Between a rock and a hard place

Cash as an asset class? Hmm...

Powell’s speech was not the most important item of note last week, it was a white paper from the Chicago Fed that was presented at the Federal Reserve’s annual Jackson Hole meeting, which, in a sentence says, “Without appropriate fiscal policy ie significantly reducing the US debt/GDP ratio to well below 100%, central bank intervention alone cannot control inflation.”

The following extract from the paper highlights the salient points.

In this paper, we argue that the answer to these important questions hinges predominantly on the fiscal authority’s credibility in stabilizing a large fiscal imbalance. The central bank’s anti-inflation reputation, albeit important, is not decisive. When fiscal imbalances are large and fiscal credibility wanes, it may become increasingly harder for the monetary authority to stabilize inflation around its desired target. If the monetary authority increases rates in response to high inflation, the economy enters a recession, which increases the debt-to-GDP ratio.

If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the deterioration of fiscal imbalances leads to even higher inflationary pressure. As a result, a vicious circle of rising nominal interest rates, rising inflation, economic stagnation, and increasing debt would arise.

In this pathological situation, monetary tightening would actually spur higher inflation and would spark a pernicious fiscal stagflation, with the inflation rate drifting away from the monetary authority’s target and with GDP growth slowing down considerably. While in the short run, monetary tightening might succeed in partially reducing the business cycle component of inflation, the trend component of inflation would move in the opposite direction as a result of the higher fiscal burden.

Fiscal stagflation does not stem from a perceived or actual loss of anti-inflation reputation by the central bank. Rather, it is caused by the progressive deterioration of the fiscal authority’s credibility to stabilize its large debt and the realization that the reputation of the monetary authority is incompatible with the expected behaviour of the fiscal authority.

You can read the full text here. It is a rather long and technical read, but the conclusion below is succinct enough.

https://www.kansascityfed.org/Jackson%20Hole/documents/9037/JH_Paper_Bianchi.pdf

Historically, movements in fiscal inflation account for changes in trend inflation, while cost-push shocks determine more transitory movements. Thus, an implicit fiscal limit arises to the extent that a low and stable inflation target requires fiscal policies that are consistent with this goal. Absent this fiscal backing, the central bank cannot maintain inflation at the desired target.

We have argued that the rise in trend inflation in the 1960s and 1970s was a fiscal phenomenon that ended when the monetary/fiscal policy mix changed in the early 1980s. Since then, fiscal inflation has remained modest because of the prevailing policy mix. In the decade before the pandemic, fiscal inflation has been counteracting deflationary forces and, in fact, helped in preventing the U.S. economy from slipping into deflation. Following the COVID pandemic, the United States, like many other countries, has implemented robust fiscal interventions. We have shown that these policy interventions facilitated the quick rebound observed after the pandemic recession. At the same time, they also contributed to the surge in fiscal inflation. Increasing rates, by itself, would not have prevented the recent surge in inflation, given that large part of the increase was due to a change in the perceived policy mix. In fact, increasing rates without the appropriate fiscal backing could result in fiscal stagflation. Instead, conquering the post-pandemic inflation requires mutually consistent monetary and fiscal policies providing a clear path for both the desired inflation rate and debt sustainability.

As Luke Gromen, the erudite editor of the Forest for the Trees www.fftt-treerings.com put it, the excerpt above from Fed economist-in plain English reads:

The Chicago Fed told Powell last weekend that he can be Arthur Burns (high inflation) or he can be Benjamin Strong (overtightening the world into the Great Depression), but he cannot be Paul Volcker (the hero Powell seems to be envisioning himself as.)

Unless of course the US government has the political will to drastically cut

•  Healthcare in a pandemic?

• Social Security benefits in a retirement crisis?

• Default on US Treasury bonds?

• Defence spending in a new Cold War?

Which of course it hasn’t. This raises the likelihood of a Fed pivot, which might work in the short-term, if it doesn’t destroy the Fed’s credibility, especially in the eye of potential foreign holders of US dollar and US Treasuries, but will just make the fiscal deficit problem even larger in the long term.

This must be one of the top definitions of “Between a rock and a hard place.” Cash as an asset class? Discuss.