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The Fed’s Monetary Tantrum Will Push The Economy Into Outright Deflation

By Mauldin Economics. Originally published at ValueWalk.

It is increasingly evident that the US economy is not taking off like some predicted after the election.

President Trump and the Republicans haven’t passed any of the fiscal stimulus measures we hoped to see. Banks and energy companies have got some regulatory relief, and that helps. But it’s a far cry from the sweeping healthcare reform, tax cuts, and infrastructure spending we were promised.

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Federal Reserve Jeffery Lacker
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Serious, major tax reform could postpone a US recession to well beyond 2020, but what we are going to get instead is tinkering around the edges.

On the bright side, unemployment has fallen further, and discouraged workers are re-entering the labor force. But consumer spending is still weak, so people may be less confident than the sentiment surveys suggest.

Inflation has perked up in certain segments like healthcare and housing, but otherwise it’s still low to nonexistent.

Is this, by any stretch of the imagination, the kind of economy in which the Federal Reserve should be tightening monetary policy? No—yet the Fed is doing so.

Making Up for Past Mistakes

It’s partly because they waited too long to end QE and to begin reducing their balance sheet.

FOMC members know they are behind the curve, and they want to pay lip service to doing something before their terms end. Plus, Janet Yellen, Stanley Fischer, and the other FOMC members are religiously devoted to the Phillips curve.

That theory says unemployment this low will create wage-inflation pressure. That no one can see this pressure mounting seems not to matter: It exists in theory and so must be countered.

The attitude among central bankers, who are basically all Keynesians, is that messy reality should not impinge on elegant theory. You just have to glance at the math to recognize the brilliance of the Phillips curve!

It was Winston Churchill who said, “However beautiful the strategy, you should occasionally look at the results.” Fact is, the lack of wage growth among the bottom 70–80% of workers (the Unprotected class) constitutes a real weakness in the US economy.

If you are a service worker, competition for your job has kept wages down.

It Will Backfire in a Big Way

The risk here is that the Fed will tighten too much, too soon.

We know from recent FOMC minutes that some members have turned hawkish in part because they wanted to offset expected fiscal stimulus from the incoming administration. That stimulus has not been coming, but the FOMC is still acting as if it will be.

What happens when the Fed raises interest rates in the early, uncertain stages of a recession instead of lowering them? I’m not sure we have any historical examples to review. Logic suggests the Fed will curb any inflation pressure that exists and push the economy into outright deflation.

Deflation in an economy as debt-burdened as ours is could be catastrophic.

We would have to repay debt with cash that is gaining purchasing power instead of losing it to inflation. Americans have not seen this happen since the 1930s. It wasn’t fun then, and it would be even less fun now.

Worse, I doubt Trump’s FOMC appointees will make a difference. Trump appears to be far more interested in reducing the Fed’s regulatory role than he is in tweaking its monetary policies.

Let me make an uncomfortable prediction: I think the Trump Fed—and since Trump will appoint at least six members of the FOMC in the coming year, it will be his Fed—will take us back down the path of massive quantitative easing and perhaps even to negative rates if we enter a recession.

The urge to “do something,” or at least be seen as trying to do something, is just going to be too strong.

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