Jerome Powell faces the unenviable choice of a market crash or inflation
Yesterday the Federal Reserve Open Market Committee — the people tasked with setting interest rates — held their first meeting since Chairman Jerome Powell conceded that inflation was unlikely to be transitory. Despite the confident market reactions to the meeting, the projections that they released paint a picture of a system cracking up.
To understand why we need to take a step back. Central banks today make much of their independence. They project themselves as being above political concerns, denying that they are influenced by politicians and even other civil servants. The rationale that underpins this independence is that they possess the ability to set monetary policy in an objective or scientific manner.
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They claim to be able to do this based on a theory in economics called the ‘natural rate of interest’. This theory states that setting monetary policy is not that dissimilar from an engineering problem. Very smart people with economic PhDs, we are told, can look at various economic statistics — unemployment, inflation, potential GDP and so on — and arrive at an objective number. This number, called the ‘equilibrium interest rate’ or ‘R*’, is then used to set the interest rate.
But yesterday’s projections are very hard to square with this theory. The R* is typically thought of as being the rate of interest minus the rate of inflation — this is the ‘real interest rate’. Today that rate is insanely low, clocking in at minus 6.8% in November — the lowest on record. If you are a saver and you put your savings in safe treasury bills, you are losing nearly 7% a year of your savings to inflation.
The Fed has effectively committed not to raise rates above 1% in 2022 or even past 2.5% in the foreseeable future. If the inflation continues, this implies that their equilibrium rate of interest is anywhere between minus 4.3% and minus 5.8%. So for anyone who wants to save some of their income, it makes literally no sense for an equilibrium rate to look like this.
The Fed has wished this inconvenient fact away by magically assuming in their projections that inflation will disappear. Why? They do not explain. More than that, this magic assumption seems to fly in the face of Powell’s statements last month that inflation is not transitory. As of today the Bank of England is following suit, projecting ‘modest tightening’ moving forward.
In reality, the Fed is stuck between a rock and a hard place. If they raise rates, they will crash the financial markets that they have been irresponsibly juicing for over a decade. If they do not raise rates, they risk spiralling inflation. This situation is giving the lie to the pretence that they set interest rates in an ‘objective’ or ‘scientific’ manner.
The central banks may get lucky. Inflation may subside on its own. But it is more likely that it will not. If it does not, real interest rates will stay very negative in perpetuity. This could lead to the central banks losing their intellectual credibility at the very same time as the public loses faith in them due to spiralling inflation. I do not envy the job of central bankers these days, but they should tread carefully.