The Fed certainly has them, but has historically failed to exercise them in a prudent manner. There's a solid argument to be made that if they had done so during the early 2000s, the GFC of 2008 would have been much milder, and things have only gotten worse since then. Before 2008, we had a clean separation between commercial banks and investment banks. That's no longer the case. We "rescued" some of the investment banks by allowing them to merge with commercial banks, while others were allowed to declare themselves "bank holding companies", when by all rights, their investors should have been wiped out. This creates a great deal of moral hazard. Investors get the idea that no matter how imprudently these companies act, the Fed and Treasury will always bail them out. But this is not new; the precedent was set in 1987 with the bailout of Continental Illinois. It's almost like the Fed doesn't really want to engage in prudent regulation of the financial industry. If they were the FDA, I'd say we've got prime example of regulator capture. But the Fed isn't a government agency, the Fed is literally owned by the industry it's supposed to regulate, so expecting them to regulate it in a sensible manner may not be entirely realistic. Now even if they were willing (i.e. if we gave you absolute power over Fed policy), I think it's more than a few years too late to for the Fed to use their regulatory powers to restore sanity and safety back to the financial markets.
You fight with the army you have, not with the army you want.
I'm not going to make any rationalizations or defenses for how the Fed has (mis)managed both monetary policy and financial regulation going back to the Greenspan era. The Fed has screwed the pooch more times than I care to count.
But these are the tools that the Fed has today. While they should have been used all along, they are tools the Fed can use today.
This much I believe is certain: as interest rates rise, derivatives such as the LDI products that have been popular in the UK as a hedge against risk will quickly become the risk, rather than the hedge. If nothing is done, there will come a point where a cascade of margin calls and/or defaults will trigger a liquidity crisis, and a number of investment funds and possibly even banks will face insolvency.
If hedge funds go broke I'm disinclined to be sympathetic. But as Quoth The Raven points out, the derivative exposure of UK pension plans is potentially the same exposure for US pension funds. If pension funds, 401(k) funds, and related investment entities are pushed into insolvency, the collateral damage among people with no real interest in the shenanigans of Wall Street will be extreme. If I had the magic wand, I'd want to prevent that.
The way to avoid that mass insolvency is to get in front of the margin calls, and use a regulatory cudgel (and I'd use any one available, given the circumstances) to start the process of unwinding derivative positions that are likely to suffer from rate hikes.
This was the piece of the puzzle Bernanke missed in 2005. When he pushed up interest rates to "cool" the subprime mortgage market, he priced a lot of subprime borrowers out of the market. Not only did that trigger a series of defaults when subprime borrowers could no longer refinance their ARMs, but it choked off the supply of mortgages which was feeding the derivatives market.
Had not just the Fed but the rest of the financial regulatory apparatus taken a more nuanced approach in 2005, and instead of just unilaterally raising rates to kill a market (which was Bernanke's stated intention at the time), proper scrutiny and regulatory enforcement were brought to bear on the subprime mortgage market AND the generation of derivative MBS products that market was feeding, to where unstable positions could be identified and unwound before they became a problem (the data was there, but no one was interested in looking at it, except for a few short sellers like Michael Burry), the 2008 GFC would never have happened. It was an entirely preventable crisis.
One of the ways a liquidity crisis gets generated is when you have a market where everyone is buying that suddenly reverses into a market where everyone is selling. The liquidity crisis is not necessarily a lack of available dollars--in many respects it is a lack of available buyers. This was the tipping point that spurred the BoE to take the action it did a few weeks ago. There was a period where for about half a day there literally were no buyers of long term gilts--and allowing that to continue would have been disastrous for pension plans trying to sell assets to cover margin calls
(derivatives are still weapons of mass financial destruction)
"Ultimately, interest rate hikes should reflect not rises in the Consumer Price Index but the recent rises in the velocity of money."
I think we diverge here. When interest rates are lower than the rate of inflation in consumer and producer prices, the time-value of money is negative, which is bound to cause all manner of mal-investment. Rather than watch their money shrink in value, people will seek something, anything that at appears to have the potential to stay even with inflation or appreciate in value. Stocks, real estate, PMs, or whatever. This causes asset price inflation. Bigger outfits who are able to will use leverage and derivatives to accomplish this, but doing that places them in considerable danger should conditions change. And conditions are indeed changing. Look at the TNX chart you linked to back to the early 1980s (40 years back) and draw some trend lines:
That chart reminds me very much of one I made of stock prices during the first quarter of 2009. When the channel they were in finally broke in March, we were clearly at an infection point, and I think we've reached one now in interest rates.
