Viewpoints

In the November 25, 2022 edition of Barron’s, Randall Forsyth penned an article entitled “Another Reason a Quick End to the Fed’s Rate Hikes Looks Unlikely (emphasis added). One of the reasons Forsyth advanced for his forecast (?) of future Federal Reserve interest-rate policy is the behavior of commercial bank credit. “…Joseph Carson, former chief economist at AllianceBernstein, points out that bank credit growth is booming. Loans to businesses and consumers, and for real estate, are accelerating at the fastest pace since 2008, he writes in his blog on LinkedIn.” Earlier in his article, Forsyth says “… [g]rowth in the M2 [money] measure, which consists of currency, checking, and other transaction and retail savings accounts, has collapsed to about 2% below the level a year ago. That’s a stunning reversal from the explosion in the money supply from pandemic monetary and fiscal stimulus; year-over-year, M2 expansion peaked at 27% in early 2021.” Forsyth goes on “… the contrast between the sharp slowing in M2 (which went negative, on a month-to-month basis, in September and October) and strong expansion in credit is puzzling. What should be done about this?” Earlier in the Forsyth article he cites Nancy Lazar, the veteran economist who heads macro research at Piper Sandler, “… [t]he slowing in money growth is the good news. The bad news is that M2, at $21.4 trillion, is still very elevated, by about $4 trillion over where she estimates it would be had it stayed on its prepandemic growth track.” This implies that the private sector has a lot of cash in reserve to fund spending even if the rate of growth in cash has slowed. Veteran economist and former chief economist at The Northern Trust Company, yours truly, discussed the implications of the large amount of cash held by the nonbank private sector in two commentaries, “Households’ Extraordinary Cash Holdings Will Thwart Fed Tightening” (March 14, 2022, LinkedIn, or “Viewpoints” section of Haver.com)) and “Households, Corporations and Banks Are in Good Shape as Recession Looms” (October 17, 2022, LinkedIn or “Viewpoints” section of Haver.com). If the nonbank private sector is now so flush with low/no-yielding M2 balances, why are they borrowing from banks at elevated loan rates? Is that a sign of private sector strength?

Let’s do some fact checking before arguing that there is reason to believe that a quick end to the Fed’s rate hikes looks likely based on the recent behavior of bank credit. Plotted in Chart 1 are month-to-month annualized percent changes in both bank credit, which includes loans, leases and securities on the books of commercial banks, and the monetary aggregate, M2. Yes, M2 growth slowed in the waning months of 2021 and M2 has been more or less contracting starting in April 2022. But notice that bank credit growth has slowed since December 2021 and bank credit has contracted in both September and October 2022. So, although the magnitudes of recent month-to-month percent changes in M2 and bank credit have differed, the trends are similar – smaller positives transitioning to negatives. So, from where does the notion of “booming” bank credit come?

Federal Reserve policymakers are considering implementing smaller rate hikes, acknowledging the lagged effects of previous rate hikes and better news on inflation. Investors have been running with this bullish view that the apparent slowdown in core inflation, along with declines in commodity prices, changes the inflation outlook so that policymakers would scale back and possibly end their rate-hiking experiment in early 2023.

The rally in equities has been impressive. From the low on September 30, the Dow Jones is up 20%. If the equity market follows the historical pattern between the second and third year of presidential terms, there is much more to go. The average gain in the Dow Jones average from the low in the second year to the high in the third year has been 45%. A Fed pivot could be the catalyst for additional gains into 2023.

The risk to that optimistic scenario and sustainable equity market gains for 2023 is that the inflation slowdown could be "transitory."

Suppose that the Fed raises official rates by 50 basis points at the December 13-14 meeting and follows that with another 50 basis points hike in early 2023. That would lift the federal funds rate to 5%. And if core inflation continues to run at 0.3% for the next five months, the twelve-month reading on core inflation in March 2023 would be 5.25%.

What are the odds of the Fed beating the current inflation cycle and bringing core inflation back to the 2% target with nominal rates below the inflation rate? History would say the odds may not be zero, but they are low. Official rates of 300 to 500 basis points above-reported core inflation broke the inflation cycles of the 1980s and 1990s.

Here are three reasons why the slowdown in inflation could prove to be "transitory."

