Federal Reserve leaders have been inept in preventing 8.5% inflation from developing. Fed officials helped push inflation higher in 2021 with quantitative easing. Now they are slamming on the brakes with perhaps 50 basis points of interest rate hikes in May, June and July and throwing monetary policy into reverse with quantitative tightening, likely starting in June if not sooner.
As a result, there is a wide range of possible outcomes for the U.S. economy and capital markets, including:
1) An equity market bust and 2023 recession;
2) 2023 stagflation, defined as little or no real growth but still high inflation;
3) The infamous soft-landing alternative.
How did we get here? There are two major reasons for the rapid increase in inflation: One is excessive federal government spending. The second is excessive quantitative easing (QE). Together they generated excess aggregate demand in the U.S.
Supply-chain bottlenecks are an issue but, had the U.S. economy grown at 3% in 2021 instead of the 5.7% it did grow, the supply chain issues would have been much smaller. The average growth in real GDP from 2010 through 2019 was 2.2%.
The global supply chain was designed to meet real growth in the 2% to 3% range per year. It was never designed to meet real GDP growth of nearly 6%. The combination of excessive Federal government outlays and excessive QE bumped real GDP up by at least 300 basis points in 2021 to the 6% range.
Everyone knew the global supply was never designed to cope with 6% real growth except, apparently, the several hundred economists in the Fed system.
CPI inflation would likely have been in the 2% to 3% range in 2021 had the U.S. grown in real terms by 2% to 2.5%, since the supply chain issues would have been much smaller.
Higher prices in 2021 led to even higher prices this year since the Fed continued QE through 2021. Fed leaders pushed prices higher in 2021 with QE, which generates still higher prices in 2022 due to time lags in monetary policy. Fed leaders behaved as if they wanted higher inflation in 2022.
The Fed has pumped in $4.7 trillion of QE since February 2020. Fed leaders must have known this excessive monetary stimulus in conjunction with excessive Federal outlays would create inflation.
The 2020 stimulus was likely needed but not the 2021 stimulus, as the vaccines were widely available by February-March 2021 and the U.S. economy had already started its rapid growth in the third quarter of 2020.
Neither the QE in 2021 that amounted to $1.4 trillion nor the $1.9 trillion Biden rescue plan, signed in March 2021, was needed.
Combined, these two on the back of QE in 2020 created the current high rate of inflation.
Fed Chairman Jerome Powell should have leaned against building inflation pressures all through 2021 by stopping QE but instead he fed the inflation pressures with another $1.4 trillion of QE.
CPI inflation was already at 4.9% in May 2021 year-over- year, while the Personal Consumption Expenditures deflator, the Fed’s preferred inflation gauge, was at 4% year-over-year. It is not clear why Powell didn’t lean against the mounting inflation pressures. There was no reason to expect Congress to show any discipline when it came to spending.
The job of the Fed is to show common sense and discipline and control inflation. Their task is not to be politicians and agree to monetize federal spending. Fed leaders acted as if Treasury Secretary Janet Yellen in 2021 took control of the Fed and then bought $1.4 trillion of Treasuries and mortgage-backed securities in order to keep bond yields low to help goose the economy even more after the $1.9 trillion Biden rescue plan was signed.
Now CPI inflation is 8.5% year-over-year and Fed leaders did not stop QE until March 2022. Market participants have the Fed behind the curve by 9 to 12 months, based on the two-year Treasury yield as a guidepost.
Market participants have the Fed funds rate at 2.5% by year-end. In addition, the Fed will likely start quantitative tightening (QT) in June. QT adverse effects are an unknown, meaning the Fed will likely go until something breaks, such as the equity market. That would mean the risk of a recession increases substantially in 2023.
Mike Cosgrove, principal at Econoclast, a Dallas-based capital markets firm, is a professor at the University of Dallas.