Viewpoints

Saturday Night Live (SNL) held a fireside chat with Former Fed Chairman Paul Volcker and current Fed Chair Jerome Powell. Here's a replay of their conversation.

Fed Powell. It is an honor to be on the same stage with you. I think of you as one of the greatest public servants in the history of the Federal Reserve.

Paul Volcker. Thank you. Those are very kind words. How goes it at the Fed nowadays.

Powell. Well, we have a little inflation problem.

Volcker. How bad is it?

Powell. Consumer prices (CPI) have risen 7.9% in the past year. But at the Fed, we focus on the personal consumption expenditure (PCE) deflator, which has only increased 6.1%.

Volcker. Why does the Fed look at the PCE and not the CPI? The CPI is what people pay for things, and the PCE includes a lot of non-market prices.

Powell. That is true, but increases in the PCE run less than CPI, making it look like inflation is less high and harmful. The Fed is in the game of trying to influence expectations, so we picked the lower number of the two.

Volcker. Selecting a price measure simply because it produces a lower inflation rate is not sound monetary policy. Good policy decisions flow from unbiased and accurate statistical information.

Powell. That is fair. But we are in the business of managing people's expectations so picking an index with a lower number helps.

Volcker. What is this rental equivalence that has replaced house prices in the measures of inflation?

Powell. It is supposed to measure what people can rent their house for if they decide to rent.

Volcker. How is that inflation? The definition of inflation is what people pay for things.

Powell. I know. But rental equivalence makes reported consumer price inflation rise less fast when there is rapid house price inflation, and that makes it appear that the Fed is doing a good job. Remember, it's our job to try to manage people's inflation expectations.

Volcker. But people know inflation when they see it. Nowadays, people have more sources of house prices than they did in the 1970s, so actual inflation or experienced inflation must be much higher. So how much higher would reported inflation be if the CPI were measured similarly to the 1970s?

Powell. Based on press reports, it would be double-digit inflation, equal to the highs of the 1970s.

Volcker. Based on press reports? Doesn't the Fed staff know?

Powell. No. If we don't calculate it, we can overlook it and make it appear that things are always better than they are. Remember, it is our job to try to manage people's inflation expectations.

Volcker. That's a section of monetary policy I never read or learned. So what are the critical drivers or sources of this inflation nowadays?

Powell. Most of the increase in inflation is due to supply shortages and bottlenecks emanating from the pandemic. But in recent months, inflation has broadened.

Volcker. I thought the Fed has consistently argued that inflation is always and everywhere a monetary phenomenon. How fast have monetary aggregates been expanding.?

Powell. We don't look at money nowadays.

Volcker. The Fed is in the business of making money.

Powell. That is true.

Volcker. So how fast?

Powell. Broad money has increased by over 40% in the past two years.

Volcker. How much?

Powell. 40%.

Volcker. Uh-oh! And the Fed is surprised by the surge in inflation?

Powell. We are committed to fighting inflation and plan to front-load official rate increases.

Volcker. Front-load? What do you mean by front-loading?

Powell. Policymakers see the Fed funds rate at 1.9% at the end of 2022 and 2.8% at 2023. So we plan to hit those targets earlier.

Volcker. When I was Fed Chair, front-loading involved lifting official rates before consumer prices surged. It seems to me the Fed is back-loading rate increases, trying to catch up to inflation.

Powell. Remember, it is our job to try to manage people's inflation expectations. So far, people and investors still think we are doing a good job.

Volcker. The pendulum of central banking has fundamentally changed, moving away from things it can control and basing policy success on influencing people's expectations. How did the Fed fall into the trap of assigning so much weight to people's expectations and not actual statistics?

Powell. I hope history will show that we are committed to price stability as much as you were. But, remember, we are judged by a different standard---people's expectations (although no one knows how to measure them)--and not actual inflation.

Volcker. I wish someone could give me one shred of neutral evidence that inflation expectations lead to actual inflation and not that persistent inflation leads to higher expectations.

Powell. When facts change, I will retire my views. Thank you.

