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The Fed’s Impossible Choice, In Three Charts

Critics of “New Age” monetary policy have been predicting that central banks would eventually run out of ways to trick people into borrowing money. There are at least three reasons to wonder if that time has finally come:

Wage inflation is accelerating
Normally, towards the end of a cycle companies have trouble finding enough workers to keep up with their rising sales. So they start paying new hires more generously. This ignites “wage inflation,” which is one of the signals central banks use to decide when to start raising interest rates. The following chart shows a big jump in wages in the second half of 2017. And that’s before all those $1,000 bonuses that companies have lately been handing out in response to lower corporate taxes. So it’s a safe bet that wage inflation will accelerate during the first half of 2018.


The conclusion: It’s time for higher interest rates.

The financial markets are flaking out
The past week was one for the record books, as bonds (both junk and sovereign) and stocks tanked pretty much everywhere while exotic volatility-based funds imploded. It was bad in the US but worse in Asia, where major Chinese markets fell by nearly 10% — an absolutely epic decline for a single week.

Normally (i.e., since the 1990s) this kind of sharp market break would lead the world’s central banks to cut interest rates and buy financial assets with newly-created currency. Why? Because after engineering the greatest debt binge in human history, the monetary authorities suspect that even a garden-variety 20% drop in equity prices might destabilize the whole system, and so can’t allow that to happen.

The conclusion: Central banks have to cut rates and ramp up asset purchases, and quickly, before things spin out of control.

So – as their critics predicted – central banks are in a box of their own making. If they don’t raise rates inflation will start to run wild, but if they don’t cut rates the financial markets might collapse, threatening the world as we know it.

There’s not enough ammo in any event
Another reason why central banks raise rates is to gain the ability to turn around and cut rates to counter the next downturn.

But in this cycle central banks were so traumatized by the near-death experience of the Great Recession that they hesitated to raise rates even as the recovery stretched into its eighth year and inflation started to revive. The Fed, in fact, is among the small handful of central banks that have raised rates at all. And as the next chart illustrates, it’s only done a little. Note that in the previous two cycles, the Fed Funds rate rose to more than 5%, giving the Fed the ability to cut rates aggressively to stimulate new borrowing. But – if the recent stock and bond market turmoil signals an end to this cycle – today’s Fed can only cut a couple of percentage points before hitting zero, which won’t make much of a dent in the angst that normally dominates the markets’ psyche in downturns.

Most other central banks, meanwhile, are still at or below zero. In a global downturn they’ll have to go sharply negative.

So here’s a scenario for the next few years: Central banks focus on the “real” economy of wages and raw material prices and (soaring) government deficits for a little while longer and either maintain current rates or raise them slightly. This reassures no one, bond yields continue to rise, stock markets grow increasingly volatile, and something – another week like the last one, for instance – happens to force central banks to choose a side.

They of course choose to let inflation run in order to prevent a stock market crash. They cut rates into negative territory around the world and restart or ramp up QE programs.

And it occurs to everyone all at once that negative-yielding paper is a terrible deal compared to real assets that generate positive cash flow (like resource stocks and a handful of other favored sectors like defense) – or sound forms of money like gold and silver that can’t be inflated away.

The private sector sells its bonds to the only entities willing to buy them – central banks – forcing the latter to create a tsunami of new currency, which sends fiat currencies on a one-way ride towards their intrinsic value. Gold and silver (and maybe bitcoin) soar as everyone falls in sudden love with safe havens.

And the experiment ends, as it always had to, in chaos.

37 thoughts on "The Fed’s Impossible Choice, In Three Charts"

  1. One possible aspect that isn’t considered here explicitly is the need/desire to defeat the “Trump agenda.” There is already unprecedented opposition to “him” that hasn’t succeeded but there are still a few options left besides just outright assassination. One option is to “let the dogs out” in the financial markets and let/make the markets crash to create misery. After all, the Trump administration seems to have no problem running deficits as long as they are “good investments” (e.g., infrastructure, border security, the military, etc.) but if the Fed dumps their toxic shit on the markets at the same time then interest rates are bound to explode and depress everything.

    Bottom line is I DON’T think the CBs are going to try to rescue the markets now. I think they actually want a crash AND high real inflation (even though you can use the same dollars to buy chicken instead of steak – hence no “official” price inflation.) The challenge is in how to blame Trump (and the republicans) for that, and to make it stick.

  2. Wage inflation is accelerating

    Normally, towards the end of a cycle companies have trouble finding
    enough workers to keep up with their rising sales. So they start paying
    new hires more generously. This ignites “wage inflation,
    ———-

    really ????? hard to find

    HERE’s labor stats from bls

    Table A-1. Employment status of the civilian population by sex and age
    https://www.bls.gov/cps/cpsatabs.htm

    Civilian noninstitutional population 256.780 mln
    Civilian labor force 160,037 mln
    Not in labor force 96,743 mln

    i just wonder what all those 95+ mln people (not in labor force )
    do and why USA companies cant find new people ?????

    alx

      1. NY times and macroeconomics!!!!!!! 🙂
        thanks god you did not mention krugman!

        ——-
        only in 2008 it was no way better: 235.03 / 80.68

        i am afraid you got it in reverse. people started losing jobs, and then
        get on drugs. !

        I have more rational explanation- NAFTA, China Mexico, free trade .

          1. sure, Stephen Moore!!!

            Moore’s work continues to appear regularly in the Wall Street Journal, The Washington Times, and various publications including The Weekly Standard and National Review

            Mr Moore probably never worked an 1 hour in private sector , so we don’t know really how good he is or his knowledge!

            ———–

            pal, you are trying to use what is called / the argument from authority/.

            St. Thomas Aquinas and/or John Locke in late 17th century wrote everything to know about this phenomena..

            tell us WHAT DO YOU THINK WHY USA companies cant find workers out of pool of 95+ mln people.

            and what / w/hy actually happened so many people are not in labor!!!!

            alx

          2. Oh you care about what I “think.” Very flattering! And here I was trying to give you actual information. Well then here you go:

            As the chart at the beginning of the article shows, wages are rising at an accelerating rate. Initial jobless claims are at 40-year lows. The government’s new budget calls for trillion dollar deficits as far as the eye can see. Add up these actual data points you get pressure on the Fed to tighten. As for where all the missing workers are, some (as those “authorities” you dismiss report) apparently can’t pass drug tests, some have college degrees that don’t qualify them for real world jobs, and a lot of them are aging boomers who have started collecting social security and are for now taking it easy. Presumably some others (like one of my sons) are working off the books. Who knows what the rest are doing. At the moment they’re not impacting the trends that central banks watch when deciding what to do about interest rates.

          3. Funny how what degree someone had didn’t seem to matter in the late 1990s.
            I knew Art History majors making $1 million a year refinancing mortgages. BTW, I saw one the other day working at Starbucks.

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