This week, Federal Reserve Chair Jerome Powell presented his semiannual testimony before Congress. A key topic of discussion was the ongoing situation surrounding interest rate hikes and the battle against inflation.
To put it simply, Powell’s campaign against inflation is far from over.
The Core Consumer Price Index (CPI), which excludes food and energy prices, is rising at an annual rate of 5.3 percent. Likewise, core personal consumption expenditures (PCE) have seen a 4.7 percent year-on-year increase.
This indicates that a federal funds rate of 5.25 percent is insufficient to manage the escalating prices. Ideally, rates should be set between 7 and 7.25 percent to effectively tackle this issue.
Following its recent Federal Open Market Committee (FOMC) meeting, the Fed hinted at implementing two more rate hikes this year. During his testimony, Powell affirmed this expectation, calling it a “pretty good guess.”
So, what prompted the pause in rate increases initially?
The troubles surrounding Silicon Valley Bank and First Republic Bank from March are merely a small facet of a much larger dilemma. Rapid interest rate hikes have left numerous banks inadequately prepared to meet depositor demands.
The yield on a 6-Month Treasury Bill is currently 5.4 percent, while many savings accounts are offering returns of less than 0.05 percent.
Under these circumstances, banks struggle to compete with short-term Treasuries. Many purchased bonds several years ago when interest rates were near zero, and now these assets are significantly devalued.
It’s important to remember that bond prices move in opposition to interest rates. As a result, banks find themselves in a predicament where they cannot liquidate bonds to meet depositor withdrawals without incurring substantial losses.
Consequently, as banks fail to compete with the alluring yields of short-term Treasuries, depositors are increasingly motivated to withdraw their savings and invest elsewhere. This situation raises concerns about the sustainability of the banks themselves.
The recent failure of SVB serves as a stark reminder that it doesn’t take much to provoke a digital bank run.
Inflationary Bias
The Fed’s decision to pause rate hikes is essentially a short-term reprieve for banks. While it gives them some breathing room to stabilize their financial positions, it ultimately serves little more than a symbolic gesture.
What can a bank realistically accomplish to adjust its bond holdings within just a month?
This pause truly only postpones an unavoidable banking crisis. Moreover, it carries the risk of escalating price inflation. Although interest rates are notably higher than they were in early 2022, they remain accommodating. Commercial banks can still access credit from the Fed’s discount window at rates lower than the core CPI.
As a result, major stock market indices are making significant strides toward their all-time highs, and residential real estate prices in various cities remain largely unaffordable. Despite the rate hikes, asset price inflation continues unrestrained.
By pausing, the Fed is making a precarious bet; should consumer price inflation rise further, this so-called hawkish stance will be regarded as another regrettable policy misstep.
Moreover, to rectify this blunder, the Fed would need to increase interest rates even more than if no pause had occurred.
Is this surprising?
The Fed’s current approach is consistent with its historical inclination toward inflation. The central bank has set an inflation target of 2 percent, consciously fostering an environment conducive to continuous price increases.
This inclination stems from the belief that deflation poses a greater threat to economic stability than inflation. Thus, central bankers err on the side of inflation to safeguard government revenues.
BOGO Offers
Deflation, by definition, refers to a general decline in prices. In contrast to inflation, deflation empowers consumers to purchase more goods or services in the future with the same amount of money they have today.
When deflation sets in, cautious consumers often postpone purchases, anticipating they can buy more for less later. This leads to excess supply, which further drives prices downward. To clear inventory, retailers may need to implement promotions like BOGO (buy one, get one free) deals.
In a deflationary cycle, reduced spending results in lower incomes for businesses and producers. This, in turn, leads to diminished production, layoffs, increased unemployment, and contraction of GDP—all contributing to ongoing deflation.
Populist politicians, fearing rising unemployment and dwindling GDP, are understandably concerned about re-election. During this week’s Fed testimony, Maxine Waters, the ranking member of the House Financial Services Committee, advised Powell:
“I caution against any approach in monetary policy that ignores the Fed’s maximum employment mandate and results in a recession with millions of people losing their homes and jobs.”
However, the real consequences of deflation primarily impact leveraged businesses, individuals, and credit markets. As asset prices, along with profits and incomes, decline, servicing existing debt becomes increasingly challenging, leading to widespread bankruptcies.
Deflation creates difficulties for lenders and can drive them toward insolvency. It may also trigger financial crises, disrupt credit markets, and lead to economic recessions or depressions.
Washington’s Bias for Continuous Inflationism
Despite these challenges, deflation shouldn’t be approached with dread; it is an inherent aspect of the business cycle and an essential characteristic of a healthy economy.
For individuals and businesses that have managed their finances prudently, deflation can be advantageous, allowing them to enjoy a better quality of life at reduced costs.
Conversely, those who made reckless choices during periods of inflation can face dire consequences in downturns, suffering the inability to meet debt obligations and facing potential bankruptcy.
When central bankers endeavor to avert deflation through persistent inflation, they amplify risks, distort prices, and lay the groundwork for future depressions. Government bailouts further compound the issue by socializing losses, impacting responsible individuals adversely.
This tendency aligns with the inflationary biases found in central banking and political arenas.
While moderate inflation can seem appealing as it diminishes debt burdens over time, the economy as a whole endures greater strains. As asset prices rise faster than wage increases, overall debt burdens expand.
As we progress, the only apparent solution to avert a collapse is to continue supplying inflation—through artificially cheap credit, higher levels of debt, and extensive money printing.
Many remain oblivious to the underlying dynamics at play… and to the potential implications ahead.
Embrace the current stability—while it lasts.
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Sincerely,
MN Gordon
for Economic Prism
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