The Fed is out of envelope

"The Fed is actually sending Americans more money than Americans are spending."

“Don’t fight the Fed” is one of Wall Street’s favorite sayings, and one of its most accurate. Unfortunately, right now, the Fed kind of wants you to sell everything.

The bureaucratic operating theory of the 20th-century Fed is the traditional tradeoff between inflation and depression. By tradition, there is always a Goldilocks policy which does not run the economy either too hot or too cold. “Hawks” may want to run the economy cold and “doves” may want to run it hot; some wise compromise, surely, will prevail.

Normalcy under this operating theory is a sort of flight envelope, in which a variety of policies can be safe and effective. Once the aircraft passes the edge of its envelope, the tradeoff between policies no longer makes sense. No policies are safe and effective. The coffin corner of monetary policy is stagflation—which is inflation plus depression.

The Fed is making a dangerous mistake by raising interest rates. Inflation is bad, but inflation alone is better than stagflation. Inflation is bad. Stagflation is even worse—and even harder to escape.

Executive summary

Consumer-price inflation caused by a perfect storm of huge exogenous supply shocks and epic asset-price inflation, the latter caused by pedal-to-the-floor monetary policy, is causing a monetary tightening. This tightening seems likely to flip the equilibrium of the bubble from expansion to contraction. Arguably it already has.

But the exogenous nature of the inflation may keep consumer prices increasing even once personal net worth starts contracting—leaving the Fed unable to respond to the contraction with its usual tool of cutting interest rates. Also, since the Fed is already almost out of fuel—at the “zero bound”—this tool is now almost expired.

The result may be a contraction so powerful that even cutting interest rates to zero cannot easily flip the equilibrium back to expansion—as has already long been the situation in Japan. Japan is doing fine. But Japan is a healthy, productive economy with a strong industrial trade surplus.

Stagflation is a trap that is hard to escape. It is hard to get people to borrow at zero rates in a contracting economy, because all investments are by default unprofitable. The financial gas that powers an inflating economy may bounce off a deflating one.

The Fed does not have a direct mechanism for injecting money into the economy. Congress would have to spend enough to counter the contraction in spending due to the fall in personal net worth. Especially in the absence of a new and exogenous disaster like covid, it is not clear that it has the energy for this kind of profligacy.