Why Have Economists Continually Underestimated Projected Inflation?

I keep reading about how inflation has peaked (even peaked many months ago) and so any minute now the Fed will relent on raising interest rates, and will in fact start reducing them. Every data point that seems to support an early Fed pivot and a gentle “soft landing” for the economy is greeted with optimistic verbiage and a rip higher in stocks.

Except – – other meaningful data points regularly appear which show that inflation (especially core inflation) is remaining stubbornly high. The Personal Consumption Expenditures (PCE) Index is the Fed’s preferred way to track core inflation. It did peak in early 2022, and is falling, but very slowly and fitfully. Just when it seems like it is about to cascade downward, along comes another uptick.  The latest report for 02/24/23 showed the PCE index (excluding the volatile categories of food and energy) increasing 0.6 percent during the month of January, which translated to a 4.7 percent year-on-year gain. That was considerably higher than the 0.4 percent monthly gain (4.3 percent year-on-year) that economists expected.

Source: MV Financial

The chart below illustrates the chronic tendency of the economists at the Fed to lowball the estimates of future inflation. Each of the ten bars depicts quarterly projections of what inflation would be for 2023, starting back in September 2020 (first, green bar).  No one in the craziness of 2020 could be held particularly responsible back then for accurately projecting 2023 conditions. But the Fed embarrassed themselves badly into late 2021 by airily dismissing inflation as “transitory”, due mainly to supply chain constraints that would quickly pass. (See towards the middle of the chart, yellow Sept 2021 and blue Dec 2021 bars projecting a mere 2.2% inflation for 2023.)

Source: Jeremy LaKosh

Only as of December 2022 did estimates of inflation jump up to 3.1% for 2023, and that estimate will surely get revised upward even further.

Many factors probably went into this systematic failure on the part of the Fed economists. There are probably political reasons for erring on the rosy optimistic side, which I will not speculate on here.

One factor in particular was mentioned in the Minutes of the Jan 31/Feb 1 Fed meeting that I thought was significant:

A few participants remarked that some business contacts appeared keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges.

Jeremy LaKosh notes regarding this feature, “If true across the economy, the idea of keeping employees for fear of facing the labor force shortage would represent a fundamental shift in the employment market. This shift would make it harder for wage increases to mitigate towards historical norms and keep upward pressure on prices.”

This all rings true to my anecdotal observations. In bygone days, when business slowed down, factories would lay off or furlough workers, with the expectation on all sides that they would call the workers back (and the workers would come back) when conditions improved. However, employers have had to struggle so hard this past year to find willing/able workers, that employers are loath to let them go, lest they never get them back. I have read that even though homebuilders are not sure they can sell the houses they are building, they are so worried about losing workers that they are keeping them on the payroll, building away.

Other inflation data points show big decreases in prices for goods (and energy), but not for services. Wages, of course, are the big driver for service costs.

So the inflation story in 2023 seems to come down largely to a labor shortage. This is a large topic cannot be fully addressed here. I will mention one factor for which I have anecdotal support, that the enormous benefits (stimulus money plus enhanced unemployment) paid out during 2020-2021 set up a large number of baby boomers to leave the workforce early and permanently. Studies show that this is a major factor in the drop in workforce participation rate post-Covid. Maybe some of those folks had not planned ahead of time for such early retirement, but they got a taste of the good life (NOT getting up and going to work every day) in 2020-2021 along with the extra cash to pad their savings, and so they decided to just not return to work. That exodus of trained and presumably productive workers has left a hole in the labor force which now manifests as a labor shortage, which drives up wages and therefore inflation and therefore interest rates, which will eventually crater the economy enough that struggling firms will finally lay off enough workers to mitigate wage gains.

I wonder if this unhappy scenario could be staved off with increased legal migration of targeted skilled workers from other countries to alleviate the labor shortage. Dunno, just a thought.

Bulls and Bears Spar Over Pace of Inflation Decline and Rate Cuts

The stock market drools and rips higher at the slightest sign that inflation is abating, since that portends rate cuts instead of rate hikes by the Fed, and a return to the golden days of easy money. But what do the latest data show? Here I’ll show several charts to show what we know so far.

