Will the Fed do the right thing on inflation?

To fight inflation, the Federal Reserve has been raising the target on its federal funds rate.  The problem with the Fed raising the federal funds rate is that it affects other interest rates and could result in the federal government having to pay higher rates on its bonds and notes.  Some have speculated that the federales might have to spend a trillion dollars a year just to service the debt — that is, pay the interest on the national debt.

On July 13, Fox Business reported that the official June inflation rate was 9.1%.  The Fed is being blamed for this 40-year high because it acted too late.  In June at the New York Post, Charles Gasparino warned about the restive bond market:

Now bonds are sniffing out more BS in the Fed's policy of incremental interest rate hikes in an effort to quell rising inflation. Bonds are saying it's not enough; we're going [to] need much higher rates and possibly a recession if we want to get inflation back to a more manageable level.

 How did we get to a place w[h]ere we need a recession? In recent years bonds have offered very little in return as the Federal Reserve kept buying them to pump up the economy though financial collapses, economic slowdowns and the pandemic.

That action, known as quantitative easing [or QE], infused the economy and markets with liquidity (a euphemism for "printing money"). It pushed up prices on stock and lowered interest rates dramatically, which initially made bonds unattractive because of the lower returns, or yields.

In addition to raising the funds rate, the Fed has other tools for fighting inflation.  One is called "tapering," whereby the Fed cuts back on pumping newly created money into the money supply.  When it's tapering, the Fed is still practicing Q.E., but to a lesser degree.  Tapering is a gradualist action, so as not to shock the economy.

When tapering gets the Fed to where it isn't creating any money in Q.E., then the Fed can reverse course in quantitative tightening, or Q.T.  Instead of infusing the economy with money, the Fed would do the opposite and suck money out.  The Fed does this by reducing its "balance sheet," which includes the assets it bought in the pandemic.  During the coronavirus pandemic, the Fed's balance sheet grew to its largest ever, nearly $9 trillion.

In May, the Fed announced that on June 1, it would embark on a program of Q.T.  But the pace that the Fed would withdraw money is much slower than the Fed's pace of creating money during the pandemic.  To wit, in three months in 2020, the Fed printed $3 trillion — a trillion bucks a month.  Ninety-five billion dollars a month is the fastest clip planned for Q.T.  But why not do Q.T. at the same speed as we did Q.E., at a trillion dollars a month?  After all, do we have an inflation problem or not?

If some are not entirely delighted with the pace of rate hikes and Q.T., at least the Fed has reversed course.  However, there are other things that enter the picture, like reverse repos.  The Fed claims that it conducts repo operations each day in order to "help keep the federal funds rate in the target range."

In August of 2021, Steve Forbes warned that reverse repos had hit $1T and could heighten inflation (three-minute video).  Steve seems pretty prescient now.

In May of 2022, Joe Brown of Heresy Financial reported that reverse repos had hit $2T for the first time ever.  If that sounds ominous, then watch Brown's May 24 video.

On June 15, Seeking Alpha ran "Fed Has Been 'Quantitatively Tightening' For More Than 6 Months" by Steven Saville.  If one is relieved that the Fed has finally gotten religion and is doing the right thing, then I recommend that one reads this short article on reverse repos (italics added):

One implication is that even though the Fed officially won't start QT until this month, for all intents and purposes QT has been happening for about six months. Another implication is that the Fed now has more than two trillion dollars that it could inject into the economy simply by allowing existing reverse repos to expire. This could enable the Fed to boost the money supply over the months ahead while pretending to do QT.

That last sentence raises the question of whether the Fed will stay the course and continue trying to do the right thing — that is, protect the value of the dollar.  If the recession is particularly painful, the Fed might be pressured to reverse course and start buying U.S. treasuries again in a new bout of Q.E.  Or the Fed might just let those reverse repos expire.

One hopes the Fed regards inflation as a greater evil than recession.  One wonders if the Fed thinks it can finesse our economic problems and vanquish both at the same time.  The Fed should guard against such delusions.  For as a very wise economist once said, "there are no solutions; there are only trade-offs."  The trade-off for slaying inflation is a recession.

On June 22, in my last article on these matters, I erred.  I had thought Q.T. was to begin in July, but it had already begun.  Sorry about that.  But one of my points that I could have stressed more is that the Fed might consider tackling inflation more with Q.T. than with rate hikes.

Forty years ago, Paul Volcker didn't have a $9T balance sheet he could use to suck money out of the system.  To kill inflation, Volcker pretty much had to raise the funds rate to the ungodly level of 20%.  But Powell & Co. do have a $9T balance sheet.  And if they want to engineer a soft landing, or maybe even save the U.S. dollar, they might ramp up QT — and PDQ.

Jon N. Hall of ULTRACON OPINION is a programmer from Kansas City.

Image: Federal Reserve.

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