The fundamental question for the U.S. macroeconomic forecast is if the pandemic recovery can continue or if the economy is heading into a recession. This outcome will be determined largely by Federal Reserve actions during the quarters ahead. Given how long the Fed waited to fight the current bought of inflation, it is not likely they can return inflation to its target rate without monetary policy changes which would also induce a recession.

It is an open question if the Fed has the fortitude to follow-through fighting inflation. The forecast then, is either for recession, or anemic growth accompanied by continued inflation.

CERF’s baseline forecast embodies the assumption that the Fed will cease substantive hikes by December 31^st of 2022 and that the economy will not be pushed into recession. We do have one 25 basis point hike in early 2023, but no other hikes. This is a low confidence forecast, since it necessarily involves predicting the behavior of a body of political actors at the Fed.

This forecast for the Fed’s policy rate has implications for inflation. Inflation, with substantial momentum at the current time of writing, will not be much reined in by this forecast of Fed policy.

How strong is the Fed’s policy stance on inflation? The real ten-year Treasury yield was -3.1 percent using September yields with the core PCE deflator. As conventional wisdom has always argued, a negative interest rate of that magnitude indicates policy that is massively stimulative.

The presumed level of short term interest rates under this forecast scenario is that they reach 4.625 percent (based on the midpoint of the Fed’s target range) by mid-2023. By the Fed’s own analysis the rate needs to be above 6 percent in order to adequately combat inflation.

Inflation will subside, but it will not subside quickly, and the real 10-year Treasury yield will remain in negative territory for all of 2023, indicating that instead of being restrictive, the Fed’s policy will remain stimulative, for about a year.

We forecast that the Core PCE deflator will still be 4.8 percent at the end of 2022, and that it will still be 4.3 percent at the end of 2023. This is higher than the consensus forecast of 3.2 percent, but our forecast is lower than inflation expectations, such as the University of Michigan’s survey value of 4.8 percent.

This forecast is one where rates are not really that high. The chart below shows the third quarter real 10-year Treasury is still quite negative, and it shows real rates during the Volcker policy era in the early 1980s that did succeed in fighting inflation, and also pushed the economy into recession.

Because rates are not really that high, inflation will remain persistent, and, growth will be weak but positive. We do not forecast a recession in this scenario, in part because rates are not actually that high. They will not get high enough to halt inflation, and they will not be high enough to cause a recession.

CERF has argued that monetary and fiscal policy has been much too stimulative. While it is possible to justify stimulating the economy in the time of crises, policies have been a ratchet, ramping up support through payments and credit in times of crises and not subsiding thereafter. This occurred after the 2007-08 financial crises and again during the Pandemic in 2020.

Overly-stimulative policies help us understand the macroeconomic environment we are in today. Some forecasters are saying that the Fed’s impotence against inflation, with 300 basis points of hikes in seven months having failed to slow inflation momentum, has surprised almost everyone. This does not surprise CERF. The economy is overstimulated. According to CoBank estimates the U.S. household sector still has $2 Trillion in excess savings. And, we point to the most recent University of Michigan survey data, which as of October showed consumer’s expect inflation will still be 4.8 percent a year from now.

There are risks to this forecast. One alternate scenario is that the Fed does continue raising rates aggressively during 2023, sending the short term policy target well-over 6 percent. In this scenario, the real 10-year Treasury yield would surge into positive territory more rapidly, inflation would subside more quickly during 2023, and the economy would experience a recession.

Why is our baseline case that the Fed does not get in front of inflation? They have shown before that they are sensitive to markets, especially, the stock market. In October of 2018, they announced a balance sheet normalization policy that sent the S&P 500 into a 24 percent decline in just 3 months. On January 4, 2019, Fed chair Jerome Powell signaled a reversal of policy normalization, and in March of that year, stated that a multi-trillion dollar balance sheet might go on indefinitely. This of course, gave rise to the notion of QE-infinity, the idea that the Fed would never normalize policy.

The effect of significantly higher rates will have an important follow-on effect of raising the debt service costs for the U.S. This is more of an issue now, where the debt to GDP ratio is 120 percent, a historically high level for the U.S. This will be another source of pressure against further Fed rate hikes to levels above 5 percent.

