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The Fed’s Obsession with Phantom Inflation Might Destroy a Strong Economy

7 minute read
Ideas
Jeffrey Sonnenfeld is Lester Crown Professor of Leadership Practice and a Senior Associate Dean of the Yale School of Management. He helped catalyze the retreat of 1,200 global corporations from Russia.
Siegel is the Russell Palmer Professor Emeritus of Finance at the Wharton School of the University of Pennsylvania
Sternlicht is the Chairman & CEO of Starwood Capital, a private investment firm focused on global real estate which he established in 1991. In addition, Sternlicht serves as Chairman & CEO of Starwood Property Trust (NYSE: STWD), a leading diversified finance company.

Will Rogers famously advised, “If you want to get out of a hole, stop digging!” Tragically, the Federal Reserve’s Board of Governors and its chair, Jay Powell, keep desperately digging in their pathological efforts to bury the phantom of inflation.

Fed heads are haunted by their fellow economists’ criticism that they were slow to react to out-of-control “transitory” inflation in 2021—when they were frozen in an obsolete 2020 drive to turbocharge economic stimulus out of COVID—but amazingly they are now making the same mistake once again, trying to fight last year’s war, by staying focused on the inflation boogeyman while missing the new and more potent economic dangers lingering on the horizon—namely, economic recession, a hard landing, and financial panic.

The impacts of Fed oversteering are felt disproportionately and inequitably by certain sectors; education, healthcare, and to some extent government are basically impervious to rising rates, comprising over half of GDP; so disinflation has to come from cyclical sectors such as services, manufacturing, and housing/construction; and already, as the third author warned on CNBC, some sectors such as the $10 trillion commercial real estate space are poised for complete havoc.

The dangers of the Fed’s policy come right out of its projections at this week’s FOMC meeting. The Fed states that appropriate monetary policy will cause GDP to only rise 0.4% this year. But data from the first quarter indicate that GDP in the first 3 months of the year will rise at an annual rate of at least 2%, if not more.

This implies that GDP must decline over the last three quarters of this year for the Fed to reach its target. If that is not planning a recession, we don’t know what is! For GDP to decline over the next three quarters means that Powell is planning for no employment growth whatsoever. In other words, payroll growth, which has averaged well over 300,000 per month over the past 6 months, must drop below zero over the remainder of this year. The only way payroll can grow is if there is another steep drop in productivity growth, which would be unprecedented following the record productivity drop the US economy experienced last year under Powell’s watch. This is a policy designed for disaster.

Read More: Make Banks Pay for More Deposit Insurance

But the worst fallout of the Powell program is yet to come. Powell himself has admitted that monetary policy works with a lag. Yet, despite the recession the Fed is planning for the US economy, Powell admits that there has been no discussion of potentially lowering rates later this year despite his recession projection.

This reminds us of Powell’s disastrous 2021 statement that, while commodity, housing and security prices were soaring, he laughingly uttered “we are not even thinking about thinking about raising interest rates!”

Powell’s rigidity is inexplicable following the collapse of SVB and other financial institutions. It appears that the Fed has been completely blindsided by the liquidity problems his policy caused the banking system. There are reports that regulatory authorities never tested the banks’ liquidity position for interest rates over 2% even though the Fed was long planning for rates to be two to three times higher. The magnitude of this failure adds to the significant missteps that Powell and the Fed have pursued since the COVID Crisis hit in March 2020.

Fortunately, capital markets disagree with the Fed’s hawkish positioning. The Federal Funds futures rates are well below the what the FOMC is now projecting just as they were presciently above Powell’s wrongly dovish projections two years ago when inflation was accelerating. Markets are pricing in expectations that the Fed will be forced to start cutting rates within a couple of months, with an expected end-of-2024 interest rate less than half that of the Fed’s, while 2-year yields have sank far below 4% already.

But the markets predictions will only force the Fed’s hand if Powell is listening to the markets. If not, watch out!

The Fed is missing pervasive disinflation throughout the economy

The Fed’s stubborn insistence on relying on faulty, time-lagged and cherry-picked statistics means that it misses the pervasive disinflation that is currently spreading throughout the entire economy. Gaudy headlines that “monthly inflation rose 6%” are hardly as straightforward as they appear.

As the second author has pointed out, Powell’s preferred inflation reading, CPI excluding energy, food, and now housing, ignores the most significant expenses for individual Americans and excludes half the entire economy. All those exclusions carelessly thrown out show prices are actually coming down across the entire economy.

Oil prices are down 50% from their peaks last year, with WTI crude oil falling from $140 to around $70 a barrel. Natural gas prices are also down. Henry Hub Natural Gas prices have fallen 80% from $10 last year to $2 per million British thermal units (mbtu) now. Food prices are down by 20% to 50% across the board, ranging from cattle, pork and poultry to soybeans, corn and wheat, to name just a few.

Even beyond energy and food, goods disinflation is widespread across the entire economy, especially across the non-food/energy commodities and industrial complex. Lumber is down 90%, industrial metals are down, while finished goods and consumer products are now being massively discounted amid supply gluts.

In housing, mortgage rates of 7% have brought the single-family housing market to a practical standstill while completely freezing commercial real estate lending, with construction jobs falling 50% last month—the steepest drop in history. From what the third author is seeing on the ground, most builders are only finishing what was already started as they refuse to start any new projects. This is on top of steep rent disinflation in new contracts, which is yet to be reflected in the time-lagged full-year rent measurements because these include older contracts that take up to 12 months to fully roll off.

Manufacturing has turned negative while supply chains have completely de-bottlenecked as shipping and cargo rates have collapsed. In fact, far from being log-jammed, major supply chain players such as railroads are now openly complaining about half-empty railcars and “significant unused excess capacity” amid huge drops in industrial production.

Contrary to time-lagged statistics, forward-looking expectations of future inflation have decreased dramatically. Financial markets, through inflation break-evens, are now pricing in future inflation will be well below 3% and much closer to 2% across any timespan.

But all of these current and forward-looking indicators are insufficient to the Fed, which stubbornly maintains a persistent, misguided focus on labor costs, partly because its staff of 400 group-thinking economists appear to be married to abstract mathematical models rather than real-world economic linkages.

But as we’ve noted before, blaming inflation on labor market tightness reflects an obsolete Phillips Curve mentality which even Powell disparaged earlier in his tenure. There has been zero empirical correlation between inflation and wages for at least 50 years, and if anything, higher wages are past overdue as real wage growth has actually trailed inflation for much of the last three years—meaning wages have been pushing inflation down, not up, and is due for some catch-up.

There is simply no way to get the wage numbers Powell wants unless he destroys crucial services sectors including hospitality, retail, restaurants, and tourism. We ought to be celebrating record employment while increasing labor supply instead of aiming to increase unemployment or kill wages.

Philosopher Abraham Kaplan warned researchers 60 years ago to beware of “the law of instrument” where if your only tool is a hammer, every problem looks like a nail. It is time to stop hammering random sectors of a strong economy due to anachronistic thinking and, perhaps, professional insecurity.

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