This is one of the charts that keeps coming back to the forefront when I look at inflation. A steady easing of money, according to theory, is supposed to generate inflation, and that didn't happen. Even if you look at ShadowStats alternative inflation metrics (which is impossible to present in a proper analysis because the data set is proprietary), the decline in interest rates is not a consistent inflationary impulse.
Now here's that same chart pushed back a decade to 1967.
Notice how in the late 60s and 70s inflation and interest rates were more closely correlated even before Volcker's rate hikes? (side note: Arthur Burns probably deserves far more credit for his monetary policy in the 70s than he typically gets).
Now here's that same chart zeroed in from 2017 forward to today.
Inflation and interest rates stopped being closely correlated in February 2021: inflation as measured by the CPI took off, interest rates did not.
The reality of inflation in 2022 is that, ironically enough, this time really IS different. The dynamics and relationships we consider to be the historical norms are simply not in effect at this time. The "why" of that is an extremely good question, and I am nowhere near having a plausible answer for it.
But this much seems clear: as the dynamics have changed, so must the policy. The Volcker playbook (flawed as it was, since the data indicates Volcker pushed rates higher than necessary longer than necessary) is not going to have the anticipated effects. And if I'm right about the supply shocks, applying Volcker-style rate hikes will do more harm than good, with the effects lasting for years.
There is a signature distinction between today and the Volcker Recession: Yields are not keeping pace with inflation. Even before Volcker raised interest rates in 1979, as inflation went up, so did yields. Not today.
While prices began rising post-lockdown in 2021, the major increases didn't happen until earlier this year. If you look at money velocity, it's in Q1 of this year that M1V begins to rise (it had been practically nonexistent after the massive money print of 2020).
Thus we have a situation with inflation that you do have a genuine inflationary impulse from all the money printing AND a non-monetary price rise due to supply chain disruptions and all the ripple effects of the 2020 lockdowns. Interest rate hikes will tame inflation from excess money but do nothing to address price rises from ruptured supply chains. Even worse, squelching labor demand and investment by excessively high interest rates (explicitly stated goals of the Federal Reserve) will actually slow the process of repairing/regenerating the supply chains.
If rates are calibrated to money velocity, the inflationary impact of the outrageously expanded money supply is targeted as that impact rises--remember, the equation is MV=PQ, and it takes both a supply of money AND velocity for that money to generate inflation. The reason there was no ginormous spike in inflation post 2008, or even immediately after 2020,is because the velocity of money dropped as the money supply expanded--the increase in the one variable was negated by the decrease in the other.
Thus the inflationary impulse arises as money velocity rises. Calibrate rate hikes to the rising money velocity and you target the inflationary impulse directly.
There is an example we may yet see of how this time around is different. One of the railroad unions rejected the proposed contract with the railroads, and if negotiations break down again sometime either late this year or early next there could be a nationwide railroad strike. That disruption of rail transport will have tremendous impacts on prices for just about everything, as the cost of getting goods from point A to point B will skyrocket. Yet that price increase would happen REGARDLESS of the amount of money circulating. This is the difference between a supply shock and inflation from too much money in circulation: if one is arguing a strict monetarist view of economics, one could even go so far as to say that the resulting price increases are not "inflation", but a sudden shift in the relative values of various goods and services.
That distinction is, of course, not one that the average consumer is going to really care about--what consumers see is rising prices, and of course they don't like that. But blanket interest rate hikes in the face of a supply shock merely suppresses demand, it doesn't restore prior relative pricing valuations. Instead of people paying more for something, a number of consumers simply don't buy at all.
However, if prices are high because of broken supply chains from China, if they stay high due to Zero COVID preventing the Chinese from restoring those supply chains then the price pressure will incentivize reshoring (right now labor in Mexico is more competitive than labor in China, and even if the manufacturing didn't return to within the US but merely to North America, the boost in employment south of the border would still be a net economic gain for the US). You actually WANT those high prices to drive that reshoring, and let the rebuilt localized supply chains bring prices down organically. Suppressing demand by interest rate hikes slows that reshoring process down and thus makes the supply chain problem worse not better.
