Wrote this today, figured I’d share. A lot of people have been comfortably riding a “mega recession ahead!!!” macro call for 18 months now. The sell-by date on that bet is coming soon.
If that “big recession, big spike in unemployment” bet does not pay off soon, it might stop being a self-fulfilling prophecy. 2H spending un-freezes at some (decent) level. The Fed eases up (saving the banks). We learn to live with 3%-4% inflation. Remember, the 1990’s weren’t all that awful (see Thought Experiment 1 below).
Yes, Economic data keep pointing to a slowdown. No, the data are are not (yet) saying “mega-crash in the next 3-6 months.”
What if things don’t crash soon? How long can the Fed hold rates here? If the yield curve stays inverted too long, it risks driving the banking system and a lot of Commercial Real estate off a cliff… The Fed has been hoping employment would fall off before it un-inverting the curve.
The current market bet (right now) seems to be that the Fed will jump out first in this game of chicken. Cutting rates sooner vs later and flattening the curve. The market bet may change. We might go off the cliff.
Please don’t staple a “no recession” forecast to my forehead. Credit is tight and getting tighter. That will definitely add to the slowdown we already see. We are definitely slowing down. The data show that. I am just noting that “slowdown” might not be enough deceleration fast enough for the assumed Fed game plan.
We’ve had 18 months for rates – raised far higher than anyone expected – to do their work. We mostly have a banking crisis to show for it Maybe macro gets really really ugly in the next 3-6 months? But if it doesn’t?
Thought experiment 1 – no-one remembers the 1970’s inflation era (scary music here), but not many people remember the 1990’s either (happy boom times music here). You wake up in 1995. PCE inflation is ~4% – heading downwards with forward expectations are well-anchored. Unemployment is below 4%. We are on the verge of a massive AI-driven technology innovation wave. Would the market be feeling depressed/worried? Or would markets be pretty happy?
Thought experiment 2 – If inflation is at 4% and trending down (or the long-term surveys and TIPS aren’t trending it up), will the Fed have the political cover to keep pressing? A steeply inverted nominal yield curve is already threatening a banking and Real Estate crisis. Is the Fed really willing to risk that?
The block in the mental model is the Fed’s 2% inflation target. That target is hardly written in stone. It is only 10-11 years old. It led to 1% trend inflation in practice. We spent the 2010’s fighting deflation…
2% has been in place since… 2012.
There is no formal academic support for 2%. It was basically pulled out a hat on a talk radio show in New Zealand.
We’ve realized a 2% “target” ended up a de-facto ceiling. So trend inflation ended up at 1% trend (too low). Goodharts Law (see below)
If we set the formal target at 3%, it would be the new de facto ceiling. Trend inflation would likely be around… 2%! That doesn’t sound too awful.
The political problem is how to you drop the 2% target and go to 3% without embarrassment? No clue. Probably just talk a lot about 2%, but let everyone know that’s not so serious anymore. Maybe use the debt ceiling crisis as cover to cut rates? But that does seems a better option than a crisis.
Goodharts Law strikes again:
Goodhart’s law is an adage often stated as, “When a measure becomes a target, it ceases to be a good measure”. It is named after British economist Charles Goodhart, who is credited with expressing the core idea of the adage in a 1975 article on monetary policy in the United Kingdom:
Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.
It was used to criticize the British Thatcher government for trying to conduct monetary policy on the basis of targets for broad and narrow money, but the law reflects a much more general phenomenon.