When Experts Get Stunned: Fed Tightening Cycle May Stimulate Inflation

The Federal Reserve's core guiding belief is that economic stimulus boosts economic growth, thus increasing employment opportunities, payrolls, tax revenues, corporate profits, retirement security and Wall Street wealth. In the context of globalism, growth aids international investment, which in turn brings people wider business and consumer opportunities. Clearly, Fed policy does not lift all boats equally, as some workers must watch their careers stagnate or decline as investment capital shifts to lower cost regions of the world. Nonetheless, in defending economic growth Fed officials see themselves as the paternalistic benefactors of the middle class. Not everyone agrees. Some analysts and money managers believe easy money policies are dampening the economy's recovery. Others are concerned that central banks are in the process of creating another Lehman moment.

Federal Reserve leaders rationalize the widening financial gap between America's haves and have-nots as a reflection of polarization in the U.S. Congress. If legislators worked wisely rather than in partisan passion, monetary policy would not be left as the only game in town to deter economic downturns. Although the Fed's easy money policies disproportionately benefit financial elites, this is viewed as less problematic than protracted economic recessions that generate unemployment and wage regression. The Fed is content that its easy money bias supports people's livelihoods and various expressions of the American Dream.

There are a number of problems with the Fed's sanguine view of its role in the system. One problem is that Fed rhetoric sucks the oxygen out of the dialogue when it comes to the objective development of other alternatives. Granted, many libertarians, gold bugs and other bank critics think the central banking function is unnecessary: a mistaken assertion that fails to delineate between constructive and destructive central bank policies. Proper public education could reduce the confusion. Nonetheless, the larger problem is society's general contentment with financial policies that facilitate return on investment for uses of capital that contribute little to the sustainable public good.

All Spending is Not Equal

Imagine a grand buffet. Fed bankers want to serve as many calories as possible to bulk up the economy. They fail to realize that balanced nutrition is what diners' need. Ideally, the U.S. Congress designs the menu wisely and lets relatively free markets do the serving. But Congress consist of parties, and parties exist to provide disproportionate benefits for their supporters at the expense of other system participants. A tragedy of the commons is the result: partisan-aligned interests exploit the commons to maximize relative takings. Republicans want Democrats to subsidize their takings, and visa-versa.

Contrary to monetarist theory, money growth is not necessarily inflationary. Money growth that stimulates productivity, business efficiency, waste curtailment and sound resource stewardship tends to be deflationary. This type of deflation is benign because it increases people's real, inflation-adjusted disposable income even when nominal wage growth stagnates. There are, however, damaging forms of deflation. Easy money can lead to deflation by stimulating businesses to over-expand and create excess capacity.

Consider the oil patch in 2010-2013: easy money led to speculation and a bubble in oil production capacity. This over-capacity necessitates writing off many billions of dollars in capital investment: an expression of economic inefficiency offset temporarily by reduced consumer energy costs. Nonetheless, the downturn in exploration and development results in a production disruption and a reciprocal swing to higher prices later on (delayed inflation). When easy money stimulates economy-wide excess capacity, deflationary pressures arise that undermine investments broadly and the viability of evolved banking schemes. The Fed fears this type of deflation but overlooks the inflation that follows. Meanwhile, the underlying problem--the over-expansion of debt--is of the Fed's making. This is one reason some Fed critics point to a lack of accountability in central banking.

Asset Appreciation as the Wrong Economic Engine

While wise fiscal policy combined with prudent innovation can produce constructive deflationary trends (something we see in technology-rich sectors), the Fed fears deflation because it has underwritten the excessively broad financialization of the economy along with a national dependency upon asset appreciation as the engine of financial prosperity. Deflation in this economic model is disruptive: hence, the trend toward negative interest rates in order to create a new channel of financial stimulus.

In the current model, whenever monetary stimulus lags, the impetus for growth gets derailed. The Fed is ensnared in its anti-deflation game largely because it has subsidized the architecture of a debt-based economic model. Fortunately, a growing number of Bernie Sanders supporters recognize this development. But the GOP and the Clinton camp remain clueless. Leaders in both groups are enamored with undeserved gains and grotesquely distorted conceptions of how earned merit should be measured and priced.

Many in the Bernie Sanders camp are disgusted with the supposed trickle down effects of elitist wealth. Ignoring socialism's problems, they seek it as a means of de-concentrating wealth. They recognize that Wall Street's financial apparatus often stifles the emergence of new competition. By strategically financing merger and acquisition activities Wall Street helps elites swallow up important new businesses. Challenges get derailed early. Wall Street facilitates buy-out activities that allow America's corporate culture to absorb outsiders that might otherwise challenge the status quo. Hence, wealth becomes increasingly concentrated in the top 1% and top 1/100th of 1%: a phenomenon that some rightly call investment inequality.

Asset prices and the progress of economies is now closely tied to central bank decision making. But the narrative of central bank success is set to change. Within a few years the Fed will discover that its project of interest rate normalization will contribute to higher inflation, not inflation control.

The Fed has painted itself into a corner with the longest and most consequential run of easy money in modern history. Most Fed officials don't see the approaching problem, since the business cycle to this point has produced but inconsequential nominal CPI inflation. Sometimes, however, appearances are misleading. Real inflation for the middle class is probably running a consequential two to three points above the Fed's claimed numbers--at least in desirable parts of the country. The shock that awaits Fed officials is that inflationary pressures may increase, not decrease, as they raise interest rates during the tightening portion of their policy cycle.

Excess Capacity and the Approach of Stagflation

Fed tightening this time around will likely produce stagflation. Low money costs are structurally embedded in the economy and in corporate business plans. In a highly financialized economy, higher money costs will weaken corporate profitability. With oligopoly widespread and corporate executives trained to protect profit margins, consumers will be forced to shoulder the burden of higher money costs as expressed in the inflationary pricing of goods and services. Rising prices will cause consumers to taper expenditures where they can. With over-capacity already in the system due to the long stretch of easy money policies, weakening demand and constrained output will reduce business efficiency resulting in higher overhead costs relative to sales. This constitutes a perfect storm for stagflation with GDP growth under 2% while inflation bumps up to 4-6% by 2020: a disaster for the middle class.

There is evidence that some consumers are beginning to become satiated with material goods and expensive experiences. Millions are tiring of trying to see, do and experience everything. A simpler way of life is gaining in appeal, including a budding dislike of advertising. This secular trend will gain momentum at the same time that executives begin to awaken to their easy-money stimulated over-capacity problem. Once business executives try to sell excess manufacturing and service capacity into weak demand environments, the business efficiencies gained through the long expansionary period will be lost, along with corporate financial performance. The tea leaves from such difficulties are not difficult to read.