I suppose you're correct in saying that some of the current inflation is due to exogenous factors and thus isn't entirely the Fed's fault, but enabling our government to "borrow" $6T more during the "pandemic" via continued ZIRP was certainly a contributing factor. The classic cause of price inflation is "too much money chasing too few goods." Certainly there's a shortage of certain types of goods, but there's also an awful lot of cash in the system. Ask any real estate agent what percentage of transactions that have been all-cash over the last two year and they'll tell you it's at an all-time high. Where did all that cash come from? Could it be the "easy money" policies that the Fed has pursued for 20+ years, and that they double-down starting in the spring of 2020? ;)
Even Volcker said that monetary policy alone was an inadequate tool for containing consumer prices and inflation, that fiscal policy was a necessary adjunct.
History suggests he was right in both directions. It took bad monetary policy and bad fiscal policy to bring us to where we are, and ultimately the fix is we need good monetary policy and good fiscal policy to undo the damage.
Unfortunately, if we're lucky we might get a "less bad" monetary policy but still be stuck with a craptacular fiscal policy. And that's the case no matter what the outcomes of either the midterms elections this year or the 2024 elections are.
I can't find the exact reference, but I seem to recall that shortly after the recovery from the GFC began, Bernanke was asked how long the Fed would be able to assist the FedGov in sustaining the massive spending increases it had undertaken. His reply was something to the effect of "Maybe ten years and by then you'd better get your house in order". Instead, the FedGov has made things worse; in fact, much, much worse during the "pandemic". And of course the USA's government was by no means the only one that did that.
I think I recall that quote. I'll have to see if I can find it.
The BoE was even more blunt last week when the end of their temporary intervention drew near. The markets were told "you have three days". ZeroHedge had a field day with that, but missed the meaning of the message.
The BoE was telling the markets to unwind these LDI derivative positions NOW, because the day of reckoning was here.
Even that seemed to not be enough warning about derivatives. Derivatives are the heroin of financial markets--once buyers get hooked on them, nothing gets them off until they're in the ER being pumped full of bailout Narcan to deal with their overdose.
"Regulatory powers"
The Fed certainly has them, but has historically failed to exercise them in a prudent manner. There's a solid argument to be made that if they had done so during the early 2000s, the GFC of 2008 would have been much milder, and things have only gotten worse since then. Before 2008, we had a clean separation between commercial banks and investment banks. That's no longer the case. We "rescued" some of the investment banks by allowing them to merge with commercial banks, while others were allowed to declare themselves "bank holding companies", when by all rights, their investors should have been wiped out. This creates a great deal of moral hazard. Investors get the idea that no matter how imprudently these companies act, the Fed and Treasury will always bail them out. But this is not new; the precedent was set in 1987 with the bailout of Continental Illinois. It's almost like the Fed doesn't really want to engage in prudent regulation of the financial industry. If they were the FDA, I'd say we've got prime example of regulator capture. But the Fed isn't a government agency, the Fed is literally owned by the industry it's supposed to regulate, so expecting them to regulate it in a sensible manner may not be entirely realistic. Now even if they were willing (i.e. if we gave you absolute power over Fed policy), I think it's more than a few years too late to for the Fed to use their regulatory powers to restore sanity and safety back to the financial markets.
You fight with the army you have, not with the army you want.
I'm not going to make any rationalizations or defenses for how the Fed has (mis)managed both monetary policy and financial regulation going back to the Greenspan era. The Fed has screwed the pooch more times than I care to count.
But these are the tools that the Fed has today. While they should have been used all along, they are tools the Fed can use today.
This much I believe is certain: as interest rates rise, derivatives such as the LDI products that have been popular in the UK as a hedge against risk will quickly become the risk, rather than the hedge. If nothing is done, there will come a point where a cascade of margin calls and/or defaults will trigger a liquidity crisis, and a number of investment funds and possibly even banks will face insolvency.
If hedge funds go broke I'm disinclined to be sympathetic. But as Quoth The Raven points out, the derivative exposure of UK pension plans is potentially the same exposure for US pension funds. If pension funds, 401(k) funds, and related investment entities are pushed into insolvency, the collateral damage among people with no real interest in the shenanigans of Wall Street will be extreme. If I had the magic wand, I'd want to prevent that.
The way to avoid that mass insolvency is to get in front of the margin calls, and use a regulatory cudgel (and I'd use any one available, given the circumstances) to start the process of unwinding derivative positions that are likely to suffer from rate hikes.
