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A Word of Caution From Lacy Hunt on Inflation, Treasury Yields, Wages

The Hoisington Management first-quarter 2022 bond outlook has a markedly different feel this month. Let's tune in.
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Consumer Price Index data from BLS, PCE data from the BEA, chart by Mish

Consumer Price Index data from BLS, PCE data from the BEA, chart by Mish

Please consider the Hoisington Management Quarterly Review and Outlook for the First Quarter of 2022. 

Disaster

Disaster is a strong but appropriate word that applies perfectly to the state of U.S. monetary policy. 

A) The Fed, in reaction to the COVID-19 crisis, dropped the Fed funds rate to 0.25 bps and expanded total reserves of the depository institutions by an average of 63% in 2020 and 2021.  

Consequently, the commercial bank deposit component of M2 (that accounts for about 78% of the M2) surged by a record 20.5% over the past two years. This fact reveals the massive coordination of monetary and fiscal policy as government checks were directly funded by monetary largesse. In the face of an unsurpassed breakdown in product delivery systems, this money creation caused a massive imbalance between the demand and supply of goods.  

B) Reversing the past monetary and fiscal excess liquidity error will take time and persistence by the Fed. Most Americans have suffered a substantial fall in their standard of living over the past twelve months. In the latest available twelve-month change, 116.2 million American wage and salary workers suffered a 3.7% decline in their inflation adjusted paychecks, the largest drop since 1980

 The Fed's Mandate  

The greatest students of the Fed, like Milton Friedman and Alan Meltzer (author of  Fed’s most detailed history), as well as former Fed Chairman Paul Volcker would not be surprised that the Fed backed themselves and the economy into a huge hole by trying to balance competing mandates from Congress.

Under the Federal Reserve Reform Act of 1977, the Fed expanded its role to “the goals of maximum employment, stable prices, and moderate long-term interest rates.” Ironically, these goals have come to be known as the Fed’s “dual mandate” even though there are three goals. The flawed dual mandate of inflation and unemployment stems from the basic fact that no stable trade-off exists between wage increases and the unemployment rate. To make matters worse, in practice the Fed has allowed the dual mandate to morph into a single mandate centered on the Phillips Curve.  

In the Fed’s Monetary Policy Report sent to Congress in late February 2022, the Fed did not include the section on policy rules that had been included in its reports since July 2017, when Janet Yellen was Fed Chair.

The Great Theorists

In a 1967 peer-reviewed paper, Edmund Phelps challenged the theoretical structure of the Phillips Curve, and Milton Friedman, independently of Phelps, came to similar conclusions.  

In a paper presented at the 2014 Federal Reserve Bank of Chicago conference, Alan Meltzer summarized the root cause of the Fed’s policy errors and long record of failed forecasts as follows: “The Fed’s error was to rely on less reliable models like the Phillips Curve … that ignore or severely limit the role of money, credit, and relative prices.”  

Restraints on Growth

Major debt and demographic strains remain a significant restraint on U.S. economic growth. This problem is exacerbated by deteriorating economic conditions around the world. Scholarly work indicates the massive surge in government spending in the past two years has pushed its multiplier deeper into negative territory, resulting in a fiscal drag of major proportions in 2022 and 2023 as deficits will have reversed from over $3 trillion to slightly under $1 trillion, according to the Congressional Budget Office. Tracking models currently estimate that real economic growth is slightly positive, indicating that the Fed will be tightening into what is an already unfolding slowdown. Thus, the Hobson’s choice for the Fed is do they accept even more pronounced economic weakness to bring inflation into their target range?  [emphasis mine]

Bond Market  

At this current level, the long-end treasury market has value considering the impending recessionary conditions which have always reduced inflation and interest rates.  

However, should the Federal Reserve cease in their efforts to calm inflation before it has been fully restrained, bond investors should be wary.  

Thanks Lacy!

That's a someone lengthy snip, by permission, but there is much more in the article that warrants deeper investigation. 

This is the most cautionary we have seen Lacy for as long as I can remember. The reason is we are at the mercy of a Fed that does not understand what inflation really is.

Phillips Curve

The Phillips Curve, an economic model developed by A. W. Phillips purports that inflation and unemployment have a stable and inverse relationship.

On numerous occasions I have pointed out the fallacy of the Phillips Curve. 

Despite the obvious, the Fed sticks with models that do not work. 

For example, in March of 2017, Janet Yellen commented the "Phillips Curve is Alive“.

Taylor Rule

Lacy also devoted time to the Taylor Rule

The rule consists of a formula that relates the Fed's operating target for short-term interest rates to two factors: the deviation between actual and desired inflation rates and the deviation between real GDP growth and the desired GDP growth rates.

Following the Taylor Rule, the Fed undoubtedly would have been hiking by now. Under the Taylor Rule the Fed would also have curtailed QE much sooner. 

However, despite leaving us in better shape than we are now, the Taylor Rule is also economic nonsense. 

Three Serious Taylor Rule Flaws 

  • The Fed does not know what the desired rate of inflation should be, and the current 2% exponential target is economic madness
  • Even if the Fed knew what the rate should be, inflation is not easily measured.
  • The measures of CPI and PCE do not include asset bubbles, even obvious ones. Taylor proposes a "rule" that excludes bubbles. 

There are no rules that can autopilot the economy. Nor can the Fed steer the economy like a truck. 

Yet, these economic charlatans keep trying. This makes Taylor a charlatan despite the fact we would be better off now (in this instance) than what the Fed has done.

Long End Value

Lacy Concluded: "At this current level, the long-end treasury market has value considering the impending recessionary conditions which have always reduced inflation and interest rates. However, should the Federal Reserve cease in their efforts to calm inflation before it has been fully restrained, bond investors should be wary."

Curiously, I was working on post about the fundamental and technical case for buying long dated bonds right now. 

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I dropped that post to cover this latest review. But I will make the case for buying bonds later today or tomorrow. 

CPI Rips Higher to 8.5 Percent From a Year Ago, the Most Since 1981

Consumer Price Index data from BLS chart by Mish

Consumer Price Index data from BLS chart by Mish

Consumer prices jumped another 1.2 percent in March. The CPI is up 8.5 percent from a year ago, the most in over four decades.

For discussion of the CPI in March, please see CPI Rips Higher to 8.5 Percent From a Year Ago, the Most Since 1981

Real Hourly Wages Dive Again in March, Negative for 13 of Last 15 Months

Hourly wage data from BLS, chart and real calculations by Mish 

Hourly wage data from BLS, chart and real calculations by Mish 

A soaring CPI had led to negative real (inflation-adjusted) earnings. The drop in purchasing power was steep in March.

For discussion, please see Real Hourly Wages Dive Again in March, Negative for 13 of Last 15 Months

Inflation Expectations

Inflation expectations are yet another widely believed Fed idea, that is nonsense. Inelastic demand is at the heart of that issue.

To tie in another huge Fed mistake, please see Hello Fed, Inflation Expectations Are Unglued, No Longer Well Anchored

Hobson's Choice

The Fed has a Hobson's Choice. What decision will it make?

I do not believe anyone knows, including the Fed. A volatile bond market is the current result.

Making matters extremely difficult for the Fed is the simple fact that much consumer demand is inelastic while hikes are a very blunt instrument.

A Hobson's Choice is what happens when you ignore asset bubbles. It's also why the Taylor Rule (which also focuses only on consumer prices) is nonsense. 

There are no rules that one can use to steer the economy like a truck. We need a free market in rates, not a pack of group-think charlatans using fatally flawed economic models.

This post originated on MishTalk.Com.

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