Fed Watch

Fed insiders have been talking again this week, notably including St. Louis’s Bullard and Boston’s Collins. Bullard gave a presentation hinting at a “terminal rate” for Fed funds between 5%-7%. Collins’s remarks were notable for explicitly keeping a 75 bp December 14 hike on the table.

The general direction is no surprise; we knew the Fed doesn’t want stock prices taking off again and they’ve been trying to do that since the last CPI release. And although the FOMC was ostensibly backing away from “forward guidance” not that long ago, at the last post meeting press conference Powell was all about tamping down anticipation of a dovish turn.

So what will they announce on December 14? It’s pretty clear, absent some major unexpected development, it will be either 50 or 75 bp. A 50 bp hike would likely be followed with at least another 25 in January.

Which one largely depends on the data between now and then. We have another monthly employment report and CPI release intervening, but also a PCE deflator … the FOMC’s preferred index of consumption price inflation. Not so widely appreciated, but not to be underestimated, is asset prices, especially stocks, in light of the Fed’s focus on “financial conditions” as an intermediate target in its inflation reduction quest.

Of the two, I’d rather see 75 bp in December, followed by a bigger step down to 25 in January. Assuming any further increases are needed at all. The drip-drip-drip water torture of future expectations is doing more harm than good. The Treasury yield curve is profoundly inverted, suggesting longer dated maturities have already begun to bake in rate cuts as soon as the second half of next year. The FOMC will look increasingly silly talking about future hikes and higher terminal rates as time passes. 

24 thoughts on “Fed Watch

  1. jk says:

    just listened to a couple of interviews with Vincent Deluard. one was titled “inflation is the solution,” and i agree.

    his scenario is that the fed works up to about a 5% terminal rate while pce inflation comes down to 5%, especially as the annual comparisons get easier in the spring. the fed declares victory [flies to an aircraft carrier with a big “mission accomplished” banner and never talks about it again.]

    then they stay there, saying that the long term pressure of the terminal rate will bring inflation down more in a gradual way. thus, in fact, they reprise the 1940’s playbook – financial repression to reduce debt relative to gdp.

    another benefit of letting inflation run hot is that it would be helpful to the millennials and gen-x’ers and essentially facilitate the transfer of wealth from the boomers to the younger cohorts. the younger group will benefit from both rising wages and rising asset prices while they are in the accumulation phase of life. household formation and fertility rates will benefit.

    historically real growth has been highest with inflation between 4 and 8%.

  2. DG says:

    jk, I see you have gone through Russell Napier’s interview from a month or two ago; although his vision had the government(s) more directly in control in the repression process -vs- the Fed I believe. Anyway, it is an interesting take on what might lay directly ahead. I would love to hear more thoughts on this idea of the Gov and/or Fed eventually establishing inflation levels at higher levels than in recent years to help “inflate away” the high debt levels from the system.

    **BTW…I’m just a random lurker from the busier iTulip days gone by. Stumbled across this site and find the discourse rather interesting. Thanks**

  3. DG says:

    Duh jk. I was browsing your comment too quickly and missed the reference at top. Russell Napier put forth a similar opinion/scenario sometime recently. Something of this nature seems to be a pretty good bet imho. Interesting stuff.

  4. jk says:

    yes, russell napier has been saying much the same thing, though i don’t recall him referring to the intergenerational aspect. i also don’t recall his putting numbers on the prediction, but that may be failure of my memory. lyn alden is another writer who has, for quite a long time, been referring to the 1940’s as the model. she was the first to bring this idea to my attention.

    luke gromen was predicting that the higher rates’ effects on federal interest payments would force the fed to pivot by about 2 months ago, but that didn’t happen. it may be relevant that federal tax receipts have increased enormously, lagging the economy of course. inflation will also help tax receipts going forward.

  5. jk says:

    ps this scenario ignores the possibility of a real recession, as is being signaled by the inverted yield curve. a plunging equity market pricing in significantly lower margins, heightened unemployment and a drop in gdp would lower inflation markedly.

    1. Bill Terrell says:

      Yes inflation has already gone into reverse in asset prices, so relief in consumer prices is in the pipeline. We’ve already seen it begin to trickle through, and so long as asset prices don’t take off again, more will follow.

