The best the Fed can do for Trump — and the rest of us — is to hold inflation down
- Key inflation indicators are hitting at, or above, the upper levels of their target ranges.
- Trump can help with more oil from Russians and the Saudis to stop energy’s double-digit price inflation.
- The Europeans and the Chinese want to keep their rising trade surpluses on trade with the U.S.
Price stability, regardless of how it is measured and defined, is the ultimate litmus test of monetary policy.
And inflation is always — regardless of sociopolitical outlook — a monetary phenomenon.
Those are the key tenets of the Chicago school of economics, as well as the “killer” arguments of one of its best known proponents — the Nobel laureate Milton Friedman.
Friedman was probably smiling somewhere when President Donald Trump told the Federal Reserve last week that “I don’t like all of this work that we’re putting into the economy and then I see rates going up.” As a graduate student, I remember the Friedman grin that looked like he was saying “I told you so.”
What Trump said was a paraphrase of Friedman’s claim that fiscal policy stimuli were ineffective — that is, their medium-term impact is zero or negative, because the ensuing higher inflation and budget deficits force the Fed to initiate credit tightening that usually leads to growth recessions and rising unemployment.
Worrying inflation outlook
Friedman was basing that view on his empirical research (part of his Nobel distinction) showing the vanishing fiscal multiplier, which is fiscal policy’s stimulus to economic activity. That was also part of his political fight against deficit-financed economic policies, advocates of big government and an ever-expanding public sector.
In case you are wondering what Friedman did advise, you can probably guess that money for him was the only policy lever. Pick any monetary aggregate (a measure of the money stock), he said, preferably the one whose growth is highly correlated with the growth of the economy, and keep it moving along on a path that is consistent with price stability.
Now, that brings us back to the Fed and the legion of its critics and would-be advisors.
From the above, one can easily infer that inflation is the only binding constraint on the Fed’s policy. Those who disagree with that conclusion are mostly the people alleging that the Fed is Wall Street’s handmaiden, regularly caving to government pressure in the run-up to elections, and the key architect of the (four-year) election business cycle.
I look at that as largely irrelevant chatter that in no way invalidates the view that inflation — or, more precisely, inflation expectations — is a guide the Fed can only ignore at the peril of debilitating recessions and crashing asset values.
Where do we stand on inflation now?
Not sitting pretty, really. The key inflation indicators are hitting at, or above, the upper levels of their target ranges. They are showing an accelerating pattern rather than a stabilizing trend. In particular, that’s the case with the personal consumption expenditures index and the consumer price index.
Indicators underlying inflation pressures, such as the unit labor costs and producer prices, are not providing any grounds for optimism either.
China and the EU won’t give up trade surpluses
The unit labor costs (wages minus labor productivity) in the fourth quarter of last year and the first quarter of this year shot up at an average annual rate of 1.6 percent — a big jump from zero growth in the first nine months of last year. That is quite a hit to profit margins that will force businesses to respond with rising prices, which always stick in a growing economy.
That is typically what happens on the way to an accelerating general price inflation.
Producer prices last month told the same story with an annual increase of 4.3 percent. They were driven by energy costs soaring at an annual rate of 17.2 percent. All that has already found its way to consumer wallets and corporate balance sheets.
The most recent business surveys are pointing to high activity levels, rising capacity constraints and slowing delivery schedules, with prices in June showing more than two years of consecutive monthly increases.
Trade disputes — if they were to lead to supply shortages and price distortions — are another problem in the current inflation outlook. Sadly, the Chinese and the Europeans are ready to fight to keep their surpluses on U.S. trades.
Speaking in the name of the EU at the G-20 finance ministers’ meeting last Saturday, France refused to even consider the American offer. The Chinese did the same thing, but much more elegantly: Beijing did not send its key trade negotiator, leaving the EU and the IMF to gang up on the U.S.
And then there is a hugely expansionary fiscal policy the Fed has to contend with. Last Thursday, the U.S. Office of Management and Budget announced that the deficit for this fiscal year, ending September 30, will come in at $890 billion — more than double the estimate of $440 billion it had published in March 2017.
How is the Fed reacting to all that?
Liquidity withdrawals are continuing. In the course of the second quarter, the Fed’s balance sheet shrank by $150 billion, showing a 3 percent decline from its year-earlier levels, but still remaining at a massive $3.6 trillion on July 18. That is a very gradual and a very cautious pace of a long-overdue “policy normalization.”
The bond markets are reacting in kind. The Treasury’s yield curve has been roughly stable since the beginning of July, with a mild tension developing on the benchmark 10-year note. The real short-term interest rate, measured by the effective federal funds rate and the CPI, is still minus 1 percent, signifying a vastly expansionary monetary policy.
Trump’s displeasure about the Fed’s intention to keep rising interest rates sounds like an unwise dig at a central bank that seems hopelessly behind the curve in preventing an inflationary flare-up.
The president could help by getting the Russians and the Saudis to pump more oil to bring energy costs down. So far this year, oil prices are up 18.4 percent, and there is no telling how far the U.S. consumer price inflation could go if energy prices were to keep rising.
That is all in Trump’s hands. There is nothing the Fed can do about it.
Fixed-income markets look like a good place to avoid. Defensive equity positions are my choice.
Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.
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