CERF’s economic forecast for the next eight quarters is for growth substantially below potential. Many forecasters, including the Fed, point to demographic factors and make post-industrialized economy arguments to rationalize below potential growth. CERF disagrees. Most of the sub-par growth is driven by poor policies, policies that throw a blanket on what would be a much more healthy and robust economy.

Monetary and fiscal policies should follow policy rules, or a logic that is guided by economic theory and analysis. Policies since 2008, especially monetary policy, have been ad hoc. They depress economic activity through the specific disincentivizing impacts they impart on investing for the future, but in addition, they depress the economy through policy uncertainty. This uncertainty doesn’t just add difficulty to forecasting, but it also reduces the ability of households, establishments, and governments to make decisions for their, and the our nation’s, future.

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Readers of CERF blogs and forecast publications know that CERF economists are critical of the Fed’s monetary policy, and have been for seven years now.  The Fed’s policies starting in December of 2008 were extraordinary, unprecedented, not recommended by economic theory, and have contributed to anemic growth and wealth generation for the past decade.

Prior to December of 2008, the Fed mainly relied on one policy tool, the Federal Funds Target rate (FFRT).  During the dark days of the financial crisis, they added two more policy tools, quantitative easing (QE) and interest on reserves (IOR).  CERF is most critical of IOR.

There are a few things that economists agree on, and one of them is that financial intermediation is good for the economy.  This is the process by which banks use savings deposits as a pool of funds to extend credit to businesses and households.  The IOR reduces the quantity of loanable funds available for intermediation by taking them out of the banking system and locking them up as reserves at the Fed.  Lending falls, investment expenditures fall, growth slows, and capital accumulation and future wealth fall.  These are unmistakably bad economic outcomes compared with having those funds available and extended to households and businesses who are growing.

What’s more, it is not clear how the Fed would respond if there were a severe recession tomorrow.  If they raised IOR, this would further restrict credit.  They could reduce IOR, but in a severe recession, weak loan demand would make this less effective.

It is clear that the Fed wants to maintain a massive balance sheet, and they have documented various technical benefits.  However, it is fearful of rapidly unwinding it, and this is the real reason for the glacial reduction pace.  A consequence of the Fed’s massive balance sheet is that it destroys the Fed’s ability to control short term interest rates.  IOR, a rate that the Fed sets directly, provides the short term interest control they desire.  The interest rate on reserves may actually be the most impactful policy that the Fed is employing, but that is only because unwinding the balance sheet would wreak unknown but horrible damage to the economy.

CERF economists have also criticized the fact that the Fed’s policy statements highlight the FFRT and QE, but IOR information is no longer provided in the Fed’s main press release.  Since December of 2015, changes to IOR have been deliberately buried in a technical note separate from the press release.

At the panel, Chair Powell and former chair Bernanke stressed the Fed’s goal of being transparent.  They repeated their desire to clearly and frequently communicate their policy intentions to the world.  However, not one word was uttered about IOR at any point during the one-hour long discussion on Monetary Policy.  It was clear this was done on purpose.  Neither the press nor the economics profession have properly brought the IOR policy and the resulting economic detriment to light until recently.  In particular, the January 1^st Wall Street Journal article, The Fed’s Obama-era Hangover by Phil Gramm and Thomas Saving, highlights the powerful impact of IOR on credit.  The article also explains that the Fed is now an interest rate follower.  It is no longer setting or leading short term rates.

It is clear that the Fed’s stated transparency goal is contradicted by the reality of the Fed’s actions.

I have a theory to explain this contradiction.  As forecasters, CERF economists routinely promulgate their economic analysis and their forecasts to the press and the community.  This is a challenge.  Economics is a complicated undertaking.  There are subtleties and complexities.  It happens that we’ll interview with the Media and then read their article and wonder what went wrong because the written article miss-represents our views and/or our analysis.  This appears to be a reality of the interface between economists and non-economists.

We have tools to deal with this issue.  We tell stories as much as possible.  We try to pull back from talking about many relevant factors to focus on one key factor.  But these strategies do not always work.

