Feds and its Fibs I

The US Federal Reserve (The Fed) conducts its annual economic symposium in the Jackson Hole mountain valley and the event is keenly watched by economists and financial experts around the globe for it has now come to witness presentation on major US monetary policy decisions and commentary on the road ahead for the world's largest economy. The event's highlight is the Fed Chair's speech and this year's roughly 8 minute readout by Fed Chair Jerome Powell was truly representative of the classic deer in the headlights moment. The Fed's commentary continues to confirm critical implications for the global economy in the wake of the COVID pandemic and hit by high inflation. Empty vessels clang the most, it is said. The fact that that the Fed has been talking a lot and acting little personifies the idiom. To delve into this, I shall be publishing a two-part blog. In the first, I intend to explore the genesis of the US' inflation problem and present circumstantial & tangible evidence on the Fed's cognitive dissonance while creating this problem. In the second, I wish to put forth the argument on why is it now going to be quite different than what it used to be in the past and what may Bhaarat look forward & adapt to.

Any market is nothing but the interaction of one, the supply-demand of goods & services and two, the money that is used to transact for the same. Inflation is a result of these two. Inflation comprises of a consumer component and a monetary component. Consumer inflation is the rise in prices that is directly attributable to the change in supply-demand situation of goods & services due to any reasons except money supply. Monetary inflation is when the actual money circulating in the economy goes up in volume and hence drops in value. To explain this phenomena, take the example of limited edition product launches that companies engage in. Since the concerned watch or a car or any luxury good is a limited edition one or is in short supply, its perceived value in the eyes of the consumer is high. The moment something is mass produced, the perceived value too drops comparatively. Similar is the case with monetary inflation, where there is a lot of money available, the per unit value or the per unit purchasing power is lower.

With this in the backdrop, I'll now present an example that would help the reader to follow the mechanics of how inflation works which would then simplify understanding the Fed's cognitive dissonance. I'll however assume that the global market is extremely simplified where there is only one commodity (apples) and only one currency (the US$). Every $ is earmarked for apples only and there is no other destination for the $ such as purchasing of other commodities, investments etc. Information is truly transparent and easily accessible for market participants. These assumptions set aside the plethora of financial forces at work and make explanations and understanding easier. When the number of commodities, currencies and money destinations/usage increase and we witness information lag, law loopholes, tax implications and crime, we would get the global market in reality but the underlying principle stays the same. Also, the example is built to demonstrate monetary inflation as that is the root cause of US' inflation issues. However, in the costing image to follow, if currency ($) is replaced by Apples (kgs) demand, the logic would hold in principle.

Assuming that the global market produces 100 kgs of apples and the money supply (i.e. notes printed and in circulation) is $100, the per kg rate of apples is fairly priced at $1 (i.e. $100/100 kgs apples). If the production of apples and/or the supply of money change, the per kg rate of apples would fluctuate giving rising to cost inflation. The explainer for the same is in the costing image below:

The base case is represented by cell B2 and any changes in production & supply and its effects on the cost ($/kg) is observed in the other eight cells of the 3x3 matrix. The light orange marked cells represent cases where there is a price increase (i.e. inflation) while the the light green market cells represent cases where there is a price decrease (i.e. deflation). When the production of apples falls (A1, A2 & A3) but the money supply increases (A3), apples witness a high cost inflation (50%). If we replace apples with goods & services in the US, we have the exact current situation in the world's largest economy. COVID has taken a toll on not only the US' domestic production but the world over. However, the rapid printing of money by the Fed since March 2020 has caused massive inflation in the US. When a central bank wants to increase money supply, it prints currency notes and purchases debt securities (viz. bonds) from market participants (institutions, businesses, governments, individuals etc). This leads to a direct transfer of loaned money into the economy which can then be used to invest or purchase. The bonds that the central bank buys, technically become its assets just like a common man's fixed deposit which are loans given to any commercial bank on which the commercial bank pays us interest. A rise in assets is reflected in the Fed's balance sheet and this balance sheet offers tangible evidence of the extent to which the Fed has printed US$. From Apr 2020 to Apr 2022, the Fed's balance sheet size has increased from ~$4tn to ~$8.9tn. It has stayed fairly constant since then, fluctuating a few million dollars here or there. Furthermore, the US Government's much touted American Rescue Plan Act of 2021 resulted in cash dole outs termed as unemployment allowance. This allowance resulted in many families in the US earning twice or thrice without working during COVID as compared to what they earned pre-COVID while working. The US Federal Government went a step further by providing states with the Fed printed cash for rental & energy assistance programmes that either waived off or drastically reduce the rents civilians are supposed to pay or the charges that are due for the electricity/gas they consume. The latest in the inflationary bandwagon are the student loan waivers. Imagine an individual, Sam, earning $10,000 but not supposed to pay for rent, electricity, loan principal repayments or interest payments etc: with the expenses reduced but the income raised, Sam is flush with cash that he could spend. This in a society that survives on credit and hence needs no second invitation. However, the opportunity to spend has been limited as the domestic and global production was still impacted due to shutdowns. With huge amount of money chasing few goods or services, inflation had nowhere to go but up. I'll draw a quick parallel here with how Bhaarat handled the COVID pandemic financially as compared to the US - political observers would recollect how the opposition in India and the Raghuram Rajan fan club coterie was pressurizing the Modi Government to dole out cash by asking RBI to print more money just like the US. The fact that our leadership did not fall into this deadly deliberate trap while focusing on mass vaccination, targeted socialism limited to providing only the basic necessity of food and a fast restoration of economic production & supply chains, is showing its effect today. While US is experiencing negative real returns (i.e. the difference between interest rates or growth or percentage returns and inflation), has entered a technical recession (i.e. two consecutive quarters of negative GDP growth rate) and is in the midst of a stagflation (low growth, high inflation economic scenario), Bhaarat is seeing an under-control real rate (with repo rate at 5.4% & inflation at 6.7%, real rate translates to -1.3%; comparative number for the US is -6.0% with the fed funds rate at 2.5% & inflation at 8.5%). Bhaarat is also continuously recording significant GST collections (which directly imply healthy consumption of goods & services thereby indicating strong production as well) and GDP growth (13.5% latest Apr-Jun 2022 quarter).