First, individuals are sitting on a cash bundle. At the end of Q2, households had $18.5 trillion in checking accounts, time deposits, and money market funds, equaling approximately 25% of total liquid financial assets, the highest share since the financial crisis. A Fed pivot could easily trigger a big risk-on rally in equity markets ("FOMO," fear of missing out, has not been retired), with spillover effects in the real economy. A rebound in equity prices, lifting consumer wealth, would boost consumer sentiment and trigger more robust consumer spending.

Second, the Fed rate hikes have hit the housing market hard. Home sales and new construction has slowed a lot in the past year. Yet, the number of existing homes for sale at 1.2 million in October is low and well below the level before the pandemic. The cost of mortgage borrowing, currently around 6% +, might look high nowadays, but that could change quickly in a risk-on environment when people's price expectations for housing starts to rise against a very low inventory backdrop. A more robust housing market would increase demand for commodities and consumer goods, lifting prices. And it has been the recent decline in consumer goods prices that have been responsible for the slowdown in core inflation.

Third, labor markets remain tight, with an unemployment rate of sub-4% and almost twice as many job openings as the number of unemployed. The jobless rate increased by over 200 basis points and remained relatively high for a few years following the tightening cycles of the late 1980s and 1990s. That helped sustain the slowdown in core inflation. Continued tightness in the labor markets is the biggest hurdle to achieving a sustainable slowdown in inflation as it maintains wage-cost pressures.

Policymakers will soon face Yogi Berra's "fork in the road." Will policymakers turn left (pause) or right (continuation of rate hikes)? Investors are betting on a left turn, expecting a rally in the short run. A right turn would create more pain in the short run but offer a better path for sustainable long-term gains.

The widespread protests witnessed in China’s major cities over the weekend is something that has been brewing [1] for months. It is a cocktail of popular discontents with zero-covid restrictions (despite policy relaxation [2] earlier), constitutional changes [3] to remove the two-term presidential limit and a weaker economy [4], while the block fire [5] in Urumqi, Xinjiang was merely a flashpoint and had fanned the recent anti-government or “A4” [6] movement. The unfolding situation in China will have profound economic and geopolitical implications that will reverberate around the world.

Certainly, this poses one of the most serious challenges to Xi’s rule, especially since he was re-elected as country leader in the recent 20th Party Congress. It will be interesting to see how the Chinese authorities respond to this unprecedented wave of protests - the most concerted and largest since the democratic student movement in 1989.

Amongst the most energetic and idealistic, numerous students and at least 51 universities are again involved in this round of anti-government protests, suggesting that the movement is unlikely to die down easily. If the authorities cannot exert effective controls over the situation in the next couple of days, we should expect a series of policies to be implemented. In the policy toolbox, vaccinating the vulnerable and a further relaxation of Covid restrictions are on the cards, a potential mass arrest of activists and measures to restrict congregations and communications. Curfews may be widely imposed in affected cities, followed by an Iranian style internet shutdown [7] with authorities cutting off mobile internet and social media platforms. If everything fails, the worst-case scenario is a Tiananmen style crack-down, which is still a possibility if the Party is determined to cling on to power. In terms of geopolitics, China might employ a diversionary foreign policy, to divert public’s attention away, instigating disturbances in the South China Sea and Taiwan strait. However remote the possibility, experts might reassess the timeline for the annexation of Taiwan [8].

Overall, the instability witnessed so far will likely linger on well into 2023 if no meaningful measures are implemented to avert the situation. The above-mentioned policies to restrict movement and information flow in major cities that generate a significant portion of the country’s economic output, if put into effect, will dent the economy further, dashing hopes for more job creation [9] which is key in promoting social stability. This truly is a dilemma for the Party. These measures will also have negative impacts on the world’s supply chains [10].