This was the piece of the puzzle Bernanke missed in 2005. When he pushed up interest rates to "cool" the subprime mortgage market, he priced a lot of subprime borrowers out of the market. Not only did that trigger a series of defaults when subprime borrowers could no longer refinance their ARMs, but it choked off the supply of mortgages which was feeding the derivatives market.
Had not just the Fed but the rest of the financial regulatory apparatus taken a more nuanced approach in 2005, and instead of just unilaterally raising rates to kill a market (which was Bernanke's stated intention at the time), proper scrutiny and regulatory enforcement were brought to bear on the subprime mortgage market AND the generation of derivative MBS products that market was feeding, to where unstable positions could be identified and unwound before they became a problem (the data was there, but no one was interested in looking at it, except for a few short sellers like Michael Burry), the 2008 GFC would never have happened. It was an entirely preventable crisis.
One of the ways a liquidity crisis gets generated is when you have a market where everyone is buying that suddenly reverses into a market where everyone is selling. The liquidity crisis is not necessarily a lack of available dollars--in many respects it is a lack of available buyers. This was the tipping point that spurred the BoE to take the action it did a few weeks ago. There was a period where for about half a day there literally were no buyers of long term gilts--and allowing that to continue would have been disastrous for pension plans trying to sell assets to cover margin calls
(derivatives are still weapons of mass financial destruction)
"Ultimately, interest rate hikes should reflect not rises in the Consumer Price Index but the recent rises in the velocity of money."
I think we diverge here. When interest rates are lower than the rate of inflation in consumer and producer prices, the time-value of money is negative, which is bound to cause all manner of mal-investment. Rather than watch their money shrink in value, people will seek something, anything that at appears to have the potential to stay even with inflation or appreciate in value. Stocks, real estate, PMs, or whatever. This causes asset price inflation. Bigger outfits who are able to will use leverage and derivatives to accomplish this, but doing that places them in considerable danger should conditions change. And conditions are indeed changing. Look at the TNX chart you linked to back to the early 1980s (40 years back) and draw some trend lines:
https://i.imgur.com/8BuCyWb.png
That chart reminds me very much of one I made of stock prices during the first quarter of 2009. When the channel they were in finally broke in March, we were clearly at an infection point, and I think we've reached one now in interest rates.
Re: the decline in interest rates over time.
Here's that same graph with YoY percent change in CPI added in, rolling from January 1 1977 onward.
https://fred.stlouisfed.org/graph/?g=Vaid
This is one of the charts that keeps coming back to the forefront when I look at inflation. A steady easing of money, according to theory, is supposed to generate inflation, and that didn't happen. Even if you look at ShadowStats alternative inflation metrics (which is impossible to present in a proper analysis because the data set is proprietary), the decline in interest rates is not a consistent inflationary impulse.
Now here's that same chart pushed back a decade to 1967.
https://fred.stlouisfed.org/graph/?g=VaiC
Notice how in the late 60s and 70s inflation and interest rates were more closely correlated even before Volcker's rate hikes? (side note: Arthur Burns probably deserves far more credit for his monetary policy in the 70s than he typically gets).
Now here's that same chart zeroed in from 2017 forward to today.
https://fred.stlouisfed.org/graph/?g=VaiO
Inflation and interest rates stopped being closely correlated in February 2021: inflation as measured by the CPI took off, interest rates did not.
The reality of inflation in 2022 is that, ironically enough, this time really IS different. The dynamics and relationships we consider to be the historical norms are simply not in effect at this time. The "why" of that is an extremely good question, and I am nowhere near having a plausible answer for it.
But this much seems clear: as the dynamics have changed, so must the policy. The Volcker playbook (flawed as it was, since the data indicates Volcker pushed rates higher than necessary longer than necessary) is not going to have the anticipated effects. And if I'm right about the supply shocks, applying Volcker-style rate hikes will do more harm than good, with the effects lasting for years.
There is a signature distinction between today and the Volcker Recession: Yields are not keeping pace with inflation. Even before Volcker raised interest rates in 1979, as inflation went up, so did yields. Not today.
While prices began rising post-lockdown in 2021, the major increases didn't happen until earlier this year. If you look at money velocity, it's in Q1 of this year that M1V begins to rise (it had been practically nonexistent after the massive money print of 2020).
