The stock market has rallied nearly 9% over the past two weeks, proving that even in this grimmest of seasons, hope springs eternal. The hope, in this case, rested on the suggestion by Mary Daly, the President of the Federal Reserve Bank of San Francisco, and member of the Federal Reserve’s rate-setting Federal Open Market Committee, that the Fed should begin to consider how and when to reverse course from its unrelenting drive to push the nation’s economy into recession. It is on such modest suggestions that market rallies hinge these days.
For months now, the Governors of the Federal Reserve have insisted that they would not be deterred from raising interest rates until there is strong evidence that inflation is coming down, and since the release of the inflation numbers for September, the Fed has been barreling toward more large increases in interest rates. Then, seemingly out of the blue – with no particularly positive news on the inflation front to point to – a few Fed Governors started whistling a different tune. Perhaps, Fed Vice Chairwoman Lael Brainard suggested in a speech in Chicago on October 10th, they should act more judiciously, and pause to see the effect of the steps the Fed had already taken. This was not a radical suggestion. After all, as any student of monetary economics could tell you, it will take time to gauge the full impact of the steps that the Fed has already taken to tighten the screws.
Surely, the Fed Governors all know this to be the case, as the existence of a time lag between monetary policy actions and outcomes – generally viewed to be in the range of nine months to two years – is axiomatic. And Fed Chair Jerome Powell, Lael Brainard, and their colleagues have experienced this time lag firsthand, as the inflation they are fighting today is at least in part a product of the actions they took two years ago when they increased the money supply by trillions of dollars to keep the economy afloat in the wake of the Covid pandemic.
If, in their zeal to prove themselves equal to the task of preventing a 1970s-style inflationary cycle – and perhaps along the way sidestep blame for a mess at least in part of their own creation – Fed Governors lost sight of that most basic truth of monetary economics, it was thrown in their face by a meme that rocketed across the financial community even as Vice Chair Brainard was speaking in Chicago. Sometimes, when people are closeted in their information bubble and immune to reasoned discourse, ridicule can wake them up. And so it was when market analyst Peter Boockvar gave up debating the nuances of monetary economics and offered instead “The Weed Gummy Theory” to explain the seeming inability of the Fed Governors to consider the risks they are running as they continue to raise interest rates without pausing to assess the impact of their actions.
According to Boockvar, the Fed is like “an eager but inexperienced consumer of weed gummies, which, notoriously, take longer than anyone expects to kick in… In other words, we may find ourselves in 2023 doing the macroeconomic equivalent of curling up in the fetal position on the couch, murmuring to no one in particular that that last gummy was too much, man.”
If Boockvar’s parody helped some here at home understand the risks inherent in the pace of Fed rate hikes, the rest of the world has not needed weed analogies to understand the potential adverse impacts from the pace of Fed rate hikes, as the Fed actions to date have already ignited a tsunami of consequences across the rest of the world.
As the Fed pushed interest rates upward over the past six months, it has shifted the flows of capital across the world into the U.S. dollar and out of other currencies. As illustrated in the graph below, Fed interest rate hikes since the beginning of the year have triggered declines of 20% or more in the value of other currencies. Among other consequences, the dramatic rise in the value of the dollar has amplified the inflationary impact of increases in the cost of energy and agricultural commodities caused by Vladimir Putin’s war. Because those commodities are priced in dollars, inflation in those countries now reflects both the higher cost of the commodities on world markets, as well as the cost of converting their currency into dollars. As a result, inflation across much of the world is higher than it is here at home, in part due to the actions of the Fed: CPI inflation in the U.S. remained just over 8% in September, but it has reached 11% in the European Union, while in Egypt, one of the world’s largest consumers of Ukrainian and Russian agricultural products, it now stands at 15%.
The response of central banks across the globe has been swift, as they have found themselves forced to raise interest rates, both to mute the inflationary impact of the rise in the dollar and to stem the pace of capital flight. The result has been that central banks in countries that had barely rebounded from Covid-related recessions are now raising interest rates, with the likely consequence of throwing their local economies back into recession, and, ultimately, severely cutting back economic growth across much of the globe.
It was not that long ago that Fed chair Ben Bernanke embraced the role of “central banker to the world” in the face of the 2008 global financial crisis. As the global financial system teetered on the verge of collapse, countries around the world looked to the United States for leadership, and the Federal Reserve in turn assured that resources were available to prevent the collapse of financial institutions across the globe. Two years ago, as the spread of Covid-19 similarly threatened to collapse economies across the globe, the Fed again stepped into the breach, assuring access to dollar reserves and liquidity for central banks around the world.
This time, however, things feel different. It is fair to say that the Fed now finds itself between a rock and hard place. While Fed Chair Jerome Powell and Vice Chair Brainard publicly acknowledge the impact of Fed policies on other countries, the persistence of domestic inflation and the emergence of inflation as the paramount focus of midterm elections seem to have left them with little wiggle room to moderate Fed policies with an eye to the impact on the world beyond our borders. Yet, it is the Fed’s singular focus on its domestic 2% inflation target that may yet bring a tsunami of unintended consequences to our shores.
2% inflation has become synonymous in the public imagination with the “good old days.” However, like many things today that we have come to view as normal – double-digit annual stock market returns, a world awash in capital, and 3% home mortgages among them – the Fed’s 2% inflation target has not been around that long, and simply may not be a prudent objective.
The Fed’s 2% target was established in 2012, four years after the introduction of zero and negative interest rate policies by central banks across the globe in response to the near collapse of the global financial system. It was a time when deflation, rather than inflation, loomed as the major threat to global economies. While inflation remained below 2% for the ensuing decade – leading people to see it as “normal” – there was little normal about it. Indeed, the last decade prior to the 2010s when inflation averaged 2% or lower was the 1950s.
