The Fed’s Folly Is Ballooning – What’s Next?

The members on the FOMC (Federal Open Market Committee) are approaching a critical decision point – continue the inflation fight or quit prematurely. Wall Street is betting they choose the latter. If so, conditions may seem to improve and worries lessen. However, defeating inflation and curing all the excesses and missteps takes more action than what this Fed has delivered. History shows that rising inflation, once begun, has strong staying power unless it is soundly trounced.

The initial year of the 1966-1982 inflationary period is a perfect example, as discussed in the latest Barron’s (March 27) – “Traders See the Fed Easing Soon. Let’s Hope They’re Wrong.”

“Investors’ nerves remain on edge over possible contagion among banks, both in the U.S. and abroad. The bigger risk is that, as in 1966, the Fed relents prematurely in its inflation fight in the face of a crisis of confidence.”

A thorough discussion of what happened in 1966 is contained in this Federal Reserve Bank of St Louis publication from September 1969: “A Historical Analysis of the Credit Crunch of 1966.”

“Reflecting demand pressures on the productive capacity of the economy, prices rose rapidly. Over the first nine months of 1966 the consumer price index rose at a 3.7 per cent annual rate and the wholesale price index rose at a 3.5 per cent rate compared to rises of 1.7 per cent for consumer prices and 2.0 per cent for wholesale prices in 1965, and compared to an average annual rate of increase of 1.2 per cent for consumer prices and essentially no change for wholesale prices during the 1960-64 period.

“In the summer of 1966 a policy of monetary restraint led to conditions popularly called the ‘Credit Crunch of 1966.’”

But there are other negative issues at work in 2023

Note those low CPI numbers in 1966 compared to the ones we continue to see. A 3.7% reading would cause applause today – back then, it was a serious concern.

Now look at the 1966 interest rates. The 3-month T-Bill rose from 4.50% in early January to 5.06% in August. The 3 – 5 year U.S. government bond yields went from 4.92% to 5.79%. So, the 1966 real (inflation-adjusted) interest rates were well over +1%, while the 2023 ones continue to be negative, as they have since 2008. Why? This is the non-discussed continuation of the Fed’s great experiment started by Ben Bernanke – the theory that 0% interest rates, while harming savers and investors, can produce superior growth and gains.

Then there is the excess money supply – the $trillions created through the Fed’s purchase of bonds with new demand deposits. There were periodic “QE” purchases prior to the Covid period, then there was the enormous creation of money supply (previously referred to as money stock) when the Covid period hit. This Fed first promised to reduce those excess $trillions, then recently said they are doing so – only the rate is pathetically slow, primarily through not reinvesting interest income and maturities up to some limit. Are they trying to keep from recognizing their large losses on the huge inventory of long-term bonds that they carry at cost? If so, they’ve simply joined the troubled banks who have tried to keep from selling their many “held-to-maturity” bonds that are currently carried at cost with large unrealized losses.

What has been lost by the 2008-2023 Fed maneuverings is the heart of the capital markets: the bid/ask dealing among capital suppliers and buyers who come together every working day for hours to determine the best interest rates and prices at that time. Contrast that to the FOMC’s every-so-often meetings to discuss and decide what’s best for the complex, interrelated, dynamic organizations and individuals.

It was never meant to be this way. And yet here we are fifteen years later watching the obviously inferior process participants wrestle with how to get out of the mess they created while maintaining their status, esteem, and portrayal as possessing superior wisdom.

Previous Fed leaders knew better. Here was the understanding in 1969. (Underlining is mine)

“The Federal Reserve, by its policy actions alone, does not determine the equilibrium level of market interest rates. [Powell improperly calls this a “neutral” level.] Likewise, its policy actions are not the only factors which enter into the determination of the equilibrium stocks of money and bank credit. The amount of money and bank credit supplied to the economy also depends upon behavioral actions of the commercial banks and the public.”

The bottom line: We’re not out of the woods yet, but…

Don’t be surprised if the Fed announces “All clear!” in the coming months. However, the only way to be in the clear is to reverse all the excesses created by the Fed directly and through “unintended consequences” that resulted from their actions.

Add to that the need to reset inflation at 2% or below, both by the numbers and in organizations’ and people’s minds. Without those latter mental and emotional adjustments, the inflation cycle can hang around, then gain speed once more. Only in that case, based on history, the second attempt to stall and reverse rising inflation will be harder to accomplish. Everyone will feel they’ve already seen the movie, so why worry – or change.