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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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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Liftoff has market watchers glued to their monitors for a number of important economic reasons. Because the rate is related to other longer-term interest rates through the Term Structure, and the longer-term rates are used to discount cash flows, this affects net present value (NPV) calculations, making more investment projects appear profitable. Aside from new projects, lower corporate bond rates bring down a firm’s borrowing costs, raising their net income.

The argument for low rates in late 2008/early 2009 was a good one. We had faced a serious financial crises and were in the middle of a serious recession, one that appeared at the time to be the second greatest economic contraction since 1929. Many financial entities faced a liquidity crunch, where short-term credit had vanished. Firms shelved positive NPV projects. Households were upside down on their homes. Because the housing market was so decimated the lower mortgage rates were thought to be needed to help resurrect home sales activity and promote refinancing which in some cases could help a household remain as a homeowner.

The Fed’s dual mandate of price stability and economic growth, argue in a conventional way against raising rates at this time. Historically, rates were raised as a way to cool down an economy with rising inflation or dropped as a way to spur economic growth. However, inflation and economic growth continue remain low compared with postwar U.S. history.

Despite this, I think the Fed should immediately begin the process of raising rates toward historically normal levels. The abnormally low interest rates were probably justified by the double feature of a financial crises and a large economic contraction back in late 2008/early 2009, but they do not have that justification now. The canonical Taylor rule formula as published by FRED at the St. Louis District Federal Reserve bank calls for a Federal Funds Target rate of 2.44 percent.

It is safe to say that financial markets, consumption activity, and savings and investment decisions are being distorted by the low interest rates. As one example, household balance sheet rebuilding was and still is important for the long-term economic health of the U.S. A higher return to savings would aid and incentivize this activity.

The economy should be able to grow with interest rates at normal levels. If it cannot, then it needs to relearn this ability. If this process ends up taking some time, we should begin it sooner rather than later. An imminent financial crisis does not seem to be a high probability event at this time. However, if one did happen now, being at the zero lower bound would be an inconvenient reality indeed.

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The normalized TED, which is the 3 month LIBOR minus the 3-month Treasury divided by the 3-month Treasury, has reached a level not seen since the fall of 2008. The TED, i.e. the numerator or the LIBOR minus the Treasury, is normally interpreted as a wholesale banking spread. When this rises, there is greater perceived risk to the banking sector. The normalized TED can also rise if the 3-month Treasury falls, which can happen in “flight to quality” situations, as is also the case now. This spread appears to be indicating a rising probability of a change to the European Union. We at CERF now believe that it is not if the European Union will break up, but when. However, this spread is just one of many indicators that we have watched to form this opinion.

The second chart shows the ten-year Treasury, TB10Yr, and the triple-A corporate bond rate (ten-year) and the normalized spread between these two measures. The normalized spread has almost reached levels that occurred in late 2008. This measure is also indicating a “flight to quality” in financial markets because the ten-year Treasury rate is falling faster than the triple-A corporate bond rate.

I have argued in this blog-space that these indicators helped us see the regime shift to a serious recession that occurred in late 2008. The current levels are uncomfortably close to indicating another regime shift.

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