The current macro outlook

Jerome Powell, current chair of the Federal Reserve.

Since Nixon broke the dollar’s tie with gold, the U.S. government has tackled every financial downturn by reducing interest rates and flooding the system with money. The economy recovers, stocks rise, and everyone’s happy again. It happened during the dotcom crash, the financial crisis of 2008, and the Covid-19 crisis. But what happens when the downturn itself is caused by flooding the system with money? What happens when the medicine causes the sickness? What is the remedy?

President Richard Nixon, who took the U.S. Dollar off the gold standard in 1971.

Federal Reserve committee members were adamant in 2020 and 2021 that inflation was transitory. It was just a result of businesses reopening from lockdowns they said. It’s now the start of June 2022, with the latest U.S. official inflation print sitting at 8.3%. The last time it was at that number was January 1982. As a result, Federal Reserve committee members have come out to say that they had made a mistake in saying that inflation was transitory, while peddling the classic excuse of “nobody saw it coming.”

Three days ago former fed chair and current treasury secretary Janet Yellen, who was adamant that inflation was transitory and that nobody had anything to worry about, told us “I was wrong then about the path that inflation would take. As I mentioned, there have been unanticipated and large shocks to the economy […] that I, at the time, didn’t fully understand.” Current fed chair Jerome Powell apparently realised inflation wasn’t transitory in December, saying “I think the word transitory has different meanings to different people, to many, it carries a time, a sense of short-lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean”, a politician’s way of admitting he was wrong.

Janet Yellen, current secretary of the treasury.

While anyone who knows their stuff knew that inflation was never transitory to begin with, somehow nobody at the fed predicted it. None of the fed’s 18 rate-setting member’s expected inflation to be above 2.5% in 2021; it finished the year at 7.0%.

Are these fed members actually this incompetent? I don’t believe so; I think they’re trying to delay the inevitable. Think of it like this: if these central bankers did indeed make an honest mistake and have now realised that inflation is running away from them, why on earth are rates still below 1% when inflation is well above 8% and looks to be continuing higher? Back in 1982 the average federal funds rate was 12.24%, today it is a measly 0.77%. If the fed truly wanted to tackle inflation, rates would be on their way up to what they were in 1982. Yet, they’re currently still below the rate that Alan Greenspan dropped them to in order to get out of the early 2000s recession. Again, with all the talk off a hawkish fed, and two rate increases in three months, rates are still below what was thought to be extremely loose policy in the early 2000s.

The market can’t handle even the smallest of rate increases anymore as everything is built upon a foundation of low rates; the S&P 500 has fallen 14% from its peak, and the Nasdaq has fallen 24%. The real reason for the fed’s inaction, however, is not the market’s reaction, but what will happen to the economy following a series of large rate hikes. U.S. federal debt is sitting at $30.4 trillion, and in 2021 the amount of interest paid on that debt was $562 billion at an average interest rate of 1.5%. The weight average maturity of the debt has dropped from 70 months to 65 months, meaning higher rates will affect debt repayment even more. As Stanley Druckenmiller has pointed out, if the 10 Year Treasury Yield rises to just 4.9% – which would be a pretty average rate historically speaking, although it hasn’t been there since 2007 – the house of cards falls down, because the interest expense on federal public debt will reach 30% of GDP, which is enough to wipe the U.S. clean out.

The fed is now stuck between a rock and a hard place, where they must choose between either raising rates to stop inflation which in turns kills the U.S. economy via national debt interest payments, or letting inflation run rampant which in turn kills the economy via spiralling inflation. This is precisely why they have not acted quickly on inflation. They either already know the dollar is done for and just trying to delay the day of reckoning, or they’re hoping inflation dies out itself – which it won’t.

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