First, regarding U.S. inflation, here are a pair of charts from a raging bull article by Dan Victor titled The Fed Pivot Debate And Why Bulls Are Winning.

The last couple months’ data points in the lower chart show that inflation (as estimated by CPI) has essentially leveled out and may be starting to decline a little.  That is fine but it still leaves inflation far above the Fed’s 2% target. Victor defines a Fed “pivot” not as actually cutting rates, but simply a halt to raising them. By that somewhat anemic definition, sure, a Fed pivot could well come in the next few months. But that leaves rates still very high by recent standards.  The real question is when will inflation come down low enough to justify significant rate cuts. The Fed screwed up so abysmally last year with its ridiculous “this inflation is only transitory supply chain issues” that they really cannot afford to relent too soon, and let inflationary psychology take hold.

Side comment: the big “blowout” jobs number for January (last bar on the right, on the top chart above) caused a huge buzz. But there are strong reasons to discount it as an artifact of  “  revisions, adjustments, control factors, and recoding  “, per Jeffrey Snider.

On the other side of the bull/bear divide, Wolf Richter published a glass-half-empty article noting how the Bureau of Labor Statistics recently revised its CPI numbers, and the changes shifted the numbers so as to undermine the argument that inflation has started to drop rapidly:

The chart above with revisions (red line) shows core CPI barely declining over the past 9 months or so, and no trend for an acceleration in that decline. The chart below shows CPI for Services (where we consumers spend most of our money, and which is closely correlated to wages) is holding nearly steady around a red-hot 0.55%/month or about 6.6% annualized. It could be longer than the market thinks before there are substantial rate cuts.

And from the Eurozone, there is this chart, courtesy of Bloomberg via Yahoo, depicting the results of polling economists as to the future course of inflation there:

The consensus view is that inflation in Europe will not approach the 2% target until well into 2024. The European Central Bank is expected to hike by 0.5% in March, followed by another 0.25% to reach 3.25%. (This is much lower than the Fed’s interest rates, but that is probably because the U.S. is still working off the orgy of COVID-related payments that dumped trillions in peoples’ pockets here in 2020-2021). Cuts by the ECB are not expected until the second quarter of 2024.

THIS JUST IN: The January CPI data just came out today (2/14), and pretty much matches up with the picture presented above. Inflation is falling, but ever so slowly, and so it becomes more likely that the Fed will keep its rates higher for longer:

“The Consumer Price Index (CPI) for January showed a 0.5% increase in prices over the past month, an acceleration from the prior reading, government data showed Tuesday. On an annual basis, CPI rose 6.4%, continuing a steady march down from a 9.1% peak last June. Economists had expected prices to climb 6.2% over the year and jump 0.5% month-over-month, per consensus estimates from Bloomberg. …

Core CPI, which strips out the volatile food and energy components of the report, climbed 5.6% year-over-year, more than expected, and 0.4% over the prior month. Forecasts called for a 5.5% annual increase and 0.4% monthly rise in the core CPI reading.”

(For another recent take on the inflation picture, see James Bailey’s The Murky Macro Picture, on this blog).

A Cornucopia of Financial Data from J. P. Morgan, Relevant to Investors

I just ran across the 1Q2023 “Guide to Markets” issued by J. P. Morgan Asset Management. This compendium of financial data is issued by a large team of their Global Market Insights Strategy Team. It consists of some seventy pages of data-packed charts, covering through December 2022. This information is selected to be of use to investors, both individual and institutional.

I was like a kid in a candy store, scrolling from one page of eye candy to the next. Without further ado, I will paste in some charts with minimal commentary.

One thing that caught my attention here was the persistence overestimation of earnings by Wall Street analysts. “Why do they keep doing that?” I wondered. A brief search led me to a 2017 article on Seeking Alpha by Lance Roberts titled “The Truth About Wall Street Analysis”.  

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Bank for International Settlements: $70 Trillion Dollars Is Missing from Official Global Financial Accounting

Seventy trillion dollars is a lot of money. It is nearly three times the size of the U.S. GDP, and approaches total global GDP (around $100 trillion). That is the amount of funds that are missing from normally reported financial statistics, according to a December, 2022 report from the Bank for International Settlements. That report caused a bit of a flurry in financial circles.