Note. Paul Volcker passed away on December 8, 2019. So his responses are my words of what I think he would say today.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Personal incomes growth varied widely across the states in 2021:Q4, in large part reflecting great differences in the growth of transfer payments, in turn owing to varying effects of the wind-down of pandemic-related federal unemployment insurance benefits. In addition, the growth of net earnings (employee wages and benefits plus proprietors' income) also differed quite substantially. Texas reported the fastest income growth rate: 9.2 percent, compared to the national figure of 2.4 percent. Texas benefited from rapid growth of net earnings (13.4 percent, at an annual rate, which was tops in the nation) and relatively little deterioration of transfers (-3.6 percent, compared to the national -17.5 percent rate of decline). In very sharp contrast, personal income fell as an 8.7 percent rate in North Dakota, as net earnings plunged at a 15.2 percent rate (transfers rose at a 4.6 percent rate in North Dakota). Developments were similar in other Plains States—declines or weak growth in earnings, with farm incomes down substantially, held down overall personal income, while the rate of decline for transfers was less that elsewhere (in some states other than North Dakota, transfers rose). In Texas's Southwest region transfers were relatively strong (or relatively less weak) and net earnings were strong. In the Far West and New England earnings were strong and transfers were weak. Looking more granularly at income generation, once again the recovery in travel led to enormous increases in income generated in leisure and hospitality in Nevada and Hawaii, but in both states large drops in transfer payments meant that overall personal income growth was relatively unimpressive.

The Fed finally admits it has an inflation problem. Yet, what is the bigger inflation problem and potentially more destabilizing to the economy as it unwinds? Is it the 40-year high in consumer price inflation, or is it the surge and record valuations of asset prices? Of course, policymakers would say it's consumer price inflation. However, I would argue its asset prices since easy money has fueled a record surge in equity prices, lifting macro valuations far above the dot.com bubble.

Asset inflation has been a dominant feature of business cycles for the past two decades or more. And, over the past two years, helped by an avalanche of liquidity as the Fed doubled its asset balance sheet to $8.5 trillion, the market valuation of domestic equities to nominal GDP (i.e., the Buffett Indicator) has jumped to levels never thought possible. At the end of 2021, the market value of domestic equities to nominal GDP stood at 2.55.

It is worth noting that before the pandemic, the Buffett Indicator hit a record high at the end of 2019, surpassing the peak level of the dot.com bubble. In other words, the Fed's easy money policies that resulted in an over-valuation of equities at the end of 2019 created a mind-boggling extreme over-valuation at the end of 2021.

To put the equity market's valuation in perspective, if equity prices dropped 25% in 2022, or a decline four times bigger than the decline in the S&P 500 to date, that would only bring the Buffet Indicator back to the peak of the dot.com bubble. And a drop of nearly double that scale to bring it to the average of the past two decades.

Before the last two years, history shows several years of negative returns following periods of extreme overvaluation. Yet, the S&P equity index has jumped nearly 50% over the past two years, while the Nasdaq is up over 80%. So instead of correcting in value, the equity market moved into a new orbit of over-valuation.

If there are laws of gravity in finance, the equity market is in for a big hurt. That's because monetary policy is a blunt instrument. As policymakers use traditional and non-traditional monetary policy tools to kill the consumer price inflation cycle, it will hit asset prices hard. Moreover, given the scale of over-valuation, the potential decline in equity prices could rival the "big" ones of years past. So investors should take note: history sometimes repeats itself in the world of finance.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Figure 1: Average unit wage cost inflation in developed economies

State payroll were generally modestly changed in January. Only 9 states reported statistically significant increases from December; the rest did not statistically significant moves of any size (the sum of the state increases was only 340,000, compared to the 481,000 increase reported in the national survey). California (53,600), New York (36,800), Pennsylvania (20,000), Georgia (19,400), and Ohio (18,600) had the largest increases, while Kansas and Maine had boosts of .6 percent.

Virtually all states saw job growth over the last 12 months. California picked up well over 1 million jobs; Nevada saw a 10.3 percent increase. Job gains were most notable from Texas west and in parts of the Northeast as well as Michigan and Florida; job growth was soft in the Plains.

