Powell recession | Looking for Alpha

Are you going to name a recession after me? I wanted to be worshiped for raising rates while the market managed inflation.

Drew Angerer

The Federal Reserve has chosen to emphasize a new objective, which is not part of its mandate.

In a recent presentation, President Jerome Powell said:

…you want to be somewhere where real rates are positive overall yield curve.

It’s a problem, because it’s absolutely not one of the mandates of the Federal Reserve. It’s not even relevant to their task. Let’s be absolutely clear:

  • The role of the Federal Reserve is not to create real positive returns.

They are responsible for maintaining price stability (which they cannot do here) and maximizing long-term employment (in the interest of improving real GDP growth rates). None of these objectives say that real rates must be (or even “should be”) positive over the entire yield curve.

If we look at the past 43 years, we can see that the 1 year Treasury market yield was higher than inflation in the 80s and 90s, but after the Great Recession there were only a few months where the 1-year Treasury yield was higher than the rolling CPI growth rate:

Chart

BLS, Board of Governors, Fred

Jerome Powell pointed to the 10-year expansion as a success of having low inflation:

…it’s no accident so when inflation is low and stable, you can have those 9, 10, 11, 10 years, whatever, expansions…

It’s a quote. Don’t blame me for the wording. This is from the official transcript.

Yet President Powell ignored that the 10-year expansion occurred with only a few months where the 1-year Treasury yield was higher than the change in the CPI.

We could use forward changes in the CPI (for accuracy), but the results would be so similar it would be a waste of time. It’s literally moving a line a fraction of an inch. We don’t need to waste time. We need greater productivity.

This should be of concern to investors when the Federal Reserve Chairman is focused on creating a measure (of positive real returns across the yield curve) that is not one of their responsibilities. They should be concerned that this glorified metric is one that rarely happened throughout the decade of expansion.

This should concern them, yet many people identify with the premise that real returns “should be” positive. This modest real return should be reached even without risk. It is to make a qualitative decision, not an economic one.

Negative real rates

Total public debt as a percentage of GDP exceeds 120%:

Debt table

OMB, Fred

It’s not good. However, negative real rates can be very powerful.

If inflation is 4% and GDP growth is 6%, real GDP would increase by 2% (rounded). However, if the budget were balanced (revenue = expenditure), the debt-to-GDP ratio would drop significantly. The GDP would increase by 6% while the debt would be stable. To be clear, the national deficit almost never decreases. It only happened a few years out of several decades, and even then, it barely declined. The reductions in the graph above were driven by GDP growth exceeding deficit growth.

If the interest rate on debt rollover increases significantly, it becomes considerably more difficult to achieve this balanced budget. Higher rates create more obligatory expenses as interest has to be paid.

I know some people believe that raising rates will “force” the government to reduce deficit spending. Sounds good, right? They think we can just spank the government with higher rates and that will fix things. It never worked. Never. In more than 80 years, rising rates have never reduced the deficit:

Federal surplus to GDP

OMB, Fred

Higher rates and debt

At the end of 2021, federal debt held by the public stood at $22.284 trillion. You can verify this using data from the CBO. Navigate to “Historical budget data” and extract the May 2022 document.

Despite the huge amount of federal debt, net interest expense was only $352.3 million. This suggests an average interest rate of around 1.6%. The last time the implied rate (net interest expense divided by federal debt held by the public) exceeded 4% was in 2008.

Why 4%? Because the Federal Reserve thinks they should be above 4%.

If the average debt rate increased to 4% as maturing debt is rolled over, this would increase net interest expense by about $539 billion per year.

We could go deeper into this topic, but I think it is more important that investors have a firm grasp on these fundamentals.

The rate increase has the following impacts:

  • Interest charges for decades are increased, increasing future deficits.
  • Investment in new capacity is discouraged. For example, home buyers who forgo deals leading to fewer new homes.
  • The currency is strengthened, making imports more competitive and exports less competitive. It’s a double-edged sword.
  • The economy is weakened, causing unemployment to rise, leading to lower output and larger deficits (unemployment and other programs).
  • There is some reduction in demand as the weak economy reduces incomes. However, due to lower production, a smaller cake is split.

Raising rates does:

  • Prevent further deficit spending. Not now. Never. It does not work. Stop anyone trying to pretend this will work. They have been wrong for 80 years. Their credibility is zero.

Powell’s Dream

President Powell’s dream of positive real rates across the yield curve is badly hurting the economy for years to come. These actions will add at least hundreds of billions, but trillions if rates are maintained, to the federal debt over the next few decades. Another $539 billion a year adds up pretty quickly. The expense will appear in the field called “Net Interest Expense” and it is just one of the lingering costs in Powell’s dream.

Since this recession is enhanced by Powell’s dream, it’s fair to name it after him. It’s the Powell recession.

Damage obtained

By repeatedly raising rates, the Federal Reserve convinced the market that it intended to create positive real rates. How can we tell? Because the yield of TIPS (Treasury Inflation Protected Securities) is around the highest level observed for a decade for 5- and 10-year TIPS. The 5-year TIPS yield is higher than at any time in the past decade:

Yield chart

Fred

However, you can also see that the 5-year break-even inflation rate is around 2.18%. Market forecasts do not foresee particularly high inflation. Certainly not compared to earlier comments that an average inflation rate of 3% might be acceptable when it was below 2% in some previous years.

The yield on 10-year TIPS is also higher than at any time in the past decade.

Table of Treasury Yields

Fred

Why does everyone say more is good?

Do you get your macro view from Bank of America?

Here’s why they thought higher rates would be so attractive:

interest income

Bank of America Third Quarter 2021 Investor Presentation

That changes things a bit, doesn’t it? They had 7.2 billion reasons to convince Americans that higher rates would be great. Does it feel good right now?

Will inflation ever end

Yes. Mainly due to increased supply. This is usually how inflation is solved. However, by raising rates today (before the market resolves inflation), Powell can take credit for the end of inflation and seek to cement a legacy as the genius who ended inflation. inflation. That sounds better than being the man who prolonged a recession and added trillions to the federal debt.

About Alexander Estrada

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