Happy Liberation Day (Comrade)!

I cannot imagine a more Orwellian name for a holiday.

It's fascinating*** how adherents of MAGA don't see the national socialism in their own policy. 

***Fascinate and Fascism both come from the same latin root meaning to be bound. In fascinate, it's like being spellbound. Fascism obviously refers to the fasces, a bound bundle of rods. 

I've been thinking a lot about my job and the way in which it is wrapped up in my identity. It's a part of what I think about myself and what I want others to think about me, which creates a lot of pain. If I perform poorly, I feel it reflects on me as a person. If I lose the job, I lose a part of myself. The job becomes more than just the job, but a validation of who I am. It seems to me this is a common experience.

The relationship between the job and my identity arises out of my self-centeredness. The job is about me. It's my career. 

I've found that the way to fix this is to remind myself that the job is not about me at all. It's about the clients and the ways in which I can help them. The job does not exist to provide me validation or even an income. The job only exists because clients have a need. That need has nothing to do with me. My clients don't need me, they need legal services. To the extent they did not need legal services, I would not have a job. And it would be wrong of me to force someone to need legal services just because I want to be a lawyer.

Separating the job from my identify not only prevents the kind of pain discussed above, but also helps me focus on what's important: putting the client in the best possible situation. 

We should think about the economy the same way. The market system is not a job machine; it does not exist to create jobs. Instead, the market functions to provide goods and services that people want and/or need. The jobs behind those goods and services only exist so that people's wants and needs are satisfied. If those wants/needs change, so must the jobs. 

None of this is to make light of unemployment or to disregard the importance of steady incomes. Most of my posts below are about the importance of policies which explicitly stabilize nominal incomes. Instead, I'm encouraging myself to think about the service of others as the primary goal. What would our conversations around government policy look like if we focused less on jobs and more on making it easier to serve others?

For starters, I don't think we'd be talking about tariffs.

Quick follow-up to yesterday's post.

There is a difference between Fed policy and the Fed's policy stance.  The Fed's policy stance is either easy, neutral, or tight. 

In contrast, Fed policy is the set of conditions the Fed hopes will achieve the goals of its policy stance. Under our current floor system, policy can be the ONRRP rate, the interest on reserves rate, the pace of QE/QT, and/or any number of banking regulations and capital requirements. 

The difficulty is determining whether any discrete policy has achieved or will achieve the goals of the policy stance. It's not necessarily the case that a "historically high" fed funds rate will achieve the goals of a tight money policy stance (a slowdown in aggregate demand). Interest rates are high during hyperinflation, and no one argues that hyperinflation occurs because of tight money. Interest rates were low during the decade prior to the pandemic, and aggregate demand was weak for most of that time. 

50 basis points.

I believe this to have been the correct decision. Equity markets may vacillate between whether to sell off because the Fed sees weakness in the economy or start buying everything because of the extra "easing." 

In truth, both of those interpretations are likely incorrect. Monetary policy has become much tighter in the past three months as the neutral rate of interest has fallen. The federal funds rate needed to come down to avoid becoming overly restrictive. Thus, the Fed is neither easing nor is it responding to a weak economy. There is no dramatic shift in the central bank's policy stance. As Powell said several weeks ago, its merely an "adjustment."

I should add that if rates start falling fast, then the Fed needs to change its policy stance entirely. This would involve very large cuts to bring the fed funds rate below the neutral rate.  

"The time has come for policy to adjust." - J. Powell

Agreed. I stated back in June that it seemed we're under a stable monetary policy regime. Since that time, interest rates have fallen. As a result, monetary policy has become increasingly tight since that time...now tighter than it needs to be. To be clear, I am not arguing the Fed needs to adopt an easy monetary policy stance. But it will need to ease to maintain a neutral and stable stance. 

I think there's still opportunity for the Fed to reduce its balance sheet even if it lowers the funds rate. The Fed should take that opportunity.

Powell continues to be a grown-up in a city full of children. I would not want to live in a country that did not have democratic elections, but it's hard to deny the advantages of having people in power who are more concerned with their own competence than the need to be re-elected..