19 states saw statistically significant drops in their unemployment rates in January (none larger than .3 percentage point), while Connecticut and DC saw increases of .2 percentage point. The range of unemployment across the nation has narrowed, in part reflecting revisions to recent numbers announced on March 2 (for instance, New Jersey's unemployment rate was reduced about 1 percentage point). Aside from DC's 6.3 percent, the highest rate in January was New Mexico's 5.9 percent, and Nebraska and Utah's 2.2 percent were the lowest. 10 states set new unemployment record lows.

Puerto Rico's unemployment rate fell from 7.5 percent in December to 7.1 percent in January, setting another new record low. The island's job count grew 7,600, and is now higher than its pre-Maria level, though still more than 150,000 under its 2005 peak. Gains over the past year have been most evident in retailing and leisure and hospitality, perhaps reflecting revived tourism.

By all indications, the Fed will raise the level of the federal funds rate, currently 0.08%, by 25 basis points on Wednesday, March 16. This will likely be the first of series of Fed rate hikes this year. (As this is being written, March13, the 12-month Federal Funds futures contract has priced in a rate of 1.87%. Later in this commentary I will explain why I do not believe the Fed will hike this much in this time period. When Fed Chair Powell is replaced by the reincarnation of Paul Volcker, then we will see more aggressive federal funds rate increases.) Two years ago, when Covid began spreading here, the federal government began handing out money to the bulk of American households, whether or not their incomes were adversely affected by Covid. Where did the federal government get this money to hand out? A lot of it came from the “printing presses” operated by the Federal Reserve and the banking system. And households still hold a lot of this Covid money. This means that as households face rising prices for essentials such as food and gasoline, they will be able to rundown their cash holdings to pay the higher prices without having to cut back on their purchases of discretionary goods and services as they otherwise would. These excess cash holdings by households will blunt the effects of the initial Fed rate hikes.

The red bars (mass) in the chart below represent the sum of currency, plus checkable deposits plus money market fund shares held by households. These cash holdings skyrocketed beginning at the end of Q1:2020. The blue line in Chart 1 represents this cash held by households as a percent of their after-tax income. This ratio also has skyrocketed, reaching a post-World War II high of 154% by Q4:2021. Think of the blue line as the inverse of the velocity of money.

Figure 1: Latest sentix survey suggests incoming economic data could disappoint

In the movie "Draft Day," Kevin Costner, the GM of the Cleveland Browns, tells a stunned GM of the Seattle Seahawks of a last-minute trade involving current and prospective draft picks that Seattle got from Cleveland only a few days ago "We live in a different world than we did just 30 seconds ago." The Fed also lives in a different world than just 30 or 60 days ago, meaning what many Fed officials thought would be the appropriate policy stance when they exited the January 25-26 FOMC meeting is no longer adequate or sufficient at the March 15-16 meeting.

At the press conference following the January FOMC meeting, Federal Reserve Chair Jerome Powell stated, "it will soon be appropriate to raise the target for the federal funds rate." Since that meeting, most policymakers have hinted that they would support a 25 basis points hike in the federal funds rate at the March meeting.

Yet, a 25 basis points hike in the federal funds rate would result in the real federal funds rate being lower in March than it was estimated to be in January. The reason is that reported consumer price inflation is markedly higher. To be sure, the reported twelve-month change in the consumer price index at the January meeting was 7%, and now through February 2022, it's almost 100 basis points higher at 7.9%.

At next week's FOMC meeting, will policymakers adopt a "go slow" or a "go bold" strategy? Betting odds indicate a "go slow" approach. Yet, if policymakers want to change the narrative and regain credibility on fighting inflation, "go bold" would be a better decision.

Ideally, a "go bold" strategy would start with a 50 basis point hike and end the promise that official rate increases would be gradual, modest in scale, and only occur at regularly scheduled meetings. Breaking the inflation cycle and inflation psychology requires bold moves.

In 1994, former Fed Chair Alan Greenspan stated, "If the Federal Reserve waits until actual inflation worsens, it would have waited too long." Policymakers have waited too long, and it's now incumbent on them to move quickly and limit the downside risks to the economy that have accompanied every inflation cycle of the past 60 years.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.