References: [1] https://www.bbc.co.uk/news/world-asia-china-63633109 https://www.washingtonpost.com/world/2022/10/14/china-protest-sitong-bridge-haidian/ https://www.bbc.co.uk/news/world-asia-china-63447755 [2] https://www.bloomberg.com/news/articles/2022-11-11/these-are-the-20-measures-guiding-china-s-covid-easing-efforts [3] https://www.bloomberg.com/news/articles/2022-10-18/anti-xi-slogans-in-rare-beijing-protest-spread-within-china?leadSource=uverify%20wall [4] https://www.imf.org/en/News/Articles/2022/11/21/pr22401-imf-staff-completes-2022-article-iv-mission-to-the-peoples-republic-of-china#:~:text=Following%20the%20impressive%20recovery%20from,percent%20in%202023%20and%202024. [5] https://www.bbc.co.uk/news/world-asia-china-63752407 [6] https://www.independent.co.uk/news/world/protesters-china-blank-paper-white-covid-b2234009.html [7] https://www.forbes.com/sites/emmawoollacott/2022/09/22/iran-shuts-down-whatsapp-and-instagram-as-protests-spread/ [8] https://www.spectator.co.uk/article/a-chinese-invasion-of-taiwan-is-coming/ [9] https://foreignpolicy.com/2022/08/04/xi-china-unemployment-jobs-economy-crisis-youth-mao-great-leap-forward/ [10] https://edition.cnn.com/2022/11/25/tech/apple-foxconn-iphone-supply-china-covid-intl-hnk/index.html

The Federal Reserve Bank of Philadelphia’s state coincident indexes in October softened, with only 23 states reporting gains from September, one (California) unchanged, and 26 seeing declines. Maryland’s index fell more than 1 percent, while number 1 Hawaii was up only .77 percent, which is fairly modest for a leader. At the three-month horizon, eleven states were down, with Maine and Montana off by more than 1 percent and West Virginia just short of that (.99 percent). On the upside, Hawaii and Alaska saw increases of more than 2 percent. Over the past 12 months, Massachusetts’s index was up nearly 9 percent, and 18 other states had increase of at least 5 percent Both Mississippi and Oklahoma had increases of less than 2 percent over this period. In all cases noted (growth at the top, numbers growing slowly and rapidly) the October results were less robust than September’s initial numbers.

Yet again, the independently estimated national figures of growth over the last 3 (.69 percent) and 12 (4.60 percent) months look weaker than the state figures would imply. These results were also lower than in the initial September report.

Hawaii has surpassed its pre-pandemic peak in this series; Connecticut is still short, by the smallest of margins. Connecticut’s index dropped in October, but its revised September reading was 121.49. The state’s peak was 121.50 in March 2020.

State labor market results in October were softer than in the last couple of years, though not very weak. Seven states had statistically significant increases in payrolls, with Colorado’s .8 percent gain the largest in those terms. California picked up more than 50,000 jobs, and Texas slightly short of that. Over the last 12 months, every state (and DC) saw a gain in payrolls, thought the increases in Alaska, DC, Mississippi, and Wyoming were not deemed to be statistically significant. Florida and Texas were the only states to see gains of at least 5.0 percent (California’s absolute increase was a hair larger than Texas’s.

A full 24 states experienced statistically significant increases in their unemployment rates from September to October (Pennsylvania’s fell .1 percentage point to 4.0 percent), but in the vast majority of cases these were, in absolute terms, fairly modest. Only Maryland’s .5 percentage point rise (from 4.0 to 4.5 percent) would normally be considered large. Unemployment rates remain fairly low across the nation DC’s rate is the highest tin the nation, at 4.8 percent, while Illinois and Nevada are both at 4.6 percent. Seven states have rates of 2.4 percent or lower.

Puerto Rico’s job count was little-changed, and for a second straight month there was insufficient information to compute the unemployment rate on the island.

One of the worst courses I took in undergraduate school was an introduction to management “science”. The only thing I remember from that class is that if one has responsibility for some outcome, one should have the authority to influence that outcome. As we approach the midterm elections, the Republicans are holding the Democrats responsible for the higher inflation that has been experienced in the past two years. The Republicans claim that the high inflation is primarily due to the rapid growth in federal government spending implemented by President Biden and his fellow congressional Democrats, forgetting that a sizeable increase in government spending occurred on the watch of President Biden’s Republican predecessor. Perhaps President Nixon was correct when he exclaimed that we are all Keynesians now.

I will argue, however, that Federal Reserve monetary policy is primarily responsible for the behavior of inflation, not federal government spending. If this is true and the executive and its political party are going to be held responsible for the rate of inflation, then it follows from Management 101 that the executive branch should have the authority to manage monetary policy, not the semi-autonomous Federal Reserve. My wife did not coin the term “econtrarian” to describe me for nothing.