As discussed yesterday, yield curve inversions and reversions do not cause recessions. They are often correlated with recessions because it's during those swings in short term interest rates that the Fed tends to make policy mistakes. So let's discuss why the Fed makes mistakes.

The New Keynesian framework is far too dependent on interest rates. To enact a tight (loose) monetary policy, the Fed must know where the neutral market rate of interest is at a given moment, where it is likely to go, and how much higher (lower) the Fed's policy rate must be to achieve its intended policy stance. Although some of the most brilliant economists in the world work at the Fed, this proposition is still extremely difficult to do accurately on a 6-7 week basis. 

The natural rate of interest can, should, and does move around constantly. It's a price. In a market system, prices respond to market forces. Those forces can shift at any moment; they do not wait for periodic Fed meetings. Yet the Fed insists that the best way to conduct monetary policy is by setting its policy rate with respect to a market rate which is constantly changing. It's nonsense. 

Consider an example. If the neutral rate of interest is 4% and the Fed wants to conduct a tight monetary policy, it may set its policy rate at 4.5%. However, if inflation suddenly breaks out, the neutral rate might go to 5%, at which point the Fed's policy rate implies a loose monetary policy stance. The Fed, thinking that it has a tight policy, is actually contributing to making inflation worse. 

The opposite example is what happens more often, where the Fed responds to a falling neutral rate by cutting interest rates (which it should do), but the Fed does not cut fast or far enough, and the policy actually becomes tighter as the neutral rate continues to fall.

Even if the Fed could know where the policy rate should be relative to the neutral rate or inflation (such as a Taylor Rule), the Fed's inability to accurately identify these variables and respond in real time precludes it from getting the job done.

The next posts are going to be longer posts but I've been meaning to write them for a while. I need to write them now because if the Fed fails its soft landing, there will be so many bad arguments attempting to explain the failure that will need to be answered sufficiently. 

Yield curve inversion is everyone's favorite recession indicator. And there's a reason why: its track record is impressive. But we should be really clear about what an inverted yield curve actually means and whether the inversion itself is the correct indicator.

Under a stable monetary policy, longer term bonds bear a higher yield called the "term premium." Investors require a greater return to forego cash for a longer time period. However, under an unstable monetary policy, all sorts of things can happen as investors react to changes to current and expected aggregate demand. If investors anticipate higher (lower) inflation or productivity in the short run, but not over a long period of time,  the shorter end of the yield curve may increase (decrease) without a significant change in the longer end. Alternatively, if the Treasury tries unloading a greater supply of shorter (longer) term bonds than the market demands, yields on the shorter (longer) end may rise. There is nothing about any of these changes in yields which necessitates a recession. 

Enter the Federal Reserve. 

Contrary to what many people believe or assert, the Fed cannot arbitrarily set interest rates wherever it wants. The Fed determines its policy stance (loose, tight, neutral) and then sets its policy as appropriate in relation to what it believes to be the neutral market interest rate. It is the market which determines the real rate, and then the Fed adjusts to the market. It's true that Fed actions (whether current or future) influence market decisions, but in general, the Fed is responding to its interpretation of real market conditions, not the other way around. 

When the economy is running "hot," ("cold") the Fed attempts to take a tighter (looser) monetary poicy stance.  This means the Fed will set its policy rate above (below) the neutral market rate. This is not my ideal monetary policy regime, but it's the one we have. 

When the yield curve inverts, there is often an attempt by the Fed to push back against the rise in short term yields. Remember that higher interest rates are generally a sign that money has been too loose. So the Fed tightens. The issue is that the Fed, more often than not, gets it wrong. If the Fed tightens too much, it can kill prospective economic activity. This causes the neutral interest rate to fall. If the Fed policy rate does not fall a commensurate amount, then Fed policy becomes tighter at exactly the moment it needs to ease.

