Stagflation and the Fed's Catch 22
rickdugan
Verified and Certifiable Super-Reviewer
Thursday, March 16, 2023 2:35 PM
It is becoming increasingly clear that we are starting to enter a period of stagflation, the last of which we experienced in the 70s. Prices continue to rise at unacceptable levels and the labor market continues to be way too tight, yet we are seeing increasing downward pressure on retail sales of goods and services. Wages, as much as they are rising, aren't keeping up with inflation, especially for blue collar workers. All signs point to an economic slowdown paired with continuing price inflation.
We all know how Volker handled this when we last had sticky inflation. He jammed up interest rates well above the inflation rate, which is widely understood to be the needed prescription when inflation grows deep roots. Yet times are different than they were back then. Yes the result was a deep recession, but the carnage was relatively short lived. In today's environment, the fallout would likely be much more severe, which seems to be really tying the hands of Powell.
For starters, pension plans were much less reliant on equities and riskier alt assets than they are today. They were also much better funded. If Powell jams up rates now, with so many underfunded state, municipal and private pension plans already on precarious footing, the results will be catastrophic. There will be no safe port in the storm - stocks, bonds, real estate and many other alt assets will all crash together. The resulting fallout from pension failures will be widespread. Personal retirement accounts would also be crushed.
Second, banks take on a lot more risk than they used to back then. SVB is just a small taste of what we would experience if large banks start taking crushing losses in their consumer lending portfolios (mortgage, credit card, etc.) due to underwater homes and lost jobs, all while their balance sheet assets also decrease in real value. The Fed would likely have to backstop the banking industry ala 2008-2009, except for a much longer time.
Third, our economy is much more globally integrated than it was back then. Every time we raise rates, it makes the USD stronger in the exchange rate market, which has negative consequences for U.S. firms which export good elsewhere as well as the many other firms globally who do business in U.S. dollars. A big jump in our rates would be downright crushing to our trading partners and would put a lot of U.S. and overseas companies out of business.
Fourth, the U.S. is now floating so much debt that sharp rate rises would be a serious blow to the U.S. budget in the form of debt service (interest rate payments). Back then we weren't carrying such a massive debt load as a % of our GDP. As of February 2023, roughly 12% of the U.S. spending budget was allocated to interest payments on outstanding debt. Every rate increase pushes that number higher and a serious jump would cause it to balloon.
I'm sure that others here can think of even more potential fallouts should interest rates get jammed up quickly. So Powell finds himself in a Catch 22. He must know what he needs to do to crush this inflation, but he's likely more afraid of the other potential consequences than he is of the inflation itself. In the meantime, our working class population continues to experience unabated reductions in their standard of living. IMHO at some point, someone at the Fed needs to cowboy up, devise a plan to contain the fallout as much as possible, and get this shit under control.
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