Even inflation in the range of 2.5 to 3% – the average rates of inflation during the 2000s and 1990s, respectively – may be an unrealistic target, as so many of the factors that enabled the past four decades of low inflation are quickly slipping away. Perhaps as much as any other factors, inflation in the 2 to 3% range over the past three decades was made possible by the fall of the Berlin Wall, the opening of China under Deng Xiaoping in 1978, and China’s entry into the World Trade Organization in 2001.
Together, those events brought more than a billion people into the global, market-based economic system, and engendered global competition in labor costs. Among the impacts of the ensuing process of global economic integration were the shipping of millions of American manufacturing jobs overseas and downward pressure on domestic wages, which together helped keep inflation in check. Now, with the combination of domestic (and global) labor shortages, support for trade unions at the highest level in 60 years, increased tensions with China, and post-Covid moves toward “onshoring” and “friend-shoring” of corporate supply chains, those trends appear to be reversing.
Perhaps the Fed can succeed in pushing back against that tide. Restoration of stable, 2% inflation is achievable, former Treasury Secretary Larry Summers insists, through a deep and long recession of sharply elevated unemployment over several years.
But Summers’ suggested roadmap raises a second factor that the Fed cannot afford to ignore, which is the dependence of the United States on the support of nations across the globe, and the potentially catastrophic consequences of the Fed failing to take into account the impact of its actions on other countries. Since the Second World War, and in particular, since the early 1970s, when the United States reached an agreement with the Kingdom of Saudi Arabia providing for the U.S. commitment to defend the Kingdom in exchange for the recycling of “petrodollars” into the U.S. economy, we have benefitted from the “exorbitant privilege” of living in a world where the dollar is the global reserve currency and trade is conducted in dollars. It is a privilege that for decades has protected the United States from consequences that other countries routinely face for running trade deficits, budget deficits, or, as we see today, being captive of inflation driven by an escalation in the value of a foreign currency.
We have come to treat that privilege as an entitlement, yet it rests, spoken or otherwise, on the consent of the rest of the world. Should the Fed fail to take into account the distress that its actions are causing in other countries, and should a consensus emerge across the globe that our actions have become too nakedly self-interested, we should not be surprised to see a fraying of that consent.
Over the past few weeks, we have been given a glimpse of what such an erosion of support might look like. Largely unreported outside of the financial press in recent weeks has been the sudden exit of major global buyers from the U.S. Treasury market, putting upward pressure on U.S. bond rates. Japan, which surpassed China in recent years as the largest holder of Treasury securities, has reduced its holdings by 10% over the course of this year, and stopped purchases of new securities, due to the high cost of hedging yen-dollar risk as the dollar has continued to rise. For its part, China has not been a net buyer of Treasury securities for more than a decade, while Russia, once among the largest holders of treasuries, completely exited the market following its annexation of Crimea.
The possibility of a continued dislocation in the Treasury market should shake people up, as the consequences of Treasury bonds falling out of favor globally would have significant domestic ramifications. Like the Fed’s 2% inflation target, the world of 2% to 3% long-term Treasury interest rates that we have come to view as “normal” over the past decade has been the exception, not the rule, and only came about in the context of the global recovery from the 2008 collapse.
Yet, in its ten-year budget projections, the Congressional Budget Office continues to assume that Treasury yields will remain in the 2.9 to 3.8% range for the balance of this decade. Should, however, long-term Treasury yields return to the range of 5% to 7% – the rate environment that prevailed for the two decades preceding the 2008 collapse – the impact would be significant, as the cost of interest on the national debt would rise from $350 billion last year to around $1.5 trillion five years from now, an amount exceeding the combined cost of Medicaid and Defense spending.
As the Fed continues its single-minded pursuit of restoring 2% inflation, it may be pursuing an unsustainable goal, given the emerging trends in a de-globalizing economy. And as Peter Boockvar suggested, and much of the rest of the world already understands, it may be risking dramatic, unintended consequences for the world, and ultimately for us. Given the deterioration of our politics during what objectively has been the best of times, one can only imagine how we will manage should that outcome come to pass.
Yet it could happen. While events may yet force a change in the Fed’s thinking – such as cascading defaults in emerging market countries or perhaps growing political instability – the Fed appears to be undeterred. Perhaps, before a tsunami of adverse, unintended consequences reverberates back on our shores, someone should remind Jerome Powell that when Paul Volcker left office in August 1987, inflation was 4.7%, and it remained in the 5% range for the next two decades. While the Fed’s 2% inflation goal has acquired almost mystical significance, the single-minded pursuit of that objective may instigate reactions that will be far more difficult to control.
David Paul is the founder and President of the Fiscal Strategies Group, a financial advisory
firm specializing in municipal and project finance. Prior to forming the Fiscal Strategies
Group, Dr. Paul was a Managing Director and member of the Board of Directors of Public
Financial Management, Inc. Dr. Paul also served as the Vice Provost of Drexel University,
and as the CEO of Mathforum.com, a mathematics and math education website and virtual
community that is now part of the National Council of Teachers of Mathematics.
Dr. Paul received a BA in economics from Yale University, an MBA in Finance from the
Wharton School, and a doctorate in Higher Education Management from the University of
Dr. Paul is the author of When the Pot Boils: The decline and turnaround of Drexel
University, and has published regular commentaries on politics and economics on The
Huffington Post and Medium, and at appalled.blogspot.com.