More About Dealing With Inflation

There’s an article at Barron’s by Brij Khurana that echoes some of what I said in yesterday’s post. Read the whole thing but here are some snippets.

Monetary policy is also becoming less effective in shaping longer-term interest rates. Historically, when the Fed cut short-term rates, long-term yields declined as well. That is no longer true. Since the Fed began its ongoing easing cycle in September 2024, 10-year Treasury yields have actually risen. This reflects resilient economic expansion and a fiscal deficit that has grown so large as to mute the effects of the cuts.

Given these changes, it is worth considering whether the Warsh Fed should prepare markets for more forceful and less predictable rate adjustments ahead.

and

The federal debt complicates the Fed’s ability to achieve its dual mandate of maximum employment and price stability. If foreign investors, who finance a third of U.S. debt, trim their Treasury holdings and the Fed responds by expanding its balance sheet, the dollar could weaken, fueling inflation.

Heavy Treasury issuance creates distortions between government bonds and derivatives linked to them. Hedge funds use substantial leverage to arbitrage these discrepancies. An estimated $1.5 trillion of such trades are outstanding, posing a risk to financial stability. Finally, government spending has helped lift equity markets, supporting wealth-driven consumption and keeping services inflation persistently high.

concluding:

Perhaps the Fed should shrink its balance sheet so the real cost and liquidity of government debt can be fully known. Maybe it should use interest-rate and balance-sheet policy to lean against debt-fueled asset price appreciation, regardless of where that debt originates.

I doubt that will have the results he’s seeking.

If the FOMC were following the Taylor Rule, interest rates would be around 5%. Given the changes in the structure of our economy it might well need to be substantially higher than that to achieve the effects that are needed. My point is not that the Fed doesn’t have the tools to curb inflation. The Fed almost certainly retains the ability to suppress inflation but doing so may require much higher interest rates, a much larger decline in asset prices, and a much deeper economic slowdown than policymakers have recently been willing to accept. My question is whether they have the political will.