It's no secret that recessions occur due to a lack of aggregate demand (NGDP growth). It's a tautology. Falling aggregate demand means there is not enough money for people to both save and spend at the level necessary to maintain current real levels of income. We know nominal incomes don't fall smoothly - people get laid off more often than their paychecks are reduced. Thus, the central bank must do everything it can to reduce real levels of income by generating the money required to do so. 

The Great Depression and the Great Recession were both caused by the Fed. The neutral market rate was falling fast and monetary base growth had slowed extraordinarily. In both cases, the Fed's failure to act caused monetary policy to be absurdly tight. In both cases, that tightness occurred after the yield curve had already re-verted. Some market participants call this reversion a "bear steepening" when there's a contemporaneous sell-off in equities markets

Neither the original inversion nor the bear steepening have anything to do with causing recessions. The inversion and reversion are simply moments in time where the Fed has a great potential for a policy mistake. I personally believe the bear steepening creates the highest likelihood for a mistake, because interest rates typically fall faster than they rise. If the Fed's tightness causes a drop in aggregate demand, the Fed must be prepared to act swiftly to ensure the public can obtain the money it needs. 

In the last post, I referenced the projection for Q2 RGDP at 2% based on the Atlanta Fed's GDPNow. Since that time, the GDPNow projection moved upward to 2.6%. Today, the official print is 2.8%. 

GDPNow has proven itself to be a very useful tool - better than the blue chip forecasters. Anyone following GDPNow has not been surprised by the strength of aggregate demand. 

I do think things are normalizing from the negative and positive supply shocks over the past 3 years. I have been surprised that Treasury rates are as low as they are considering the growth and sticky inflation, but recent evidence indicates that low demand for bank loans has caused banks to act in ways that are supportive of the Treasury market. 

Monetary base growth, while still positive, has slowed from February of this year. We're still about $400B away from zeroing out the ONRRP facility, which I believe to be correlated with the amount of excess reserves in the banking system. If the banks are hungry for Treasuries, the Fed should feed them with QT until the ONRRP is drained. 

Today's CPI print is what we should have been getting a year ago. Disinflation stopped around June-July of 2023 and we've been bouncing around 3.3% YOY inflation since that time.

There is no reason disinflation should have stopped. Inflation should have continued to fall. In fact, the Fed should have allowed inflation to go below its 2% target as we have been undergoing a positive supply shock due to increased productivity. It's the Fed's job to see through supply shocks, whether negative or positive. 

The proof is in the pudding, and a sufficiently restrictive monetary policy combined with a positive supply shock should have resulted in continued declines in the rate of inflation. Unfortunately, monetary policy hasn't been sufficiently restrictive. It should be noted that the pause in disinflation correlates with an increasing monetary base. Why is the monetary base increasing at all - especially with increasing velocity?

The current projection for Q2 RGDP is 2%. We're likely going to get sub-5% NGDP. This is good result, but it's come way too late. The Fed is far too backward looking.

Haven't posted in a while; haven't had much to say. That's because it seems we're under a stable monetary policy regime. I still think the Fed is about 15-25 basis points below where it needs to be, but things definitely seem a lot softer than they were a couple months ago. 

Update to the last post...NGDP growth came in a compounded annual rate of 4.8% which is a decrease from the prior quarter. Real GDP was around 1.6%. This was a surprise to the downside...the first one in a while. I'm still trying to figure out why this figure was so much lower than anticipated - GDPNow had GDP at 2.7%. I wouldn't be surprised if we have some upward revisions. 

Today's release of personal incomes and outlays has resulted in a GDPNow prediction for the Q2 at 3.9%. Obviously, this should be taken with a grain of salt, but it appears income and spending growth remain strong. Inflation seems resilient. 

Not sure what to make of all of this. The Treasury keeps spending, so unless something changes, it's possible that both stocks and bond yields continue to go up. 

Q1 GDP release is in one week. 

NGDP growth should be sub 5%. 

If it comes in over 5.5% (which looks very likely), the Fed is failing. 

Another surprisingly hot inflation report that should have surprised no one. 