      Asset prices lead consumer prices. Remember the massive inflation in bonds, stocks, and real estate beginning in March 2020. Massive inflation in consumer prices followed in 2022. We still have the downstream effects of the inflation of the preceding years, but that occurred more gradually and will be worked off more gradually.

      The Fed gets it. This is why we see Fed speakers rush out and stomp on stock market rallies. So long as this works, interest rates will not need to go much higher.

  6. Finster says:

    The notion of debt relief through inflation is superficially appealing, but has two fundamental flaws. First, it overlooks how the excessive debt happened in the first place. At any given level of interest rates, there is an equilibrium between debt being taken out and debt being paid off. Lower the interest rate, and it makes borrowing more attractive and shifts the equilibrium in favor of more debt. Put simply, any strategy that makes debt easier to bear results in more debt. So trying to cure a debt problem caused by inflation with more inflation is like trying to cure an alcoholic with more booze. It may well provide symptomatic relief for the overindebted, but at the cost of ensuring the overindebtedness itself gets worse.

    We had fourteen years of ultralow rate policy. It follows like heat from fire that debt is at astronomical levels.

    In contrast, the forties debt was caused by World War II. The key ingredient in the cure was ending the war.

    Second, the argument for inflation only appeals presented from the point of view of those that benefit from it. Consider those from whom that benefit is taken and it doesn’t sound so good. You can make bank robbery sound like a path to prosperity if you only look at it from the point of view of the perpetrator.

    So it won’t work, and will inflict a lot of unacknowledged damage if it is tried. I’m not saying it won’t be tried … there is incredible pressure on the Fed from both Wall Street and Washington … those who inflation benefits are far more wealthy and powerful than those who bear the costs. The result could well be a series of failed attempts before there is enough conviction to change course. So far this Fed seems determined to get it right the first time and avoid a long period of misery, but the pressure may be too much to resist for long. Hope for the best, but prepare for the worst.

    The recent experience of the UK highlights this. When a new government tried to use debt and inflation to “grow” its way out of debt, interest rates surged. The government was replaced and forced to tighten its belt. The US has so far avoided such discipline because of the “exorbitant privilege” conferred by its position as issuer of the world’s main reserve currency. But that privilege isn’t infinite; the more it is used the less of it remains. Other nations are already hard at work to devise alternatives to the US dollar and the financial system built around it. The US will have to learn to live without the exorbitant privilege, and the sooner it starts preparing, the less traumatic it will be, and the less it relies on it, the longer it will last.

  7. jk says:

    those who suffer loss via inflation are bondholders and savers in general. these are people who already have assets. debtors, otoh, benefit.

    IMF Working Paper
    Research Department
    The Liquidation of Government Debt1
    Prepared by Carmen M. Reinhart and M. Belen Sbrancia
    Authorized for distribution by Atish R. Ghosh
    January 2015

    High public debt often produces the drama of default and restructuring. But debt is also
    reduced through financial repression, a tax on bondholders and savers via negative or belowmarket real interest rates. After WWII, capital controls and regulatory restrictions created a captive audience for government debt, limiting tax-base erosion. Financial repression is most
    successful in liquidating debt when accompanied by inflation. For the advanced economies,
    real interest rates were negative ½ of the time during 1945–1980. Average annual interest
    expense savings for a 12—country sample range from about 1 to 5 percent of GDP for the full
    1945–1980 period. We suggest that, once again, financial repression may be part of the
    toolkit deployed to cope with the most recent surge in public debt in advanced economies.

    1. Finster says:

      The negative impact of inflation is broader and deeper than acknowledged in the IMF paper. Ordinary wage earners – a group that falls outside the wealthy and powerful that have the most policy influence – are victims. This is clear from the failure of even increased nominal wages to keep up with price increases. Real wages stagnate to decline. Retirees are another group. Since ultra-inflationary policy was adopted post GFC, the wealth gap has exploded. It’s pretty safe to say the inflationary process benefits the wealthy and powerful at the expense of the ordinary citizen. And the IMF’s bailiwick is international finance, not the welfare of the average American. In short, the IMF is not an unbiased observer. It’s unsurprising that it fails to recognize the key difference between the post war debt problem and today’s.

      But there’s a much more fundamental issue. Every unit of purchasing power the government spends comes from somewhere. It’s taken either in direct taxes or via inflation (we could include borrowed, but that assumes the debt is eventually repaid).

