On October 26, my blog posed the question: How Fast and Far Should the Fed Go? Now this follow-on post carries the discussion a bit further — addressing two questions:
Are there metrics that represent potentially achievable targets for monetary policy and U.S. economic performance during normalized times — without crisis?
What are the implications for monetary policy of the Federal Reserve and Congressional fiscal policy to achieve a balanced set of outcomes through today’s inflation and anticipated 2023 recession?
This blog post suggests that the nation’s recent experience — of low inflation, interest and unemployment rates — represents an outlier not likely to be readily re-experienced anytime soon. The Fed is likely to experience difficulty getting back to 2% inflation except at high and perhaps unacceptable economic cost. The current federal response appears to be one of hurry up and slow down — with a Congressional foot on the accelerator even as the Fed’s foot presses on the brakes. A better coordinated and more sustainable approach is warranted going forward.
Historical Performance
This post focuses on four metrics as indicators pivotal to assessing performance of the U.S. economy: CPI inflation, federal funds rates set by the Fed, conventional 30-year residential mortgage rates, and unemployment. Monthly conditions for these four key metrics are visually portrayed by the following graph — covering the period from 1963 - present for which data is available.
Source: FRED data of the St. Louis Federal Reserve. Data is through the month of November 2022.
There is more going on with these four data sets than can be readily absorbed and interpreted by the human brain. What is clear is that there are clearly periods of abnormal economic behavior — as occurred during the mid 1970s, early 1980s, 2008 and most recently with the pandemic followed by inflationary run-up of 2020-22.
Normalized Performance
What is less clear from this initial look is the determination of what might represent normalized (or typical) economic behavior over this nearly 60-year time frame. And if a typical (or average) experience can be identified, is it relevant as a basis for targeting future performance going forward?
This second graphic (below) illustrates the average multi-year performance for each of the four metrics. Also shown by way of comparison is a calculation for each metric’s median figure.
Source: FRED and E. D. Hovee. Data is up through the month of November 2022.
As indicated, the average annualized rate of inflation over this full 59 year period is just under 3.9% per year. The effective federal funds rate comes in about 1% point higher at 4.9% per year, averaged over the same time period.
Mortgage rates have averaged over 7.6% — including some very high rates as experienced in the 1980s. Over this historical time period, mortgage rates typically have averaged about 2.7% points above the federal funds rate for the corresponding point in time.
And from 1963-2022, unemployment nationally has averaged just under 6% of the U.S. labor force.
Median figures are also indicated for each of the four metrics considered. The median is calculated as the observation mid-way between the high and low figures included across the full time period considered. For each of the four metrics, the median estimate is below the calculated mean (or average). This occurs as there are some very high (spiking) figures that skew the averages above what the mid-point figure would otherwise indicate.
Sequentially, the inflationary cycle typically unfolds with increased cost of living which subsequently is responded to by increasing the federal funds rate in an effort to reduce demand and bring the rate of inflation down. However, this does not happen overnight and effects can be less than fully predictable.
Funds rates set by the Fed then affect interest rates on the private market — ranging from cost of corporate debt to mortgages and household debt. Higher costs associated with repaying debt results in reduced demand for economic activity sensitive to the cost of credit for borrowing — which then leads to slowing of the U.S. economy and increased unemployment with private and public sector job reductions.
COMPARISON WITH CURRENT EXPERIENCE
Clearly, these long-term averages represent typical conditions that are at substantial variance with U.S. experience of the pandemic and its immediate aftermath. Until early 2022, inflation was viewed as a phenomenon of the past. Interest and unemployment rates were at historic lows.
Recent experience represents an outlier — not representative of the norm. For 2023 and beyond, is there any reasonable expectation of reverting to a world of low inflation, interest rates and unemployment? If not, what are the implications of downshifting to the norm in the years ahead?
RATE LINKAGES TO CPI
To address these questions, it is useful to again review the typical relationships that have been experienced between inflation and the associated response of the other economic metrics considered:
Fed funds rates have averaged about 1% point above the rate of inflation
Conventional residential mortgages average approximately 3.7% above the rate of inflation
And unemployment averages just over 2% points above the inflation rate
This would suggest that if policymakers target 2% as the desired normalized rate of inflation, the fed funds rate should average about 3% with mortgages in the range of 5.7% and unemployment averaging just over 4%. These might be considered as target averages over the full economic cycle — with interest rates and then unemployment peaking at different times (generally behind) peaking inflation.