It’s not that this money has been stolen, it’s just that it is not publicly known exactly where it is, i.e., how much money that which parties owe to whom. Here is the Abstract of this paper:

FX swaps, forwards and currency swaps create forward dollar payment obligations that do not appear on balance sheets and are missing in standard debt statistics. Non-banks outside the United States owe as much as $25 trillion in such missing debt, up from $17 trillion in 2016. NonUS banks owe upwards of $35 trillion. Much of this debt is very short-term and the resulting rollover needs make for dollar funding squeezes. Policy responses to such squeezes include central bank swap lines that are set in a fog, with little information about the geographic distribution of the missing debt.

Much of this money is in the form of currency swaps, especially foreign exchange (FX) swaps. Even though the U.S. economy no longer dominates the whole world, the U.S. dollar remains the premier basis for international trade and even more for foreign exchange:

As a vehicle currency, the US dollar is on one side of 88% of outstanding positions – or $85 trillion. An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty.

Who cares? Well, the incessant demand for dollars periodically leads to a dollar funding squeeze in international trade, which in turn reverberates into world GDP.

Currency Swaps as Lending Events

In many cases these currency swaps effectively amount to short-term lending /borrowing (of dollars). Much of the financial world is utterly dependent on smoothly flowing short-term funding to cover longer term debt or investments. Borrowing short-term (at usually lower interest rates) and investing or lending out longer-term (at higher rates) is how many institutions and funds exist. For instance, depositors at banks effectively lend their deposits to the bank (short-term), in return for some pitiful little interest on their checking or savings accounts, while the banks turn around and make say 5 year or 30-year loans to businesses or home-buyers. Banks earn profits on the spread between the interest rates they receive on the funds they loan out, and the typically lower rates on the short term funds they “borrow” from their depositors.

This “mismatch” between the maturities of borrowed funds (especially dollars) and invested funds can cause a complete melt-down of the financial system if holders of dollars stop being willing to lend them out, or to lend them out at less than ruinous interest rates:

The very short maturity of the typical FX swap/forward creates potential for liquidity squeezes. Almost four fifths of outstanding amounts at end-June 2022 in Graph 1.B matured in less than one year. Data from the April 2022 Triennial Survey show not only that instruments maturing within a week accounted for some 70% of FX swaps turnover, but also that those maturing overnight accounted for more than 30%. When dollar lenders step back from the FX swap market, the squeeze follows immediately.

Financial customers dominate non-financial firms in the use of FX swaps/forwards. Non-bank financial institutions (NBFIs), proxied by “other financial institutions” in Graph 1.C, are the biggest users of FX swaps, deploying them to fund and hedge portfolios as well as take positions. Despite their long-term foreign currency assets, the likes of Dutch pension funds or Japanese life insurers roll over swaps every month or quarter, running a maturity mismatch.  For their part, dealers’ non-financial customers such as exporters and importers use FX forwards to hedge trade-related payments and receipts, half of which are dollar-invoiced. And corporations of all types use longer-term currency swaps to hedge their own foreign currency bond liabilities .

It is really bad if pension funds or insurance companies get starved of needed ongoing funding. Central banks, especially the dollar-rich Fed, have had to repeatedly jump in and spray dollar liquidity in all directions to mitigate these “dollar squeezes”.  The BIS authors’ main concern is that these big public policy decisions are currently made in absence of data on what the actual needs and issues are.  Hence, “Policy responses to such squeezes include central bank swap lines that are set in a fog.”

This all is part of the murky “Eurodollar” universe of dollar-denominated bank deposits circulating outside the U.S. (more on this some other time).  Investing adviser Jeffery Snider offers the “Eurodollar University” on podcasts and on YouTube, in which he explores the many dimensions of the Eurodollar scene. He likens the Eurodollar system to a black hole: we cannot observe it directly, but we can estimate its size by its effects.

In his YouTube talk on this BIS paper, among other things Snider notes that this short-term lending associated with currency swaps functions much like repo borrowing, except the currency swaps (unlike repo) do not appear on bank or other balance sheets as assets/liabilities. That is part of the attraction of these swaps, since they are effectively invisible to regulators and are not constrained by e.g., capital requirements.