      Of the two, one is above board, requiring politicians to send the bill for their programs to voters. The other is covert and surreptitious … the payers of the inflation tax generally aren’t even aware of where their lost purchasing power is going. So it precludes a rational, democratic, cost-benefit determination of the worth of government spending programs. And it therefore undermines democracy itself.

      These government programs, incidentally, include war. Do you think the US would so readily have incinerated eight trillion dollars in Iraq and Afghanistan had its leaders been forced to confront voters with the bill?

      The net result is that inflation not only erodes living standards, but it is fundamentally dishonest and antidemocratic. And it maims and kills.

      Better to levy direct taxes … especially on the biggest and richest corporations who have the most influence on government policy and reap most of its benefits. The government is also going to have to tighten its belt … the UK won’t be the last. But regardless of what the solution is, we know it’s not still more inflation.

  8. jk says:

    i agree better to levy taxes.

    mmt says spend til there’s inflation but then raise taxes. keynes says run deficits in bad times but surpluses in good times. the problem is political: politicians like to spend money but then renege on paying the piper. they won’t raise taxes as demanded by mmt, they won’t run surpluses as demanded by keynes.

    i’m afraid the choice is inflation or default, and governments always choose inflation if that option is available.

    1. Finster says:

      As a practical matter, the question isn’t whether there will be inflation, but how much. There already has been and there‘s more to come. But alternatives have far from been fully explored … it wasn’t that long ago that the TCJA slashed taxes on the biggest and richest corporations, which were already doing quite well thank you. It’s easy to sympathize with the lower rate argument in the case of smaller companies, but if a progressive rate structure is good enough for individuals, why not corporations? So much capital has been bottling up there even the very biggest are looking for new ways to expand.

      Federal belt tightening has to be a part of the prescription too. Military expense leaves a lot of room for cutting, eg the aforementioned eight trillion dumped into Iraq and Afghanistan, and approaching a hundred billion more in Ukraine. On the domestic side, there are the billions in giveaways waiting for college grads whose degrees are apparently not worth enough to cover their cost. And since the federal government has nothing to give away, it all must be taken, plus overhead, in one way or another. Covering all this with the regressive inflation tax just puts most of the burden on those who can least afford it.

      And it doesn’t even do much to help with inflation indexed entitlements.

      So it boils down to prioritization. My position is that it’s waaay premature to be talking about inflating away the debt before these other avenues have been exhausted.

      This takes us full circle back to the Fed. So long as interest rates are artificially low and the printing press is going brrrr, there is no pressure on the fiscal side and Washington can plunder the average American via the inflation tax with impunity. That’s what got us to this point in the first place. The Fed’s damage control efforts are late, but better than never.

      Compare with the peaceful and prosperous 1990s, when rates were higher, deficits declined, inflation fell, and wealth was more widely shared.

      Big picture is that inflation is a machine for moving wealth from America’s lower and middle classes to its corporate oligarchs and financial elites. This, more than anything else, explains why there is so much support for it.

  9. jk says:

    the peaceful and prosperous 1990’s benefitted from an enormous asset bubble in the stock market. remember, there were surpluses and greenspan testified to congress that he was worried that the tax receipts generated by the N*E*W E*R*A would eliminate the treasury bond market.

    finster, i’m afraid the real world does not and will never live up to your rationality. you’re talking economics but it’s all politics.

    1. Finster says:

      The bubble factor is a wash at best. We had one in the 2010s too. The differences were higher interest rates, falling deficits, and widely shared prosperity in the nineties, versus lower rates, growing deficits and an exploding wealth gap in the teens. Monetary and fiscal policy in the nineties weren’t perfect, just vastly superior to the teens.

      So you’re conceding that my argument is rational and economic, but now intimating that it’s politically naive. That gambit fails too.

      In fact the example of the nineties is a real world case study illustrating that higher interest rates and fiscal restraint are not only economically viable, but politically as well, unsupported assertions to the contrary notwithstanding.

      But it’s not all we have; this path is the one the US Federal Reserve is pursuing … right now.

      Not to mention being put into practice by the UK government … right now.

      So what we’re left with is a claim that the only viable policy option is to inflate away the debt, refuted by the alternatives of higher taxes and lower spending. My conclusion is that the way forward will include fiscal effort, with inflation, based on deception and obfuscation and with worse economic outcomes, bringing up the rear as gap filler of last resort. Versus your contention that inflation, deception and obfuscation, and worse economic outcomes, should be the only resort.

