significant slowdown in price inflation in the months ahead already is baked in the cake. Neither the Fed (nor any other mortal) has a clue as to what the current or future levels of the neutral interest are. Yet the Fed persists in blindly changing the level of the federal funds rate in desperate hope that one day it will luck out and hit on the neutral level. Why won’t the Fed and its army of economists just take a look at the behavior of thin-air credit in relation to inflation? Perhaps, similar to the level of the neutral interest rate, the approximate lags between percent changes in thin-air credit and consumer price inflation are unknowable? In that case, the Fed could do worse than choosing and achieving some relatively stable rate of growth in thin-air credit. I am confident that if the Fed were to do this, the amplitude of booms and busts in the economy would be reduced. Moreover, if the “wrong” rate of growth in thin-air credit were chosen, at least errors would not cumulate as they do when the wrong level of the neutral interest rate is chosen (see Larry R. Mote, “Looking back: The use of interest rates in monetary policy” for a discussion of this).

Of course, it is wishful thinking that the Fed would consider switching from using the federal funds as its instrument of monetary policy to growth in thin-air credit or growth in some other better monetary quantity. So, unless the rate of inflation of the Fed’s favorite flavor slows significantly in the next few months, the Fed will continue to raise the level of the federal funds rate and cause the economy to slip into an unnecessarily severe recession, only to slash the fed funds rate again and allow thin-air credit growth to rise to relatively high rates. The economic roller coaster ride will start anew. If so, the time for me to add duration to my fixed-income portfolio is quickly approaching, IF I WERE SURE THAT THE DEBT CEILING WOULD BE RAISED TO AVOID A TREASURY DEFAULT. Too bad Silicon Valley Bank did not wait to add duration. (Thanks to the market turmoil caused by SVP, the add-duration trade has already sailed without me onboard.)

As an aside, there is a vacant seat on the Federal Reserve Board. I’m available if I can work remotely from Sturgeon Bay. Call the White House, 202-456-1111 to suggest my nomination. I have already written the script for my confirmation hearing (see my commentary of June 27, 2022, "Fed, First Do No Harm, Confirmation Hearings for Paul Kasriel’s Nomination to the Federal Reserve Board of Governors" at the Haver website.