by Philip Pilkington
Friday, 17
December 2021
Analysis
07:45

The Fed risks losing all credibility over inflation

Jerome Powell faces the unenviable choice of a market crash or inflation
by Philip Pilkington
Credit: Getty

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.

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.

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J Bryant
J Bryant
5 months ago

Surely this short article is one of the most important published this year on Unherd. What are the implications of long-term negative interest rates on society? Profound instability, I would guess.
The author notes:
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.
So what are we to do? Is there any way out of this situation? Are we about to witness economic collapse and the birth of a new (not necessarily better) economic system? I’d love to see this author write on those types of issues.
After the 2008 economic collapse there was a slew of books and magazine articles describing what happened and how we reached that sad situation. Some were excellent and I couldn’t help wonder where those clever economists were in the years leading up to the economic collapse? Why didn’t they see it coming? Why weren’t they writing about it and trying to guide us away from disaster? The world is full of Monday morning quarterbacks but there are few prophets.

Giles Chance
Giles Chance
5 months ago
Reply to  J Bryant

The implications of long-term negative interest rates are to destroy any credibility in money. The rise of Bitcoin is evidence this has started already.

Giles Chance
Giles Chance
5 months ago
Reply to  J Bryant

ps. If you like prophecy, I suggest you read my book “China and the Credit Crisis: the emergence of a new world order” (2010, John Wiley, and in a Chinese edition 2011). It describes the run-up to the 2008 crash and the immediate consequences, as well as China’s switch away from the US and its determination to strike its own independent path.

J Bryant
J Bryant
5 months ago
Reply to  Giles Chance

Thanks.

Galeti Tavas
Galeti Tavas
5 months ago
Reply to  J Bryant

I wish Unherd had a Finance Desk. The thing is you have ‘Deflationists’, ‘Inflationists’, ‘Gold Bugs’, Bit Coin shills’, MMTers, Monetarists, Keynesian Macro’, and lots of every sore of doom sayer – and the total Tech Bulls, like Kathy Wood.

I would like them all to come along, and also the crazy ones like Emil, and his partner https://www.youtube.com/c/EmilKalinowski – total Deflationists, and huge on the ‘Euro-Dollar’ driving the world.

(the Euro-Dollar is a fascinating thing – basically as $ is the global reserve and 65% of all international transactions happen in it – there are not enough $ issued by the Treasury, SO… as all money is created by being ‘Loaned Into Existence’ by Banks – European Banks (and ones in the Caribbean and elsewhere) Make international and domestic loans in USA $! This $ Dollars, called Eurodollars – which now are in existence on Bank and non-bank balance books – AND Have to be repaid in $! (this last bit has huge consequences in any down turn – and may well cause the $ to rise when it should fall)

Stories on this all – Unherd is missing a bet not covering the esoteric aspects of finance – the world would love it if they did….

J Bryant
J Bryant
5 months ago
Reply to  Galeti Tavas

Stories on this all – Unherd is missing a bet not covering the esoteric aspects of finance – the world would love it if they did….
Yeah, for a magazine devoted to ‘unherd’ stories they’re missing a chance to get ahead of the curve. Some might argue economics isn’t interesting to most readers but I think a good journalist can write in plain English and make these issues intelligible and interesting to a general audience.

Giles Chance
Giles Chance
5 months ago

Negative real interest rates will destroy the US and Western financial system. We know this, because it’s a fact which follows inevitably from historical precedent. I blame the situation we’re in on incorrect policy framed by Bernanke (whose Ph D thesis was on the Great Depression of 1931-2, and how it could have been avoided) and his disciple and executor Alan Greenspan. Bernanke created a new monetary orthodoxy which most economists under the age of 50 (and some older like David Blanchflower at Dartmouth in the US), have been brought up on, or have embraced. By contrast, China, under US-educated Yi Gang as central bank governor, has respected the real interest rate reality. Consequently the RMB yuan now represents a solid alternative to the dollar, for the first time. Stand by !!!

Last edited 5 months ago by Giles Chance
Galeti Tavas
Galeti Tavas
5 months ago
Reply to  Giles Chance

Where is today’s Paul Vocker? (head of FED 1970s who raised interest to a high of 20% to kill inflation)

Giles Chance
Giles Chance
5 months ago
Reply to  Galeti Tavas

early 1980’s.

Galeti Tavas
Galeti Tavas
5 months ago

“The Fed has wished this inconvenient fact away by magically assuming in their projections that inflation will disappear. Why? They do not explain.”

The world of economics is divided between Deflationists, like Kathy Wood, Lacy Hunt, Harry Dent (Hunt is On De Martino-Booths new Youtube, as is Jim Rogers on Stansberry Research Youtube)

And Inflationists like Schiff, – basically all the gold bugs, and Market Crash, 2008 GFC people.

The world is exceptionally deflationary – Tech, AI and computers replacing office workers and automation replacing manual workers. More produced for less costs = Deflation. Also the demographics are very Deflationary as the population gets past the high consumption years of family costs.

Dis-inflation is widely predicted 2022, and ending of inflation 2023, and then begins the deflation.

In this time a major stock market crash/correction is inevitable – unless another ‘Powell Flip’ happens because the Stock Market corrects – and so Powell has QE double rather than tapering, and the market makes a giant death rattle Bull Run.