  10. jk says:

    yes, there were bubbles in both the ’90s and the ’00s. the former was in stocks, which turn over frequently and in a rising market generate capital gains. the latter was in housing which does not generate the tax receipts of an equities bubble.

    i don’t see higher taxes and lower gov’t spending except, perhaps, after we have another serious financial crisis. do you seriously think increased taxes and lower gov’t spending lie in our short to intermediate term future?

    1. Finster says:

      I was referring not to the bubble in oughts, but to the one in the teens (the one that’s deflating now) … the comparison was between the 1990s and the 2010s. It’s not that important though … the basis of my argument is logic … history is only cited as real world illustration.

      I can only speculate as to when we’ll see higher taxes, but higher corporate taxes are under discussion. I don’t necessarily see lower spending … at least not in nominal terms, although it’s already come down some from the insane free-for-all of the Covid aftermath. By “restraint” I mean greater consideration of the costs of spending initiatives.

      Expanding on my remarks about the US Fed and UK government might clarify.

      The colorful James Carville once quipped that if reincarnation existed, he would want to come back as the bond market, because it’s the bond market that has the ultimate power.

      We just saw that power in action in the UK. The incoming Truss government attempted a massive fiscal borrowing; tax cuts and spending increases. The bond market said no you don’t. You will pay either through much higher interest rates or a much lower currency. The Truss government was shown the door and a new one put in its place.

      A version of that happened in the US. A massive increase in deficit borrowing was met with much higher interest rates, the biggest increase in decades. The Fed followed with rate target increases of its own. One interpretation is that the Fed led rates higher, but in fact the bond market hiked first. For most of the year, Fed funds has been well below where the rest of the yield curve would place it. The Fed had little choice but to ratify it. The Fed isn’t trying to destroy the bond market, it’s trying to save it.

      In short, federal borrowing is crowding out borrowing in the private sector. This we see in the housing market as well as in pressure on corporate borrowing. This will result in what will be called a “recession”. So mechanical details aside, the upshot is that the government and the private sector compete for the same finite real resources, and it’s not possible for both to live large without limit.

      The government can take its claim on resources either through direct taxes or inflation. How much of each is tolerated is a political question. As long as the latter isn’t biting too hard, the public will tolerate it. The harder it bites, though, the greater the political imperative to restrain it. This can only come through some combination of higher direct taxes or more spending restraint. The share of each of the latter though, is once again a political question.

      The best option is spending restraint coupled with higher taxes on the biggest, richest corporations. They have the most influence on government policy and benefit most from it. There will also be some inflation, but because it’s not only unpleasant and unpopular but also antidemocratic and plays reverse robin hood, best kept in the last resort column. And given the public’s newfound sensitivity to it, this seems the most likely political outcome as well.

  11. jk says:

    let’s see if they can successfully implement a 15% minimum corporate tax before we assume we can rely on substantial corporate taxes. i suspect the double irish with a dutch sandwich isn’t going away.

    1. Finster says:

      Yeah I haven’t really been following that. A minimum 15% wouldn’t be enough … still less than many individuals pay. Not that anyone has asked for my input, but much better would be a progressive rate structure so that the biggest pay a higher rate. Progressive rates are good enough for individuals, why not corporations? It could obviate a lot of otherwise unnecessary antitrust litigation.

      How about 50%? On all profits above, say, twenty or fifty billion, net of bond interest and dividends paid. Those are taxed at the individual level. This would also unify the corporate tax code, making separate classifications like REITs and BDCs redundant. It would also discourage capital from being bottled up in a few giant corporations. With the double taxation of dividends being eliminated, dividends would then be taxed at the same rate for individuals the same as ordinary income. Warren Buffett would no longer have to complain about paying a lower tax rate than his secretary.

  12. jk says:

    bill, if they can’t do 15% how on earth could they do 50? i’ll be interested to see the proceeds of the 15% alternate minimum corporate tax in the so-called inflation reduction act. i suspect that a lot what might otherwise be corporate profits will still end up as some kind of royalty payments to an entity in a tax haven.

    1. Finster says:

      Haha … guess this is where I have to admit to wandering into political fantasyland. But the 15% would apply to all corporations, not just the biggest. And numbers like these are just illustrative.

      Instead look at the way individual rates are structured. Fashion something like that for corporations, except thousands become billions. And ask voters why they should pay higher rates than trillion dollar corporations like Apple, Amazon, Alphabet.