For the economic cycles considered since 1963, the time period from the initial signs of inflation to the subsequent credit tightening and peaking of unemployment has ranged widely from 18-66 months, averaging about 40 months. The fastest cycle was experienced from 2010-12 (following the Great Recession); the longest cycle from 1987-92 (part of the economic time period termed as the Great Moderation).
2023 Forecast
Given current domestic market and global circumstances, what is reasonable to expect for this coming year? Two observations stand out:
The Fed will have a difficult time getting inflation under control — at least back to a 2% target rate that would enable meaningful interest rate reduction. Impediments to achieving target CPI inflation reflect both demand- and supply-side considerations. The primary demand-side issue is continued excess fiscal stimulus — most notably with the end of 2022 Omnibus federal funding. Taken together with previous historically high stimulus the result is simply more spending capacity than the level of goods and services that can reasonably be delivered. The result will be continued upward pricing pressure.
Demand pressures will be exacerbated by supply-side constraints — further increasing upward consumer pricing pressure. The good news is that supply-chain bottlenecks appear headed toward successful resolution — with increased inventories (as with semi-conductors) and improved return to more normalized global shipping delivery schedules. The bad news is that while now easing somewhat, significant labor shortages can be expected to persist — perhaps through this decade — as massive exodus of baby boomers from the labor force are not easily replaced by smaller incoming workforce (as with Generation Z).
An added supply issue with uncertain resolution relates to adequacy of reliable energy supplies. Continued public policy favoring a rapid green transition reliant in the near term on added international rather than domestic sources at competitive prices will create ongoing supply uncertainties with resulting bottlenecks and attendant upward pricing pressures.
Unless the Fed changes course, the nation runs the risk of an unnecessarily severe recession and subsequent challenging recovery. To offset the excessive fiscal stimulus, the Fed and its chair Jerome Powell appear to feel compelled to apply the brakes more forcefully and over a longer duration than is the case in the recessionary portion of a typical business cycle. Even more challenging is that with its monetary tool kit focused on demand reduction, the Fed will be much less effective in addressing supply-side issues including continued labor and potential on-going energy shortfalls. Addressing these issues will require action that extends largely beyond the Fed’s capabilities.
Policy IMPLICATIONS
Major observations are summarized as follows:
Based on experience of the last nearly 60 years, supportable average normative benchmarks appear to include 4% inflation, 5% federal funds rate, 7-8% conventional mortgage financing and 6% unemployment.
However, this historically normalized experience reflects an economy that typically runs considerably cooler than what was has been experienced with recovery from the Great Recession of 2007-09 and more recently through the pandemic and initial recovery from 2020-21.
In short, running a hotter economy in recent years appears to be inconsistent with long term experience and unsustainable without eventually having to pay a substantial price — especially if interest revert back to the long-term norm rather than to the experience of the last several years.
The current Fed target of 2% inflation also appears inconsistent with and perhaps an unreasonably optimistic expectation of a sustainable long-term outcome; more likely is that inflation runs above the 2% target pending re-normalization of labor force supply, improved productivity and shift to an adaptive yet more sustainable energy capacity.
If the Fed proves unable on its own to tame inflation at reasonable economic cost, consideration of a major change in institutional arrangements may be warranted — to assure better and more consistent coordination of Fed monetary with Congressionally authorized fiscal policy.
HURRY UP AND SLOW DOWN
At this point, the American economy can be likened to an automobile with one foot on the accelerator while the other foot is slamming on the brakes. The more that Congress steps on the gas, the more it is that that the Fed feel compelled to jam on the brakes.
No form of transportation can withstand these countervailing forces for long without trashing the vehicle. And no nation can readily withstand the on-going whiplash of these opposing forces without considerable harm to its workforce, business vitality, consumer and social service capacity, housing affordability (especially for millennials), investment returns (especially for retirees), and fiscal sustainability.
Welcome to 2023!
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