It may be that the Fed does not talk about IOR because it is difficult to explain.  There is more to IOR than the financial intermediation impact, as the Gramm and Saving article reveals.  The complexities include IOR interaction with other policy tools and various aspects of the economy.  It is difficult to explain to the public, in fact, even to economists who do not follow monetary policy closely.  Perhaps more important, the Fed does not want to publicly admit they are deeply fearful of the impact of rapidly unwinding the balance sheet.  Chair Powell would loathe to discuss either the difficulties with unwinding the balance sheet, or the IOR’s impact on the economy in public.

The Fed needs to come clean.  The Gramm-Saving article is likely to generate greater commentary, more articles, and additional questions directed to the Fed about its IOR policy and its assessment of the impact of IOR on the economy.  I expect that the pressure will become large enough that the Fed will be forced to directly address its IOR policy to the public.

With greater Fed transparency in IOR, academic researchers should then contribute.  They can build theoretical models of monetary policy that postulate and analyze formulae linking IOR to reserve flows, lending, investment, economic growth, and capital formation.  Empirical papers should then be written that test and use these new theories, and in particular, they should measure the detriment that IOR has on financial intermediation, economic growth, and wealth formation.

As we await greater scrutiny of Fed policy, it is becoming increasingly clear to the CERF team that the Fed doesn’t know how to undo the mess it created during the financial crisis.  The need to maintain its massive balance sheet necessitates ever higher IOR.  It places the Fed in the position of following market interest rates rather than driving them, as highlighted by Gramm and Saving.  It jeopardizes the Fed’s activist mandate and renders it impotent if a severe recession were to occur tomorrow.  This is such a mess that we should assume the next economic contraction could be at least as bad as the last one that the Fed seeded.

Gramm P. and T. Saving, The Fed’s Obama-Era Hangover, The Wall Street Journal, Jan. 1, 2019 https://www.wsj.com/articles/the-feds-obama-era-hangover-11546374393?mod=mhp

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I have complained for years that California’s economy is not performing as it should, and it’s not working for a large part of the population, young people, minorities, less educated workers, even much of the middle class.  Those who disagree with me point out that, measured by job growth and GDP growth, California is doing better than the United States.  Therefore, California is doing great, and Bill Watkins is a cranky old hack.

Bill Watkins may be a cranky old hack, but that argument is ridiculous.

The argument that California is doing better than the U.S. and therefore doing well is based on the implicit assumption that the U.S. economy is doing well.  It’s not.

We are almost a decade into America’s weakest post-war recovery, a recovery characterized by low investment, slow economic growth, slow productivity growth, slow job growth, a falling labor force participation rate, increasing welfare rolls, and persistent high poverty rates.

It’s not like its close.  This recovery is dramatically weaker than previous recoveries.

Doing better than the weakest recovery in 70 years is not good enough for California.

At one time, the very name California was synonymous with prosperity and opportunity.  The state attracted people from throughout the world.  California was the model of the good life.

Today, California has the nation’s highest poverty rate, after consideration of housing costs.  Net domestic migration is negative, as Californians move to places like Texas and Oklahoma to find the prosperity, opportunity, and life-style they can’t find in California.  Businesses are leaving, and taking their jobs with them.  College graduates must leave to find appropriate jobs, because California creates more college graduates than jobs.  Home ownership is beyond the imagination of most young families.

California is not doing well because its policies have been hijacked by a coastal elite, which has molded policy to meet their utility functions, utility functions with no consideration for the well-being of California’s less fortunate.

California’s elite are really no different than our two presidential candidates.  Trump was born into wealth.  He was sent to the best schools.  He had every advantage.  Much of that advantage has been squandered as he followed his whims into gambling casinos, beauty pageants, reality shows, buildings, whatever attracted his attention at the time.  In his wake, he’s left failed businesses and consequently destroyed lives.  But, as they say, he’s a winner.  He’s maximized his wealth without concern for the lives of the less fortunate he’s used to maximize that wealth.

Clinton didn’t start with Trump’s wealth, but she went to the best schools, and along with her husband, has risen to the heights of power and wealth.  Like Trump, Clinton rose without concern for the lives of the less fortunate that she used to maximize her wealth and power.  From Arkansas to Washington DC and beyond, she has left a landscape that is littered with broken lives.