Thus we have a situation with inflation that you do have a genuine inflationary impulse from all the money printing AND a non-monetary price rise due to supply chain disruptions and all the ripple effects of the 2020 lockdowns. Interest rate hikes will tame inflation from excess money but do nothing to address price rises from ruptured supply chains. Even worse, squelching labor demand and investment by excessively high interest rates (explicitly stated goals of the Federal Reserve) will actually slow the process of repairing/regenerating the supply chains.
If rates are calibrated to money velocity, the inflationary impact of the outrageously expanded money supply is targeted as that impact rises--remember, the equation is MV=PQ, and it takes both a supply of money AND velocity for that money to generate inflation. The reason there was no ginormous spike in inflation post 2008, or even immediately after 2020,is because the velocity of money dropped as the money supply expanded--the increase in the one variable was negated by the decrease in the other.
Thus the inflationary impulse arises as money velocity rises. Calibrate rate hikes to the rising money velocity and you target the inflationary impulse directly.
There is an example we may yet see of how this time around is different. One of the railroad unions rejected the proposed contract with the railroads, and if negotiations break down again sometime either late this year or early next there could be a nationwide railroad strike. That disruption of rail transport will have tremendous impacts on prices for just about everything, as the cost of getting goods from point A to point B will skyrocket. Yet that price increase would happen REGARDLESS of the amount of money circulating. This is the difference between a supply shock and inflation from too much money in circulation: if one is arguing a strict monetarist view of economics, one could even go so far as to say that the resulting price increases are not "inflation", but a sudden shift in the relative values of various goods and services.
That distinction is, of course, not one that the average consumer is going to really care about--what consumers see is rising prices, and of course they don't like that. But blanket interest rate hikes in the face of a supply shock merely suppresses demand, it doesn't restore prior relative pricing valuations. Instead of people paying more for something, a number of consumers simply don't buy at all.
However, if prices are high because of broken supply chains from China, if they stay high due to Zero COVID preventing the Chinese from restoring those supply chains then the price pressure will incentivize reshoring (right now labor in Mexico is more competitive than labor in China, and even if the manufacturing didn't return to within the US but merely to North America, the boost in employment south of the border would still be a net economic gain for the US). You actually WANT those high prices to drive that reshoring, and let the rebuilt localized supply chains bring prices down organically. Suppressing demand by interest rate hikes slows that reshoring process down and thus makes the supply chain problem worse not better.
I suppose you're correct in saying that some of the current inflation is due to exogenous factors and thus isn't entirely the Fed's fault, but enabling our government to "borrow" $6T more during the "pandemic" via continued ZIRP was certainly a contributing factor. The classic cause of price inflation is "too much money chasing too few goods." Certainly there's a shortage of certain types of goods, but there's also an awful lot of cash in the system. Ask any real estate agent what percentage of transactions that have been all-cash over the last two year and they'll tell you it's at an all-time high. Where did all that cash come from? Could it be the "easy money" policies that the Fed has pursued for 20+ years, and that they double-down starting in the spring of 2020? ;)
Even Volcker said that monetary policy alone was an inadequate tool for containing consumer prices and inflation, that fiscal policy was a necessary adjunct.
History suggests he was right in both directions. It took bad monetary policy and bad fiscal policy to bring us to where we are, and ultimately the fix is we need good monetary policy and good fiscal policy to undo the damage.
Unfortunately, if we're lucky we might get a "less bad" monetary policy but still be stuck with a craptacular fiscal policy. And that's the case no matter what the outcomes of either the midterms elections this year or the 2024 elections are.
I can't find the exact reference, but I seem to recall that shortly after the recovery from the GFC began, Bernanke was asked how long the Fed would be able to assist the FedGov in sustaining the massive spending increases it had undertaken. His reply was something to the effect of "Maybe ten years and by then you'd better get your house in order". Instead, the FedGov has made things worse; in fact, much, much worse during the "pandemic". And of course the USA's government was by no means the only one that did that.
I think I recall that quote. I'll have to see if I can find it.
The BoE was even more blunt last week when the end of their temporary intervention drew near. The markets were told "you have three days". ZeroHedge had a field day with that, but missed the meaning of the message.
The BoE was telling the markets to unwind these LDI derivative positions NOW, because the day of reckoning was here.
Even that seemed to not be enough warning about derivatives. Derivatives are the heroin of financial markets--once buyers get hooked on them, nothing gets them off until they're in the ER being pumped full of bailout Narcan to deal with their overdose.