What the Fed does in a dollar squeeze is largely lend dollars to large dealer banks. But unless those other banks then lend those dollars out into the private marketplace of manufacturers and shippers and pension funds, having trillions of dollars in central bank reserves has little effect. It is not the case that “the Fed floods the world with dollars”  — actually, mainstream banks get those dollars, and then lend out at high rates to the dollar-starved rest of financial world, where they can actually do something.

The result, according to Snider, is that the Eurodollar is the only functional reserve currency in existence. This is the real, effective banking system (not “reserves” sitting on some bank’s balance sheet), even though the current accounting system doesn’t show it.

Can Central Banks Go Bankrupt?

Finnish crisis researcher Tuomas Malinen has for some time been predicting the collapse of the Western financial system, starting with the melt-down of the European Central Bank. Malinen, an associate professor of economics at the University of Helsinki, offers his views on his substack and elsewhere. He correctly warned in early/mid 2021 of coming inflation, which would present central bankers with severe challenges.

Among other things, by raising interest rates (to counter inflation), the banks necessarily cause the value of bonds to drop. However, a lot of the assets of the central banks consist of medium and long term bonds, especially those issued by sovereign governments. We have come to the point where some central banks are technically insolvent: the current cash value of their liabilities exceed their assets.

Is that a problem? Most authors I found did not seem to think so. For a normal private bank, as soon as the word got out that it was insolvent, customers would rush to withdraw their funds, in a classic “run on the bank”. Customers who waited too late to panic would simply lose their money, since there would not be enough assets on the bank’s balance sheet to cover all withdrawals.

However, no one seems to be in a hurry to beat down the doors of the Fed and demand their money. Most of the liabilities of the Fed are (a) paper currency in circulation, and (b) “Reserve” accounts of major banks at the Fed.

Bandyopadhyay, et al. note that negative equity in central banks (including those of smaller countries) is not uncommon; at any given time, about one out of seven central banks worldwide in the 2014-2017 timeframe suffered operating losses, some of which were large enough to wipe out their capital. However, most central banks are owned by, or have some other synergistic  relationship to , the governments of their respective countries. For instance, there is a standard contractual relationship between the Bank of England (BOE) and the British government. Thus, when the BOE recently fell into arrears, the government provided them with additional funds. This was apparently a routine non-event. (I don’t know where the government came up with those additional funds; did they just issue more bonds, which in turn were purchased by the BOE?)

The Fed, as a privately-owned public/private hybrid, technically has a more arms-length distancing from the U.S. Treasury. For instance, the Fed is not supposed to buy government bonds directly from the government. Rather, the government sells them to large banks, who in turn sell them to the Fed (if the Fed is buying). It is possible for the U.S. Treasury to transfer funds to the Fed to recapitalize it; but for now, the Fed is just booking losses as a “deferred asset”. Voila, the magic of central bank accounting. The presumption is that sometime in the future, the Fed will receive enough net income to overcome these losses.

The biggest debate is over the fate of the European Central Bank (ECB). Its relation to sovereign governments is even more arms-length; it is difficult to see all the European countries, with their own budget issues, agreeing to cough up money to give to ECB. As Malinen sees it, this likely leads to the “deferred asset” accounting scheme to handle negative equity for the ECB. He worries, “Will the markets or the banks trust the ECB after losses starts to mount forcing the Bank to operate with (large) negative equity? We simply do not know.” This is a weighty issue. As we noted earlier, “money” is in the end a social construct, an item of trust among parties for future payments of value. Central banks are the lenders of last resort, the source of money when it has dried up elsewhere; they regularly have to step into financial liquidity crises to inject more money to keep the system going. If people stopped accepted the keystroke-created money from central banks, the whole economy could freeze up.