So it is with California’s coastal elite who dominate policy.  They have their homes and their lives in beautiful places with world-class weather and abundant amenities.  Economic growth threatens their lifestyle.  They don’t want factories or even other people’s homes marring their viewsheds.  Their attitude is that if you can’t find a job or buy a home here, well you can probably do both in Texas or Arizona.  Never mind that many people can’t afford the cost of the move.  If you live in poverty, they tell you about California’s generous safety net, ignoring the devastating impacts of a life on the dole.

Of course, California’s coastal elite who dominate policy aren’t the majority.  It seems to me that when policy is optimized for a fortunate few and actually detrimental to the interest of the majority of the population, something is seriously wrong.  Somehow, we managed to lose our way with how we select policy makers and how we make policy.

It’s not a just a California problem.  When I look at the presidential candidates and the political leaders of both parties in Congress, I see failure, failure to put competent leaders in important leadership positions.  The problem is worse in California than most other states.  Is there anywhere else in America where policy is optimized for so few at the cost to so many?

It’s difficult to believe that this is a sustainable situation.  It seems that it must reach a crisis at some point.  For California that crisis is likely to be financial, a fiscal crisis.  California’s fiscal position is fragile and volatile.  At some point, California’s under-achieving economy won’t generate the resources needed to meet California’s commitments.

California’s commitments were made based on the twin assumptions that California’s golden economy is everlasting, and there is nothing policy makers do can do to harm that economy.  Those assumptions aren’t true.  For many Californians, the state is already in crisis.  That sounds extreme, but when you can’t find a job, you have a crisis.

We need to make California work for everyone.  I’m not sure how to do that.  I am sure that we won’t make California work for everyone until we admit we have a problem.  Only then, we can start trying to find a way to choose policy makers and set up a policy infrastructure that works for everyone.

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First, some presenters documented empirically that real interest rates since 1860 has had episodes, some of which lasted many decades, of very different behavior.  Not only has the level changed significantly in both directions, but the volatility has changed over time.  Of relevance for the current economy, it has recently been very low, oftentimes negative.

Some researchers discussed a variety of reasons why the real interest rate is so low, including the rate of time preference, fed policy, and other factors, but they did not mention the incremental productivity of equipment and structures.  This is probably because it is not intuitive that the incremental productivity of a computer, forklift, or a warehouse has fallen dramatically over time.

In Macroeconomic theory we relate real interest rates to the incremental productivity of equipment and structures via a formula.  However, when we go to the data, the latter is not observable.  To obtain a measure of the real interest rate, we must go to financial markets data and subtract inflation from a bond rate.  In thinking about a productive economy, a reasonable bond rate to deflate is the corporate bond rate.

Some researchers postulated the idea that the low real interest rate is the reason for the low performance of the US Economy.  I prefer the idea, promulgated by John Taylor, John Williams, and others, that the low real interest rate has been caused by other factors, in particular, fiscal policy uncertainty and costly regulations.  I worry that there is a wedge, partly policy driven, that has inserted itself between the after tax incremental productivity of equipment and structures, and the deflated corporate bond yield.  Another way of saying this is that while equipment and structures are themselves roughly as productive as before, but the productivity net of these recently higher costs is lower because the costs have risen substantially.

With this idea, we see that there are other factors, fiscal policy uncertainty and regulations, that have caused both slow economic growth as well as historically low real interest rates.  It is at least a possible that long-term trends in the regulatory environment have partly contributed to the long-term evolution of the real interest rates since the 1860s.

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California has a long history of boom and bust cycles, but over the past 25 years or so, California’s cycles appear to be becoming more volatile, with increasing frequency, higher highs, and lower lows.  The fast-moving business cycle may not provide the time necessary for many people to recover from previous busts, and may be too limited in its impact. Even now, 22 of California’s 58 counties have unemployment rates of 7.5 percent or higher. Eleven California counties have unemployment rates of at least nine percent.  And these, we are told, are the best of times.

Policy behavior is predictable throughout the business cycle.

Sacramento is awash in cash during a boom, because California’s revenues are more closely related to asset prices than economic activity.  As the economy grows, particularly in an era of ultra-low interest rates, asset prices climb faster than the economy grows, and California is flush.  Sacramento acts as if the boom will continue forever.  Spending commitments are increased, or taxes are decreased.  Politicians congratulate themselves on “fixing” the budget problem.

