Has the Fed Overshot the Economy?

Not since the early 1990s or the 1970s have we seen interest rates on money rise so far and so fast. It is clear that Jerome Powell would like to be Paul Volcker and break the inflation cycle that we are in. However, in his quest to break inflation, could the Federal Reserve wreck the American and the global economy?

Interest Rates and Demand Destruction

The goal of the Fed with its interest rates hikes is to cause demand destruction. If borrowing money is more expensive then business and consumers will borrow less, spend less, demand less and prices will fall until they are willing to spend again. This would be the text-book response to a rise in inflation over the 2% target the Fed has always tried to maintain.

We are not in a text-book situation. Chairman Powell has admitted as much. Inflation is coming from many corners but cheap money isn’t really the cause. It has far more to do with supply chain issues and two years of saved up demand from consumers and the money they were sitting on while sitting at home waiting for the pandemic to finally pass on by. There is also the matter that the governments of the world and the US government printed trillions of new money to fund pandemic programs and now that money, on top of consumer savings, is sloshing around the economy looking for somewhere to go. The Fed is misreading the problem.

Long, Cheap, Money

The Fed is also trying to solve a problem they should have started solving back in 2017: cheap money. since the Great Financial Crisis, interest rates have been low and created an economic environment where debt has been unreasonably cheap and this has caused companies to take on debt to buy back shares to cause higher stock prices rather than investing in actual production or raising worker’s wages when inflation was low. This environment also enabled consumers to take on debt. That is why some commentators call our current environment, the “everything bubble.” From used car prices to housing, low interest rates have allowed corporations and consumers to over-leverage. People have bought more than they would have normally. Companies have hoarded wealth and returned profit to investors more than grown their businesses. Now, that house of cards is falling apart and all the inflation that we should have had has come home to roost. In some sense, we are having the crash we should have had back in 2008 but that was avoided with austerity and cheap money. That fun ride is over and now the economy must adjust to higher interest rates. This wouldn’t have been as painful if it had happened years ago but now it’s happening all at once and the Fed will likely cause a recession as a result.

Global Deflation

For the US Dollar, one of the other problems facing the Fed is the fact that while inflation is surging within the United States with higher prices and rising wages, globally, against other currencies, the dollar couldn’t be doing better. The US is getting more valuable against every currency including the Euro. This is in no small part due to the fact that inflation is rising all over the world due to demand slack from the pandemic and the trillions spent on propping up the global economy during an unprecedented period. For the Fed, this means that they could be exporting much of the domestic dollar inflation by selling more dollars overseas. To some degree, their ending of quantitative easing and their reducing their balance sheets and offering their bonds on the open market is doing this but they could be moving more dollars abroad; at least more than naturally moves abroad. All things considered, if/when there is a European banking crisis, much like 2008, it will be solved in dollars. Good thing the dollar is strong right now. It is bad for US exports and it would be good for the dollar to lose some strength for that purpose but given the global economic environment, it is doubtful that we will see that anytime soon leaving the Fed with its only tool: raise interest rates.

So What’s With the Fed?

When all you have a hammer, every problem becomes a nail. An apt idea for the problem the Fed is trying to solve. They are trying to solve an inflation problem and inflation is a terrible problem. However, the only tool they have is to raise interest rates and destroy demand get people to stop doing economic activities that increase prices. However, the real problem is over in supply chain, commodities, and geopolitics and those are problems that the Fed can’t solve. I think what’s bad about this situation is that they will likely cause a deep recession (Bloomberg now says its 100% for 2023) unnecessarily because they are now trying to solve a problem that should have been solved 5 years ago. The combination of easy money for too long and major shifts in the economy and geopolitics have now put the Fed into a corner. The Fed will need to find a way out of this but it’s likely to involve some pain. How do we know? Chairman Powell has already told us.

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