Last week the Federal Reserve clearly stated that it is going to tolerate higher inflation in the future. The central bank also reaffirmed its opinion that America is now addicted to very low interest rates.
These two statements – expect higher inflation as well as low interest rates – are logically incompatible when inflation is driven by money printing.
More on that in a moment. First, let’s recap the inflation worries. We have been consistent in our inflation outlook, explaining in our Economic Newsletter how we have a big, monetized inflation gap in our economy and how that gap has the potential of causing the highest inflation we have seen in 40 years. This comprehensive forecast provides a thorough explanation of why we face such an ominous inflation threat, but we are not the only ones who have seen inflation coming. For example, on January 9, Bloomberg reported:
They’re still in the minority, but investors and economists who think America is in for a bout of inflation — perhaps a serious one — start the year with some fresh ammunition for their arguments.
They also note that the Biden administration
will likely prop up household spending with more financial aid, after Senate elections this month gave Democrats a majority. And in the background, the dollar has been weakening and commodity prices rising steadily for months. All this has pushed bond-market measures of expected inflation higher. The so-called breakeven rate on 10-year Treasuries climbed above 2% this past week to the highest in more than two years.
This break-even rate means that if you are looking for income on a coupon investment, inflation erodes its real value. The higher the inflation rate, the higher the interest rate you need in order to make money on your investment.
Here is a guy who actually puts a number on his forecast. It is still modest compared to mine, and likely not built on the same comprehensive analysis, but it is still noteworthy. From MSN Money back on December 26:
Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania, author of the classic “Stocks for the Long Run” and a senior investment strategy advisor to Wisdom Tree Funds, predicts that “we will see much more significant inflation for the next few years than we have seen over the last two decades.” Though Siegel does not forecast where inflation will be at the end of 2021 in particular, he says: “I would not be surprised to see 3% to 5% inflation over the next several years.”
On December 30, Jeff Cox over at CNBC noted that “many see inflation moving toward and perhaps a bit above the Federal Reserve’s 2% target rate”. He also explains:
The Fed considers some inflation good for the economy, as it signals growth and allows room for the central bank to act the next time a crisis comes along and demands help from monetary policy. However, a number of factors have conspired to keep inflation low, and they likely will help contain a rise in the coming months.
No, inflation will not be contained, but other than that there is an important point here that we will return to in just a second. First, here is a contribution from Forbes, December 29:
It also seems that much central banking stimulus has gone into producing asset price inflation rather than retail or consumer price inflation. The behaviour of stock markets in the past two years is a case in point and hints that the business cycles of old have now given way to liquidity cycles of our time.
The comment about cycles in business activities and liquidity is incorrect per se, but it does hint at the big problem here: over-monetization of the economy. It is also worth keeping in mind – as we explained in our Economic Newsletter on the monetary inflation gap – that asset-price inflation precedes consumer-price inflation. Since we have had very high asset-price inflation for some time now, and since the flow of newly printed money into the economy has continued at very high rates, it is only reasonable to expect consumer-price inflation in the near future.
Which brings us back to the Federal Reserve. In its Federal Open Market Committee statement of last week, where it explained:
The Committee seeks to achieve maximum employment and inflation at hte rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.
In plain English, this means that the Federal Reserve not only wants, but expects inflation to rise above two percent.
But there is more. The same day, January 27, as the central bank issued this FOMC statement, it also reaffirmed its commitment to what it called a “Statement on Longer-Run Goals and Monetary Policy Strategy”. In this statement the bank explains:
The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate. The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past.
This all sounds technical and irrelevant, but there is an explosive piece of information embedded in it. Here, the Federal Reserve says outright that in order to help keep the economy at a high level of activity – maximum employment – the bank has to keep interest rates low. Currently, the Federal Funds Rate, the central bank’s key policy indicator, stands at 0.25 percent, and we still have unemployment lingering from the 2020 artificial economic shutdown.
Simply put, the Federal Reserve says that higher interest rates will hamper economic activity and prevent “maximum employment” (which is a less ambitious policy goal than “full employment”). Therefore, we can expect that the Federal Reserve will keep interest rates well below two percent for the foreseeable future.
But how does that work with higher inflation? Does this not mean that the Fed is juggling two conflicting policy goals? On the one hand it wants higher inflation, on the other hand it wants very low interest rates. How does that work out?
It doesn’t. There will come a point when the central bank is going to have to let go of one of these two goals. The problem is that the inflation we will see is going to be monetary in nature, a kind of inflation that is virtually impossible to get rid of unless you turn of the liquidity faucet. That, in turn, will drastically raise interest rates, which will cripple the real sector of the economy.
In its statement above, the Federal Reserve makes clear that our economy has become dependent on low rates. They are correct, and the reason for this dependency goes back to our low GDP growth rates which we are not going to delve into here. What matters here is that the Fed is now caught in a situation it cannot get out of alone. The policy instruments for giving up either of its two goals – higher inflation and low interest rates – are essentially the same; the choice is a matter of policy priorities.
It may very well turn out to be the case that the Fed is unable to make that choice: so long as Congress keeps borrowing profusely (almost 25 percent of its spending already before 2020) the central bank will remain a main funding source for government spending. It cannot give up that role without forcing Congress into rapid, drastic spending reductions.
The Federal Reserve would never do this. Therefore, the choice regarding our nation’s economic future, especially its inflationary outlook, now lies squarely in the hands of Congress. It is unlikely that they will pay any attention to it before inflation actually hits.
Which, as we have been saying here at the Liberty Bullhorn, is going to happen soon.