Now that we have an idea on the inflation mechanics and how the two Feds (the US Federal Reserve and the US Federal Government) caused this inflation problem and then aggravated it manifold, we can get a nice peek into the cognitive dissonance that I mentioned. In the most recent Jackson Hole speech, Jerome Powell mentioned that households have to go through necessary inflationary pain as demand (for products such as apples due to the cash flush individuals) far exceeds supply (of the said apples). He ended the same speech with an affirmative statement of intent and control, "the Fed is taking forceful steps to moderate demand." On the one hand, the Fed has been continuously talking about curtailing inflation but on the other hand, it is simply not doing enough to actually impact reality. Central banks world over control inflation by employing the following actions:

1. Raising interest/policy rates (repo rate for RBI, fed funds rate for the Fed) : this action nudges the banking system to raise their lending rates. Higher interest rates mean costlier credit to businesses and individuals. Businesses tend to delay capital investment while individuals defer or switch their credit based purchases such as cars, homes etc to less costlier alternatives. This deferment cools down the demand for goods & services effectively cooling down costs or inflation as well. (note: higher interest rates tend to also result in better return debt issues which means investment of money becomes attractive over spending the money)
2. Lowering money supply: We saw earlier that how increased printing of money or higher money supply causes monetary inflation. Now conversely so, lowering supply reduces inflation. Alternately or in tandem, central banks may suck out the money circulation in the economy by selling debt securities (instead of buying them, as seen earlier in this blog). With lower money supply (cells A1, B1 & C1 of the costing table), inflation again cools off and can actually be deflationary. That however is a separate topic.

The Fed however, is neither increasing the fed funds rate above inflation (or at least, near inflation) nor is it cutting down money supply (i.e. its $8.9tn balance sheet) which is causing the inflation in the first place. Thereby, it is allowing the inflation to continue peaking (though it has slightly fallen from the 9.1% 40-year high for the moment being). The reason why it can't conclusively and confidently do either is because the US economy as we know would suffer a great deal no matter what the Fed decides. With the US Government being the 'proud' owner of $30tn worth external debt (the highest in the world and more than twice of the next best, China at $13tn), higher interest rates would translate into higher debt servicing costs which would mean either defaulting on payment or cutting down government expenditure or raising tax rates to mop up more revenues or a combination of all these or more printing of US$. The last would be in direct conflict with the recommended lowering of US$ money supply. Even if the recommendation is followed, any reduction in the Fed balance sheet would mean less money available to finance student loan waivers, rental & energy assistance, unemployment allowances etc. Thus, both recommended Central Bank tools would cause civil unrest in the US which any country knows it can't afford (ask Sri Lanka today or Venezuela before). However, since the Fed can't do either, it is doing only what it can - lie through its teeth by talking tough & showing it it is in control while crossing its fingers praying that the inflation problem resolves itself as it has always done in the past because US is the global superpower. It is an unchallenged behemoth with no peer as the world's largest and undisputed economy. These policies are since the days of Adam and hence the US is simply too big to fail; or is it anymore?

In the next part, Feds and its Fibs II, I shall make a case on how the US' inflation problem today is very different than what it was in the past and in all likelihood, Uncle Sam can no way keep cheating the laws of economics all the time. I hope to present indications of global undercurrents that suggest a gradual and partial de-coupling of the global economy from the US' selfish & disastrous fiscal and monetary policies. We'll take the prominent examples of Middle-East revisiting the Saddam Hussein dare, Russia-Ukraine War & its impact on Western Europe, Chinese ambitions for the Renminbi Yuan and India's bouquet of policy & diplomatic decisions that are all now feeding into this de-coupling. We'll finally take a look and what this de-coupling means specifically for the US & Bhaarat and by extension, for the world.

Jai Hind!