USA Spent 12 $Trillion on covid Response insanity, and coincidentally the super wealthy saw their wealth grow by 12 $ Trillion during those same 20 months, and Inflation go wild, equities insanely make a Bull Run, and QE Keep interest to zero. This is the final harvesting of the middle class and working class savings before the big depression coming.

To give some picture – the entire USA Military, 13 aircraft carrier fleets, 2.8 MILLION Employees!, Tanks, ships, planes, bases in vast numbers around the world – This all costs $ 800 Billion, about 1/15 of what we just spent insanely on ‘Covid’ (it was criminal, and I hope they pay).

I hope you are shifting your investments to cash to miss the crash, maybe 10% gold and some hard assets. We have been set up to become – own nothing, be happy, and this is the phase where they take everything from you.

Last edited 5 months ago by Galeti Tavas
James Joyce
James Joyce
5 months ago

Jerome Powell is running a clown show, but the alternatives are likely to be much worse. ALL of these policies are designed to punish savers and reward borrowers–especially profligate borrowers who spend irresponsibly.
“Very smart people with Economic Phds….” Does anyone agree with me that this is an oxymoron? Supposedly very smart people with these degrees–or in the UK, PPEs–have created this disaster.
Future economics Phds will look to Turkey, which is conducting a natural experiment (unnatural experiment?) with inflation. How is that working out? Lowering interest rates keeps inflation low? Reality seems to suggest otherwise.
The economic Phds steering the plane into the ground can Let’s Go Brandon. They can take their economic R factor and shove it, as even these very basic numbers show they are stealing from savers. R factor here is as useful a bit of information–even if real, which I doubt–is just as useful as it is with Corona; it’s something academics love to study and debate while the world crashes around them.
The value of money should never be zero. I suggest a default rate of interest of 5%, to be adjusted upward or downward to stimulate or slow the economy. It used to be that way, more or less. What boffins determined that the “right” rate of interest should be zero? Maybe Turkey’s Erdogan.

chris sullivan
chris sullivan
5 months ago
Reply to  James Joyce

To say that central banks are outside of politics is pure BS – they are clearly captured by the politics of the profligate too big to let crash banks and corporations – and of course it will be the poorer savers who will get hit -let them eat cake ! let some heads literally roll. Where is Baader Meinhof when you need them……

Galeti Tavas
Galeti Tavas
5 months ago
Reply to  James Joyce

1913 when the FED was created this track was predictable. EVERY Fiat currency ever, has devalued the money by spending more than is taken in, and so collapses. At the end of Rome much of the coinage was down to a couple percent silver, utterly debased – same thing.

All the economy is based on debt – debt is MUCH larger than the assets which justify it. Like USA 130% debt to GDP. All the stock Market is ‘Margin’;

Margin is where you have,say, $1000 in a Money Market fund. You borrow enough to buy $10,000 of stock with the $1000 as collateral – because the bank holds title to the stock – and if its value drops the $1000 collateralized – the bank sells the stock unless you give him more money.. The Borrower is out his $1000 – the bank gets his money back.

This is called a ‘Margin Call’. The money you used as collatteral is now lost to the falling stock prices – so pay more to the lender, or they sell your stock.

SEE – so a HUGE amount of stock is on Margin – and when it drops it will be sold to margin calls by the trillion, and so the domino is set falling.

Galeti Tavas
Galeti Tavas
5 months ago
Reply to  Galeti Tavas

(this is why raising interest will crash the market – the people with margin debt would have to pay more for it, so sell out of some positions, dropping prices – (now debt is totally cheap) – PLUS most companies have huge debt, and a raised interest means they will decrease dividends to cover increased payments – so their P/E crashes, and so they drop in price like a rock (triggering margin calls, and so prices crash, so on and on…)

Katharine Eyre
Katharine Eyre
5 months ago

“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”. 
Now, I am absolutely no economist but that last sentence fails to take one very important thing into account and that is the political instability which will inevitably result from trying to keep interest rates low. As James Joyce (!) points out in the first paragraph of his comment, these policies punish savers and reward those who behave in a fiscally irresponsible way. The rich will become even richer.
Just thinking about what proportions of the population are on each side of that divide – it seems likely that patience with a low interest rate policy will run thin fairly quickly. It’s going to get nasty whichever way you spin it.

Chris Wheatley
Chris Wheatley
5 months ago
Reply to  Katharine Eyre

I am also not qualified in economics but I do see that the whole edifice of Big Finance is built on fiction. The only reason that Big Finance is there is to reward those people working in it. Therefore, to try to see a logic which benefits everyone else is a waste of time.
I often wonder why there is so much vitriol aimed at Big Pharma when it is in reality just a branch of BF. In another string today on UnHerd, people are flinging abuse at greedy capitalists getting into bed with Big China. Isn’t this just the definition of capitalism?

Galeti Tavas
Galeti Tavas
5 months ago
Reply to  Chris Wheatley

“In another string today on UnHerd, people are flinging abuse at greedy capitalists getting into bed with Big China. Isn’t this just the definition of capitalism?”

No. The Capitalists should have long and short term goals. The thing is the pay structure of all the CEOs and head people is based on a cut of profits – thus they sell out tomorrow for today. These are Criminals and Robber Barons and Ponzi/Madoff sociopaths in charge.