For Sacramento, economic busts and the resulting fiscal crisis are acts of God, completely independent of policy.  State revenues fall more rapidly than economic activity falls, because asset prices fall faster than overall economic activity. Sacramento tries to transfer the fiscal pain to local governments.  Mostly, they are successful. As of July, Local government employment was still down almost five percent from its pre-recession high, while state government employment is up about 4.5 percent over the same period.

Sacramento is currently enjoying a boom, but this boom, like all booms, will ultimately lead to a bust.  There are signs that California’s confrontation with its next bust could come soon.

Asset prices are cause for concern.  After a five-year Bull Market that saw cumulative gains of over 70 percent, the S&P is little changed this year.  Over the past 60 days, it’s been very volatile.  California’s median home price is up over 70 percent from its recession low.  It too has recently shown volatility, reflecting the huge differences between regional markets.

Housing affordability (percentage of population that could afford the median home) is down too.  It’s fallen from over 50 percent to about 30 percent.  We can’t be sure, but it’s probably below a sustainable level.  That is, below a level that can sustain a middle-class population.  Several California communities have lower levels home ownership rates, but places like Marin County have minimal middle classes.

California’s tech sector has served the state well over the past business cycle.  In quarter after quarter the Bay Area has led the state in job creation.  In many quarters, the Bay Area was the only California region to gain jobs.

But California’s tech sector can be very volatile, as the last dot.com bust in 2000 showed.  Today, venture capital investment is near the levels we saw just before tech’s big bust.  The number of deals is lower though.  It’s not clear that it is again a bubble about to bust, the possibility should be seriously considered.  Ideally, we would have a plan to deal with the subsequent fiscal challenges.

If tech does decline, the impacts will be more than fiscal.  California’s Information sector, down more than 100,000 jobs from its previous high, still has not recovered from the dot.com bust:

Recent data imply that continued economic growth, even the slow growth we’ve become accustomed to, is threatened.  California’s most recent jobs report was a big disappointment.  National data was disappointing too.  Only 20 states saw employment increases in September.

California’s position on the Pacific Rim between Asia’s manufacturing sector and the world’s largest consumer market guarantees that trade is an important sector for California.  Increasingly, however, that sector is at risk.  China’s economic growth is weakening.  Competing ports in Mexico and Canada threaten California’s trade sector, as does the Panama Canal expansion.  California’s response has been to ignore the challenges and to refuse to expand ports to accept today’s largest ships.  California’s share of North American trade will surely continue to decline:

An economic downturn would have a huge impact on California and its citizens.  California’s budget surplus is precarious, and the state has failed to make any real changes in California’s fiscal structure.  Instead of using California’s period of good fortune to reduce the budget’s vulnerability to volatile asset prices, by broadening the tax base, Sacramento has amazingly elected to increase revenue volatility by augmenting the status quo with a temporary tax.

The games that partisan politicians play leads me to the conclusion that they either don’t believe that their policies adversely affect real lives, or they don’t care.  Certainly, economic outcomes   affect real lives.  There is abundant evidence that unemployment and poverty cause drug abuse, domestic violence, broken families, poor health outcomes, and many other social pathologies.

The question, then, is do policies affect economic outcomes?  In their book Why Nations Fail, Acemoglu and Robinson compare side-by-side communities that appear identical but have different economic outcomes, cities like Nogales Arizona and Nogales Mexico.  These two cities, and the other pairs in the book, are identical, except for being in different countries.  They are adjacent to other.  They have the same resources.  They are demographically very similar.  They only differ by political regimes.   Acemoglu and Robinson find that policy decisions and the inclusiveness of the decision process have dramatic impacts on economic outcomes, and thus people’s lives.

California policy is dominated by a rich coastal elite who control most of the media, finance campaigns, rule over the universities and generally dominate all discussion.  The result is extreme inequality, persistent nation-leading poverty, high housing costs, and limited opportunity for California’s most disadvantaged populations.  And, California’s most disadvantaged will pay the most for California’s next downturn.  They won’t write checks, because they can’t.  Their net worth won’t decline, because it’s already at or below zero.  They’ll pay a far higher cost in broken homes, broken families, and broken lives.

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