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A trader watches as Federal Reserve Chair Jerome Powell speaks on a screen on the floor of the New York Stock Exchange (NYSE), November 2, 2022.
Brendan McDermid | Reuters
St. Louis Federal Reserve President James Bullard suggested on Thursday that the central bank might have to raise short-term interest rates as high as 7% to ensure that inflation goes away.
Once again, Bullard and other Fed officials say that the central bank cannot repeat the policy errors of the 1970s.
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Former U.S. Treasury Secretary Larry Summers and others have supported this view as well, putting increasing pressure on the Fed to solve a problem that has no single historical analog.
Bullard noted that policy would become restrictive with the federal funds rate somewhere between 5% to 7%, and it may well have to remain there before the Fed can declare that inflation is dead.
His “7% solution” is, in my view, completely and utterly absurd.
Raising rates by up to three full percentage points from the Fed’s current target range of 3.75% to 4% would ensure a very deep recession. It would ensure that something somewhere breaks, risking a systemic market or economic event that will shake the financial markets or the economy to their very core.
That, in turn, would force the Fed to “pivot,” lowering rates to avoid the type of systemic risk that can quickly become global and disastrous.
Signs of inflationary pressures letting up
First and most importantly, inflation is beginning to abate. That’s the case whether its headline or core consumer prices or other measures of inflation more closely watched by the Fed.
The last four months of headline consumer price index readings, if annualized, imply that consumer prices will return to just above 2% by sometime next year, well ahead of the Fed’s projected timetable.
Energy prices are collapsing further as crude oil tumbled on Thursday to its lowest level since January.
Some Wall Street firms are forecasting a 15% to 20% decline in home prices in 2023, as mortgage applications, pending home sales, new and existing home sales and purchase cancellations are all indicative of a very deep recession in residential real estate.
The economy has rarely, if ever, avoided a general recession after real estate activity has collapsed.
Yield curve inversion
Maybe even more telling is the steepening inversion of the yield curve.
The three-month T-bill now yields almost a half-percentage point more than the 10-year note.
Former New York Fed economist Arturo Estrella, whom I often quote and who did seminal research on the predictive powers of that particular spread, says that unless the curve steepens so much in the weeks ahead that the 10-year note yields more than the three-month bill, a recession sometime in 2023 is a certainty.
There is almost no scenario in the next two weeks that would suggest a steeper yield curve by any observable measure.
The question now becomes just how broad and how deep will next year’s recession be?
That leads me to my claim that not just Jim Bullard, but nearly the entire panels of voting Fed officials, are suffering from some sort of mass delusion.
A radically different time versus the 1970s
This economy is nothing like that of the 1970s. A policy mistake that is far too restrictive, rather than too easy, is the critical mistake the Fed is risking.
If the Fed were to lift rates to 7%, well above an inflation rate that could decline to 3% or lower, next year would be historically tight. This would risk creating a deeper problem than the one the Fed is trying to fix and the one that the central bank is desperately trying to avoid repeating.
Relative to the 1970s, the energy intensity of the economy is radically different, as is the composition of the labor market.
When the U.S. exited the gold standard, suffered two major oil shocks and felt the ill-effects of poor policy decisions, greater sensitivity to changes in energy prices and heavier unionization of the labor force created fertile ground for the wage/price spiral the Fed so fears today.
Those fears continue to drive current policy decisions despite notable improvement in inflation data itself, forward expectations of future inflationary pressure, softening consumer demand and the decided shift in financial market concerns from inflation to recession.
The conditions that created inflation a generation ago simply do not exist today. This makes comparisons to the many and varied factors that drove inflation higher from 1964 through 1980 a gross misjudgment.
Supply chain disruptions have eased, as measured by a crash in the cost of shipping containers from China to the West Coast of the U.S.
Inventories of unsold goods are still hurting the nation’s retailers, as Target demonstrated earlier this week. Meanwhile, even economically sensitive firms like FedEx are paring back workers’ hours and employment before the usually busy holiday delivery season, a sign of a weakening economy and declining price pressures for consumer goods.
The Fed’s current stance on policy is one of fear and not at all forward looking.
By simply attempting to avoid the mistakes of the past, the central is embarking on a mistake that will affect our future.
You cannot drive a car looking through the rear-view mirror, and you cannot steer an economy using outdated comparisons.
If short rates rise to 7%, that solution will be far more painful than the current problem it hopes to address.
I remain deeply puzzled by the policy judgment of this Federal Reserve.
It appears to have abandoned its reliance on the so-called “reaction function” of markets and instead is focused solely on the phantoms of inflation past.
As we approach the holiday season, it might behoove the Fed to take a more charitable view of the economy. If central bankers fail to do so, not only will they take away the punchbowl, but it will be nearly impossible to refill it once the party has come to a crashing halt.
— Ron Insana is a CNBC contributor and a senior advisor at Schroders.