Rising velocity, rising monetary base, rising asset prices, rising wages, rising oil prices and rising Treasury issuance.

In my opinion, the only reason inflation is as low as 3.8% is because of the productivity boom.  It's possible that we are experiencing a positive supply shock with continued excess money creation. I love the idea that the ONRRP roughly measures the amount of that excess. As a result, we would need to see a complete drain of the RRP facility before we get to a truly restrictive monetary policy. The rate of drain has slowed as Treasury yields have gone down since their October highs. If yields go back up, the speed of ONRRP drain could pick up again. The rate of drain was about $400B per month with 2-year Treasuries over 5%.

[UPDATE]: today's Treasury auction was a gigantic whiff. Tail over 3 basis points. Very low demand. Rates need to move higher.

I still don't quite understand why we're talking about rate cuts. How many are priced in? Why?

Milton Friedman had many a brilliant insight. He is credited with the idea that monetary policy works with "long and variable lags." Those advocating for cuts often argue that the Fed does not need to wait for weakness before cutting because it will be too late. They appeal to the lag time as support for their argument. But we need to recognize the differences between the Fed of the Friedman era and the current Fed, in both policy framework and operating procedure. 

The current Fed provides significant forward guidance. I was not alive in the 60s-80s, but it seems to me that there is significantly more focus on the Fed now than there was 50 years ago. The Fed's mere words have a lot of power, which is a point Krugman famously made in his 1998 paper on Japan. Market rates and attitudes can change instantly if Powell says something unexpected. These are real changes, and the Fed does not actually have to change anything. ***Obviously, if they don't keep their promises over time the Fed loses credibility, which hampers the effectiveness of forward guidance. But the point remains that a credible central bank can conduct monetary policy without actually doing anything concrete. This may be more true now than ever.

Furthermore, Friedman was speaking at a time when a change in the Fed's policy rate was caused by changes to the Fed's balance sheet. The Fed targeted the market price of base money by managing its supply. When the Fed wanted to raise rates, it decreased the supply of base money. Now, the Fed's policy rate is changed by fiat and alterations to the Fed's balance sheet are not intended to (and for the most part, don't) affect that rate. What this means is that, all things equal, the supply of base money increases when the Fed raises rates. 

When people advocate for rate cuts, what precisely are they asking for? Cheaper credit? Because at this point, there's no lack of liquidity, no excess private debt (except maybe credit cards), and no weakness in employment data. The economy seems to be doing just fine where things are. 

The recent "team transitory" victory lap has been so strange. If you believed inflation was transitory, the Fed should have done nothing, which it is precisely what happened in 2021. Except, we continued to experience higher and higher inflation. It did not come down on its own during that time. 

Then, from March of 2022 to August of 2023, the Fed increased its policy rate from 0% to 5%, faster than ever. Inflation came down.

You might say that inflation would have come down despite what the Fed did. This is only correct if the inflation were purely due to a negative supply shock. The problem is we don't have access to that counterfactual. Instead, it appears inflation responded to monetary policy in the exact way Fed officials wanted (although not the way I would have wanted).

The problem with team transitory's argument is that if inflation were due solely (or even almost solely) to a negative supply shock, then we would expect a period of roughly 0% inflation as prices returned to baseline. The problem is that the PCE is up over 16% during the last four years.  If your goal is an average of 2% annual inflation, then (ignoring compounding), 8% of that inflation must have been due to excess demand. 

Increased coupon issuance plus continued QT means the private sector is going to have to absorb more longer-term Treasuries than it may want to hold at current prices. Barring some real increase in demand for those securities, expect yields to rise...perhaps back to where they were in the fall of 2023. 

It's very clear the market wants/expects the Fed to cut rates early this year. Surveys seem to think the most likely scenario is March. It's possible the Fed cuts in March, but I don't believe it will unless something materially changes. Why?

3.1% RGDP growth last quarter indicates the economy is going strong in the face of a federal funds target that has not changed since August. Stronger real growth can result in higher real interest rates. Higher real rates against any given Federal Funds rate means the policy stance is becoming more accommodative. In other words, the increase in real rates can have the same effect as a cut by the Fed. 