      The highest break point could be chosen so that only the biggest corporations are affected … in the area where you might otherwise be breaking up corps under antitrust law anyway. The tax code then disincentivizes acquisitions that would otherwise be challenged by the government regardless.

      Also remember that dividends paid would be deductible. That could be a game changer. Why aren’t some of these supersize companies paying dividends? They prefer to “return money to shareholders” via buybacks, which actually are more of a way to enrich insiders. Or “grow” the company which is already bigger than many national governments.

      Making dividends deductible to corporations IIRC was actually on the table during the Bush admin. It would have eliminated the double taxation but was passed on because it was thought the optics of lowering the rate individuals pay on them instead would sell better to Republican voters. But then Warren Buffett could complain about paying a lower rate than his secretary…

      On top of that we had the TCJA that lowered corporate tax rates. That sold largely on the basis of most corporations being small companies, many struggling. But it also cut rates for the Apples, Amazons and Alphabets of the world which are obviously not. So the case for a progressive rate structure for corporations isn’t as big a stretch as it might seem.

      Finally, it’s not that different than the REIT model. Weyerhaeuser for instance. The corporation escapes federal income tax completely so long as it distributes 90% of its taxable income to shareholders, who then pay at their normal individual rates. The corporation is more like a pass-thru in this sense. So why not just make it a sliding scale for all corporations … to the extent you pass on your income, you’re a pass thru, to the extent you don’t you’re not.

  13. jk says:

    wouldn’t a vat be easier and much more enforceable? do away with income taxes altogether and thus kill the loopholes embedded therein, and just have a vat.

    1. Finster says:

      Possibly … the tacit premise behind all of the foregoing is that the income tax model remains. If you were going to go for a more fundamental overhaul, a consumption tax would be in play.

      Are you familiar with the Fair Tax? It would scrap the individual income tax completely, replacing it with a national sales tax. For progressivity, it would be coupled with a rebate program akin to a UBI. Everybody gets a regular check for some same fixed amount. Because of that it could also replace a whole alphabet of programs. Since most states already have a sales tax collection infrastructure, implementation would be very efficient. Very appealing … it already has a number of cosponsors in Congress. The political downside is that because it’s so simple, politicians don’t have much scope for doling out favors to special interests.

      I don’t know how it would affect corporate taxation, if at all. There is though a fundamental justification for a separate or additional system of corporate taxation … corporations are creatures of the state, not natural entities with presumed fundamental rights. So there’s little scope for objection on principle or ideological grounds, even from libertarian types like me. I worry that we’re in a slippery slope situation where we’re courting government of the corporations, by the corporations, and for the corporations.

      Far as corporate tax enforceability goes, the key there is to make the taxable earnings the same as the highest figures management touts to shareholders. Two birds with one stone!

  14. jk says:

    where do get this corporations “are not natural entities” idea? they’re people! the supreme court said so.

  15. Bill Terrell says:

    If the initial market reaction is any indication, Powell took a step in the higher inflation direction today. In a Brookings speech and subsequent interview, Powell said virtually nothing new … that the FOMC could downshift to a slower pace of hiking at the expense of a likely higher terminal rate.

    But markets may have expected more, because this slammed the dollar, which declined versus just about everything else, from foreign currencies to bonds to stocks to commodities. This real time plunge in purchasing power represents an inflationary impulse that will ripple throughout the economy in the coming months and years, in opposition to the disinflationary impulses from earlier this year.

    Wall Street dominated financial media are, however, unsurprisingly focusing on stock prices and spinning this dollar plunge as a market celebration of “positive” economic news.

    If past is any guide, this is the exact opposite of what Powell and Co want to see, and could be met with some pushback in the coming days. But it’s also possible this is a deliberate attempt to soften the collapse in the yield curve … pushing out policy rate hikes favors slightly lower near term rates and slightly higher long term rates than would otherwise be the case.

    The markets are putting all their focus on the slightly easier near term policy and forgetting about the higher terminal rate part. This isn’t surprising; they know that despite the talk, the Fed has virtually no commitment to policy several meetings in the future. The FOMC has so overused and abused “forward guidance” it barely has any effect left.

    This could however paradoxically box the Fed in … because it means hotter inflation data in the months ahead, which would then pressure it to follow through with the higher rates anyway.

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