A more sanguine view of central bank negative equity issues from MMT proponent Bill Mitchell. In his “Central banks can operate with negative equity forever” Mitchell heaps scorn on the very idea that central banks could run into solvency problems. He states that a “government bailout” is an inconsequential paper operation, merely transferring money from the left pocket to the right pocket of the government/central bank joint entity (as he views it). Furthermore, central banks have the capability of creating money out of thin air, so they can always meet their obligations and therefore can never be deemed insolvent:

The global press is full of stories lately about how central banks are taking big losses and risking solvency and then analysing the dire consequences of government bailouts of the said banks. All preposterous nonsense of course. It would be like daily news stories about the threat of ships falling off the edge of the earth. But then we know better than that. But in the economic commentariat there are plenty of flat earthers for sure. Some day, humanity (if it survives) will look back on this period and wonder how their predecessors could have been so ignorant of basic logic and facts. What a stupid bunch those 2022 humans really were.

AS-AD: From Levels to Percent

The aggregate supply & aggregate demand model (AS-AD) is nice because it’s flexible and clear. Often professors will teach it in levels. That is, they teach it with the level of output on one axis, and the price level on the other axis. This presentation is convenient for the equation of exchange, which can be arranged to reflect that aggregate demand (AD) is a hyperbola in (Y, P) space. Graphed below is the AD curve in 2019Q4 and in 2020Q2 using real GDP, NGDP, and the GDP price deflator.

The textbook that I use for Principles of Macroeconomics, instead places inflation (π) on the vertical axis while keeping the level of output on the horizontal axis. The authors motivate the downward slope by asserting that there is a policy reaction function for the Federal Reserve. When people observe high rates of inflation, state the authors, they know that the Fed will increase interest rates and reduce output. Personally, I find this reasoning to be inadequate because it makes a fundamental feature of the AS-AD model – downward sloping demand – contingent on policy context.

At the same time, I do think that it can be useful to put inflation on the vertical axis. Afterall, individuals are forward looking. We expect positive inflation because that’s what has happened previously, and we tend to be correct. So, I tell my students that “for our purposes”, placing inflation on the vertical axis is fine. I tell them that, when they take intermediate macro, they’ll want to express both axes as rates of change. I usually say this, and then go about my business of teaching principles.

But, what does it look like when we do graph in percent-change space?

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In Praise of the FRED Excel Add-in

Sometimes, large entities have enough money to throw at a problem that by sheer magnitude they produce something great (albeit at too high a cost). The iPhone app from the FRED is not that thing. But the Excel add-in is something that every macroeconomics professor should consider adding to their toolkit.

Personally, I include links to FRED content in the lecture notes that I provide to students. But FRED makes it easy to do so much more. They now have an add-in that makes accessing data *much* faster. With it, professors can demonstrate in excel their transformations that students can easily replicate. The advantage is that students can learn to access and transform their own data rather than relying on links that I provide them.

The tool is easy enough to find – FRED wants you to use it. After that, the installation is largely automatic.

Installed in excel you will see the below new ribbon option. It’s very user friendly.

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Housing & The Fed’s Reputation

I am not worried about inflation and I’m not worried about the total spending in the economy. As I’ve said previously, total spending is on track with the pre-pandemic trend and, I think, that helped us experience the briefest recession in US history. When output growth declines below trend, we face higher prices or lower incomes. The former causes inflation, the latter causes large-scale defaults. Looking at the historical record, I’m for more concerned about the latter.

I do, however, want to call special attention to the composition of the Fed’s balance sheets. Specifically, its Mortgage Backed Security (MBS) assets. Having learned from the 2008 recession, the Fed was very intent on maintaining a stable and liquid housing market. Purchasing MBS is one way that it maintained that stability. Its total MBS holdings almost doubled from March of 2020 to December of 2021 to $2.6 trillion. Should we be concerned?

At first, a doubling sounds scary. And, anything with the word ‘trillion’ is also scary. Even the graph below looks a little scary. MBS holdings by the Fed jumped and have continued to increase at about a constant rate. Is the housing market just being supported by government financing? What happens when the Fed decides to exit the market?

Luckily for us, there is precedent for Fed MBS tapering. The graph below is in log units and reflects that a similar acceleration in MBS purchases occurred in 2013. Fed net purchases were practically zero by 2015 and total MBS assets owned by the Fed were even falling by 2018. Do you remember the recession that we had in 2013 when the Fed stopped buying more MBS’s? Wasn’t 2018-2019 a rough time for the economy when the Fed started reducing its MBS holdings? No. We experienced a recession in neither 2013 nor 2018. Financial stress was low and RGDP growth was unexceptional.