Let’s go through the verbal argument as to why monetary policy, not fiscal policy has the primary influence on the behavior of the inflation rate. If the government increases spending, from where does the funding of this new spending come? It comes from either an increase in taxes or an increase in securities issuance, i.e., borrowing. If taxes are increased, some entities, on net, must decrease their current spending. (There is the possibility that entities could deplete their cash holdings to make their increased tax payments, but generally this would be de minimis.) So, an increase in taxes to fund an increase in government spending would result in approximately a net zero increase in aggregate spending in the economy. The government would spend more; the private sector would spend less. Thus, a tax-financed increase in government spending would not lead to a net increase in aggregate demand, which, in turn, would not put upward pressure on the rate of inflation. The same result would obtain if the increase in government spending were financed by an increase in securities issuance to the nonbank public. To pay for the new issues of government debt purchased, just as was the case for increased taxes due, the nonbank public would have to cut back on their current spending. Thus, a securities-financed increase in government spending would not lead to a net increase in aggregate demand, which, in turn, would not put upward pressure on the rate of inflation. If foreign entities were to purchase the increased amount of government securities, they would have to cut back on their purchases of US exports because there has been no increase in their US dollar holdings. Foreign entities would purchase more US bonds and fewer US-produced Buicks. In sum, there is no logical reason to expect a tax-financed or a securities-financed increase in government spending to lead to a net increase in aggregate spending or an increase in the inflation rate. (Perhaps I am the lone non-Keynesian left.)

Let’s look at some data. Plotted is Chart 1 are the year-over-year percent changes in the annual average of calendar year nominal U.S. government expenditures and the year-over-year percent changes in the annual average All-Items CPI from 1960 through 2021. The growth in U.S. government expenditures is lagged by two years because this yielded the highest correlation coefficient between the two series, 0.51 (shown in the little box in the upper left corner of the chart). Lagging changes in government spending by two years means that the inflation rate this year is associated with the change in government spending two years prior. Remember, if the two series moved in perfect tandem, the correlation coefficient would have a value of 1.00. So, there does appear to be some positive relationship between changes in government spending and the inflation rate.

When policymakers started to raise official rates in the spring, the official projections showed an official peak rate of 2.8% at the end of 2023. With inflation running much faster at the time, I argued that the peak rate could be as much as 100 basis points higher than what the Fed was telegraphing. We were all wrong.

Four consecutive seventy-five basis points increases and three hundred and seventy-five basis points in eight months look like a substantial increase in official rates. But the starting point was zero, and much more is still needed to reverse inflation risks.

Price increases lead to revenue and profit increases for companies, while wage increases trigger income gains for workers. So when the price cycle broadens and wages increase, it takes more and more rate hikes to break the cycle because higher profits and income offsets the higher borrowing costs.

In October, core consumer prices were up 6.7% from one year ago, while average wages for non-supervisory workers increased by 5.9%. Price increases are 260 basis points above last year's gain, while wage increases are roughly the same. At 4%, the fed funds rate is still far below the price and wage gains, so there is more ground to cover before the policy is even neutral, let alone restrictive.

Businesses and consumers do not borrow at the fed funds rate. But the federal funds rate is the benchmark for all borrowing costs, so for market rates to be at levels that restrict borrowing, the Fed needs to lift rates to prohibitive levels. The fed funds moved above price and wage gains in the past three cyclical inflation cycles (the 1980s, 1990s, and 2000s).

So we all were wrong. Fast and broad price and wage gains require higher official rates.

The Federal Reserve Bank of Philadelphia's state coincident indexes in September were again somewhat softer than earlier, and somewhat dispersed. 11 states report declines from August to September, with Montana down .59 percent. On the plus side, both Hawaii and New Jersey clocked increases above 1 percent and New York was just shy at .99 (the Northeast was strong, with Massachusetts and Maryland both comparable to New York, and Pennsylvania at .59 percent). At the three-month horizon, six states declined, with West Virginia and Montana, as in the initial August report, both off by more than one percent. Hawaii and Indiana both had increases above 2 percent. Over the past 12 months, Massachusetts's index was up more than 9 1/2 percent, and 25 other states had increase of at least 5 percent. Four states (Arizona, Wisconsin, Oklahoma, and Mississippi) had increases of less than 3 percent over this period.

As always seems to be the case, the independently estimated national figures of growth over the last 3 (1.02 percent) and 12 (4.98 percent) months look weaker than the state figures would imply.

Connecticut and Hawaii remain under-by very small margins--their pre-pandemic peaks in this series.