There is an argument that the Fed's policy is too restrictive given the softening of the labor market. This may be true, but the labor market isn't so soft that it requires a pivot in the policy stance. 

There are only two questions the Fed need ever ask:

1. How will our action (or inaction) affect the supply and demand for base money?

2. How will that new equilibrium affect NGDP growth?

"Banks don't lend out their reserves."

This statement highlights the difference between bad and good economic thinking.  As Bastiat pointed out, bad economists reasons only from what is seen; good economists reason from not only what is seen, but what is unseen.  

When an economist talks about banks "lending out" their reserves, they are almost never speaking literally. No one is under the impression that bankers go check their vaults and reserve accounts before making an individual loan. Instead, the economist is using short hand to describe the way in which increases in reserves affect lending. The economist understands this relationship because he sees "what is unseen."

There are a multitude of factors affecting the supply and demand for credit. Banks (like all firms) try to arrange their assets and liabilities in such a way that they generate the highest return for shareholders. The central bank can directly affect a bank's marginal return on assets (abundant reserves) and its marginal cost of capital (scarce reserves) via monetary policy. To say these changes do not, in aggregate, affect lending is wrong.

Some folks think higher interest rates are stimulative and/or inflationary. The reasoning is that higher interest rates equal higher interest payments on reserves/Treasuries. It is a popular belief among the MMT or post-Keynesian crowd.

"Higher" interest rates don't tell us anything. It's reasoning from a price change. 

The question is whether the stance of monetary policy is loose or tight. Just because the Fed says it's braking doesn't mean the car is slowing down. Conversely, even if you believe the Fed is pressing the accelerator, it doesn't mean the car is speeding up. 

Velocity has been rising at the same time as the nominal quantity of base money. When that happens, the only possible result is an expansion of the economy, inflation, or both. 

I have yet to be convinced that LLMs are going to impact the legal profession in a positive way. 

GPT 4 is awful at any sort of legal analysis relevant to litigation. It gets easy things wrong way too often. The "even-handed" bias is unhelpful. Sometimes there are right answers. 

"But what about analyzing and/or summarizing massive amounts of documents?" Maybe. But sometimes you don't know what you're looking for until you've found it. How do you identify the needle in the haystack when you don't know what the needle is? 

Q3 real GDP revised upward to 5.2%. 

Tight money when?

I continue to see and hear questions asking why home prices have not come down significantly in the face of high mortgage rates. 

The answer is simple. Mortgage rates are the wrong metric.***

Interest rates (including mortgage rates) affect both the supply and demand for home sales. Thus, you may have a situation where the equilibrium price is not affected if both supply and demand fall by a commensurate amount. 

Prices are determined at the margin. For prices to fall, you need the marginal buyer to be unwilling to pay at the current price and the marginal seller to accept a lower price. As long as more people want houses than are available, it will be tough for prices to come down. My opinion is that we'll need a massive amount of forced selling before prices meaningfully move. 

*** As an aside, When people say mortgage rates are high, they almost always mean compared to rates over the past 20 years....especially compared to rates 2-3 years ago. That definition of "high" is meaningless in terms of its affect on current home prices. 

One interesting dynamic to watch is the interplay between the overnight reverse repurchase (ONRRP) facility and the Treasury market. The ONRRP facility was mostly was created to solve the "leaks" in the floor system created by QE. As such, the rate at which the Fed pays participants in the facility is close to (10 basis points below) the Fed's policy rate.  

In the Spring of 2021, the ONRRP saw massive inflows, mostly from money market funds (MMFs). This mechanically resulted in fewer deposits and reserves in the banking system.

However, since yields on Treasury bills rose above the expected path of Fed policy, a lot of money has been moved out of the ONRRP. When investors buy Treasuries instead of using the ONRRP, the money moves into the Treasury General Account, where it is inevitably spent back into the banking system, increasing both reserves and deposits.

The additional liquidity in the banking system may result in easing while the Fed tries to keep the lid on inflation. 