Although there was no macroeconomic disruption, what about the residential sector performance during those times? Here is a worrisome proposed chain of causation:

  1. Relative to a heavier MBS balance sheet, the Fed reducing its holdings increases supply on the MBS market.
  2. This means that the return on creating new MBS’s falls (the price rises).
  3. A lower return on MBS’s means that there is less demand from the financial sector for new loans from loan originators.
  4. A tighter secondary market for mortgages decreases the eagerness with which banks lend to individuals.
  5. Fewer loans to individuals puts downward pressure on the demand for houses and on the price of the associated construction materials.

The data fits this story, but without major disruption.

Less eager lenders went hand-in-hand with higher mortgage rates and less residential construction spending. The substitution effect pushed more real-estate lending and spending to the commercial side. Whereas residential spending was almost the same in late 2019 as it was in early 2018, commercial real-estate spending rose 13% over the same time period.

But, importantly in the story, the income effect of a Fed disruption should have been negative, resulting in less total spending and lower construction material prices. And that’s not what happened. Total Construction spending rose and so did construction material prices. Both of these are the opposite of what we would expect if the Fed had caused disruption in the housing construction sector due to its MBS holding changes.   Spending on residential construction fell understandably. But spending on commercial construction and the price of construction materials rose.

My point is that you should not listen to the hysteria.

The Fed has a variety of assets on its balance sheet and it pays special attention to the residential construction sector. Do you think that there is a residential asset bubble? Ok. Now you have to address whether the high prices are due to demand or supply. Do you suspect that the Fed unloading its MBS’s will result a popped bubble and maybe even contagion? It’s ok – you’re allowed to think that. But the most recent example of the Fed doing that didn’t result in either a macroeconomic crisis or substantial disruption in the construction markets.

The Fed has a track record and it has a reputation that serves as valuable information concerning its current and prospective activities. The next time that someone gets hysterical about Fed involvement in the housing sector, ask them what happened last time? Odds are that they don’t know. Maybe that information doesn’t matter for their opinion. You should value their opinion accordingly.

Covid-19 & The Federal Reserve

I remember people talking about Covid-19 in January of 2020. There had been several epidemic scare-claims from major news outlets in the decade prior and those all turned out to be nothing. So, I was not excited about this one. By the end of the month, I saw people making substantiated claims and I started to suspect that my low-information heuristic might not perform well.

People are different. We have different degrees of excitability, different risk tolerances, and different biases. At the start of the pandemic, these differences were on full display between political figures and their parties, and among the state and municipal governments. There were a lot of divergent beliefs about the world. Depending on your news outlet of choice, you probably think that some politicians and bureaucrats acted with either malice or incompetence.

I think that the Federal Reserve did a fine job, however. What follows is an abridged timeline, graph by graph, of how and when the Fed managed monetary policy during the Covid-19 pandemic.

February, 2020: Financial Markets recognize a big problem

The S&P begins its rapid decent on February 20th and would ultimately lose a third of its value by March 23rd.  Financial markets are often easily scared, however. The primary tool that the Fed has is adjusting the number of reserves and the available money supply by purchasing various assets. The Fed didn’t begin buying extra assets of any kind until mid-March. There is a clear response by the 18th, though they may have started making a change by the 11th.  One might argue that they cut the federal funds rate as early as the 4th, but given that there was no change in their balance sheet, this was probably demand driven.


March, 2020: The Fed Accommodates quickly and substantially.

In the month following March 9th, the Fed increased M2 by 8.3%. By the week of March 21st, consumer sentiment and mobility was down and economic policy uncertainty began to rise substantially – people freaked out. Although the consumer sentiment weekly indicator was back within the range of normal by the end of April, EPU remained elevated through May of 2020. Additionally, although lending was only slightly down, bank reserves increased 71% from February to April. Much of that was due to Fed asset purchases. But there was also a healthy chunk that was due to consumer spending tanking by 20% over the same period.


