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Wanted: New Tools For Controlling Inflation-Especially When There Isn't Any

A chart I posted (showing Fed Funds to initial unemployment claims, reproduced here) showed the relationship between rising rates and rising unemployment.

As the Fed continues on it's path of raising rates, even with little "real," or "classic" inflation (i.e., too many dollars chasing two few goods) along with remaining pockets of labor slack and paltry wage growth, it seems to me we have yet another tool that has lost a great deal of relevance in our post crisis era.

There is nothing new about this. Since the Great Financial Crisis, some economic models have lost a good deal of relevance, including what is known as the "Philips Curve," where it is presumed that declining unemployment will raise wages. Even if you don't know a thing about economics, you probably realize that doesn't quite seem to be in play at the moment. Yet, because most present day economists have been weaned on the theory, they can't let go of it. Another is the "Taylor Rule," which is a model the Fed can use to set interest rates. It's a complex formula, but the basis of it is that the "real" interest rate should be 1.5 times the inflation rate. If it were followed, the Fed should have started hiking rates in 2013. Neel Kashkari of the Minneapolis Fed estimates that had it done so, it would have cost the economy 2.5 million jobs, and so the Fed was wise not to deploy it.

However, there are some asset prices that have reflated or inflated to the concern of many. But is this really "inflation?" For example, housing prices continue to rise, even, to my surprise, with the reduced deductibility of property taxes and mortgage interest. But if the Fed is concerned about arresting this particular piece of inflation, raising the Fed Funds rate, by itself, will not raise mortgage financing rates, simply because short term rates and ten year rates (which 30 year mortgage paper is priced from) do not march in lockstep. And even if they did, why use rising ownership costs as a tool to restrain purchasing, especially since prices are more affected by constrained supply thanks to local factors like zoning regulations that restrict density, and more of a macro problem of the lack of inventory of existing homes for sale. Fiddling with rates won't affect either problem. And in some areas at least, analysts are starting to notice softening in rental prices, thanks to supply finally catching up with demand. (Even "shovel ready" projects take time.)

Why is that piece important? Because when it comes to calculating CPI, the Fed only factors in the cost of rent, not the costs of owner occupied homes. So if this is the kind of inflation the Fed is seeking to tame, the market will probably do the job for them. Lack of workforce mobility has been blamed for all sorts of economic ills, and combined with tax policy, rented properties may play a larger role in our housing mix in the future.

This dilemma also holds true for short term rates used for auto lending. Since these loans are keyed off of shorter maturities, rising Fed Funds rates affect these more than than they do for say, real estate. Since inflation can be affected by scores of inputs, like oil prices, crop production, commodity shortages, and now tariffs, why raise the cost of auto financing and crimp auto sales (and employment) when increased production is a positive thing for the economy?

Rising stock markets can also cause fear of an asset bubble, but if that is so, the Fed has a rusty weapon in it's arsenal: setting margin requirements. The Fed, since 1934, has changed margin requirements 23 times. But the last time it moved the needle was back in 1974. Ever since Alan Greenspan made his "irrational exuberance" comment about stock valuations in 1996, I often wonder how history would have been different if he just tapped the brakes on the level of leverage that was permitted at that moment. The mere utterance of the phrase knocked 3% off the market practically overnight, but he took no other action. So the Dow continued on its rise from a level of around 10,200 when he uttered it, to 17,188 three years later, almost to the day, before the dot-com crash commenced.

Many of you know there is quite a bit of concern about the "yield curve" inverting, where the long dated end of bond yields flips to become lower than the shorter dated end. In the past, this has been a fairly reliable indicator of the onset of a recession. So there are some nervous voices out there as the Fed continues to ratchet up the Fed Funds rate and longer dated yields remain stubbornly low. As we've seen with other metrics and models, maybe this one has outlasted its usefulness in this environment as well. But the bond veterans are nervous.

All of this points to the idea that using interest rates to control or blunt the effects of prices that have nothing to do with traditional inflation might be destructive to the overall economy. The simple fact is that absent the costs of shelter and health care, there is really no inflation to be seen, and as much I would like to see rising rates bring hospital bills down, I don't think that's possible.

Personally, I hope the Fed takes a breather here on rate policy. It takes time for these inputs to work their way through an economy as large and complex as ours, and slowing the gains we've made in the past 10 years doesn't seem to be the path we want to head down just yet. There is still work to be done, especially since Congress abdicated its authority to provide the fiscal stimulus we needed, and these ill conceived tariff tantrums may derail our progress.

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