Projections for the 2024 fiscal year deficit are around $1.8 trillion. Quantitative tightening means the private sector will also be saddled with an additional $700 billion to fund SOMA redemptions. How is the U.S. Treasury going to convince investors to absorb ~$2.5 Trillion dollars in debt issuance?

It seems the Treasury is poised to increase bill issuance relative to coupons, but will still need to increase coupon issuance to historically high levels. No matter how the Treasury manages the maturity structure, the private sector will need to come to grips with increased issuance. This may result in much higher rates if something else (e.g. a recession) doesn't cause an increase in demand for U.S. debt.

Equities rallied and bond yields took a dive after the Fed decision to keep rates steady in the face of 8.5% NGDP growth. If the previous increase in bond yields was considered part of a "tightening" of financial conditions, would the more recent decrease in yields suggest a loosening?  If we're using the logic of the Fed Governors, then yes. If we're using sound economic reasoning, then the answer is: who knows? It certainly seems the market is interpreting the Fed's decision as a loosening of policy. 

My prediction was that Q3 NGDP would come in hot. 

Today's print was 8.5%. 

That's hot. 

In the Q&A today, Fed Chair Powell was asked why longer term yields have risen. He rightfully stated there are many "candidate reasons," including expectations of a stronger economy, heightened focus on fiscal deficits, QT, and the reduced demand for bonds relative to other investments.

Powell also characterized these higher long term rates as a tightening of financial conditions. However, it's important to distinguish between cause and effect. Higher rates can indeed result in tighter financial conditions without being caused by tighter financial conditions. However, if higher rates do not actually slow economic growth, then there has been no tightening. In that situation, if the Fed does nothing, the stance of policy will become looser. 

The UAW strike is one of the most well-executed strikes in my lifetime. The WGA strike, for all the mediat coverage it received, is one of the worst. 

WGA demanded pay increases over the next three years of 6%, 5%, 5%. They got 5%, 4% and 3.5%. Keep in mind that since January 2020, inflation has totaled approximately 19%. Since that time, WGA members have experienced only a 7.5% increase in pay. That means that, to keep pace with inflation, the year one demand had to be at least 11.5%. 

Meanwhile, the UAW rejected an offer including a 20% pay increase and has demanded 40%.

Auction of 30 year bonds took place today.

Demand was lackluster. 18.7% of the offering was purchased by the primary dealers. The median yield was 4.74%. An hour later, the market rate was 13 basis points higher and climbing. The dollar soared.

As discussed yesterday, there are many reasons bond yields change. If higher yields are due to an increase in the natural rate of interest, the Fed needs to increase the policy rate by a commensurate amount or the stance of policy will effectively loosen. 

Of course, this whole issue highlights the problems with relying on interest rates as both an indicator of monetary policy and the primary tool through which policy is conducted.  

San Francisco Fed President Mary Daly described the recent rise in bond yields as "tightening" by the bond market. She then described this tightening as equivalent to a rate hike by the Federal Reserve, and suggested the Fed may not have raise rates further in the short term. There are so many things wrong with Daly's position it's hard to know where to begin. 

First, bond yields can move higher due to many reasons that have nothing to do with tightening financial conditions. For example, bond yields may move higher in anticipation of greater future inflation. Yields can move up in response to greater economic growth and returns to capital. Alternatively, bond yields may move higher due to a perceived increase in the credit risk of the bond's issuer. None of these situations necessarily imply that financial conditions are tight or tightening. 

Second, if market interest rates are rising, but the Fed does nothing, then the stance of monetary policy becomes looser, ceteris paribus. Under a Keynesian framework, a tight monetary policy means the Fed's policy rate must exceed the natural rate. If the natural rate continues to rise above the policy rate, the Fed is doing the opposite of tightening. 

I don't know whether monetary policy is too tight or too lose right now. My gut is that it's been too loose; predictions are Q3 NGDP comes in hot. But one thing is for sure: policy is not necessarily getting tighter just because of an increase in bond yields.