In the 18 months prior to 2020, M2 had grown at rate of about 0.5% per month. For the almost 18 months following the sudden 8.3% increase, the new growth rate of M2 almost doubled to about 1% per month. The Fed accommodated quite quickly in March.

April, 2020: People are awash with money

Falling consumption caused bank deposit balances to rise by 5.6% between March 11th and April 8th. The first round of stimulus checks were deposited during the weekend of April 11th. That contributed to bank deposits rising by another 6.7% by May 13th.

By the end of March, three weeks after it began increasing M2, the Fed remembered that it really didn’t want another housing crisis. It didn’t want another round of fire sales, bank failures, disintermediation, collapsed lending, and debt deflation. It went from owning $0 in mortgage-backed securities (MBS) on March 25th to owning nearly $1.5 billion worth by the week of April 1st. Nobody’s talking about it, but the Fed kept buying MBS at a constant growth rate through 2021.

May, 2020 – December, 2021: The Fed Prevents Last-Time’s Crisis

Jerome Powell presided over the shortest US recession ever on record. The Fed helped to successfully avoid a housing collapse, disintermediation, and debt deflation – by 2008 standards. The monthly supply of housing collapsed, but it had bottomed out by the end of the summer. By August of 2021, the supply of housing had entirely recovered. The average price of new house sales never fell. Prices in April of 2020 were typical of the year prior, then rose thereafter. A broader measure of success was that total loans did not fall sharply and are nearly back to their pre-pandemic volumes. After 2008, it took six years to again reach the prior peak. A broader measure still, total spending in the US economy is back to the level predicted by the pre-pandemic trend.

The Fed can’t control long-run output. As I’ve written previously, insofar as aggregate demand management is concerned, we are perfectly on track. The problem in the US economy now is real output. The Fed avoided debt deflation, but it can’t control the real responses in production, supply chains, and labor markets that were disrupted by Covid-19 and the associated policy responses.

What was the cost of the Fed’s apparent success? Some have argued that the Fed has lost some of its political insulation and that it unnecessarily and imprudently over-reached into non-monetary areas. Maybe future Fed responses will depend on who is in office or will depend on which group of favored interests need help. Personally, I’m not so worried about political exposure. But I am quite worried about the Fed’s interventions in particular markets, such as MBS, and how/whether they will divest responsibly.

Of course, another cost of the Fed’s policies has been higher inflation. During the 17 months prior to the pandemic, inflation was 0.125% per month. During the pandemic recession, consumer prices dipped and inflation was moderate through November.  But, in the 16 months since April of 2020, consumer prices have grown at a rate of 0.393% per month – more than three times the previous rate. Some of that is catch-up after the brief fall in prices.

Although people are genuinely worried about inflation, they were also worried about if after the 2008 recession and it never came. This time, inflation is actually elevated. But people were complaining about inflation before it was ever perceptible. The compound annual rate of inflation rose to 7% in March of 2021. But it had been almost zero as recent as November, 2020. That March 2021 number is misleading. The actual change in prices from February to March was 0.567%. Something that was priced at $10 in February was then priced at $10.06 in March. Hardly noticeable, were it not for headlines and news feeds.

QE, Stock Prices, and TINA

The U.S. economy as quantified by GDP has been sputtering along in slow growth mode for a number of years. It took a huge hit in 2020 due to covid shutdowns and has not nearly recovered. But stock prices have been rocketing upwards, and this past year is no exception. Markets took a cliff-dive in March, but have since way overshot to the upside.

Here is a plot of the past five decades of U.S. GDP and of the Wilshire 5000 index, which approximates the total stock market capitalization in the U.S.:

Chart Source: St. Louis Fed, as plotted by Lyn Alden Schwartzer

These two curves have crisscrossed each other over the past five decades, but in recent years the stock market has roared to the upside. One of Warren Buffet’s favorite metrics as to whether stock are overvalued is to consider the ratio of these two quantities, i.e. the market-capitalization-to-GDP (Cap/GDP) ratio:

Source: Lyn Alden Schwartzer

The ratio is much higher than it has even been. The last time it got this high was in 2000, and that did not end well.

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