Inflation & Interest Rates: share your data sources, models, and assumptions

[Mr. Green]

12-month PPI came in at 1.1%, with month-over-month actually down 0.3%. So we're seeing a little bit more deflation, which is probably not a bad thing given what's happened over the last two years.

[ChpBstrd]

Here are a few recession indicators that were not on my radar. They come from Colby Smith and the Financial Times.

1) RV sales have plummeted by a greater percentage than we've seen since at least the late 1980s, and as we can see that's a great recession predictor. Maybe it's the hangover from the 2020 boom, but such a hangover didn't happen after the 2010 boom. It might be falling consumer confidence or it might have something to do with bank lending...

2) The Fed's survey of loan officers seems to be among the more reliable recession indicators. These 1Q2023 results do not even account for the full horror of the April-May squeeze that killed First Republic and almost killed a few others. I bet the 2Q numbers are much more severe. In terms of "tightening standards", we are were three months ago already at the threshold which marked the start of past recessions. In terms of "stronger demand", we're already at the point where we were over midway through the 2001 and 2008-2009 recessions. A robot looking only at these charts might predict a recession starting next month.

3) 18 states plus DC meet the Sahm rule for predicting recessions. Of course, the missing context here is how often this kind of outcome occurs independently of a national recession.

4) The headline says "more debtors falling behind", but I view this chart optimistically, perhaps as a companion to a chart of debt as a percentage of disposable income. Neither chart shows a recognizable pattern that predicts recessions, so maybe consumer indebtedness has had little to do with modern recessions. However, both charts show that even with the recent uptick, consumers are doing better managing debt than they've done throughout much of recent history. For every story you hear about people unable to afford housing or car/student loans, there are lots more people who locked in low rates on those same things over the past several years. So I don't think the origin of any future recession is going to be consumers running out of money, even if they do have to cut back on housing, credit card, and auto expenses. The origin is more likely to be a banking contraction, asset repricing, or an externality IMO. Consumers might actually be the force which bails out the other elements of the economy.

[reeshau]

1) RV sales have plummeted by a greater percentage than we've seen since at least the late 1980s, and as we can see that's a great recession predictor. Maybe it's the hangover from the 2020 boom, but such a hangover didn't happen after the 2010 boom. It might be falling consumer confidence or it might have something to do with bank lending...

One caution reading this:  it's in the news because Thor recently reported.  But, there is a nuance.  *NEW* RV sales are down, but *USED* are up.

In its Q1 earnings call, Camping World reported new unit sales were 13,912; down 26% (5,108) vs. last year, but used unit sales were 12,432--up 13% from 10,976 last year.  So yes, RV sales did get a pandemic boost.  But a good part of the downturn seen by OEM's is really a tradeoff from new to used.

[SpaceCow]

Powell finally said in his press conference today that we need "meaningfully positive real interest rates" in order to bring inflation down. This comment, in line with the Taylor Rule, would have been quite surprising in 2022! Although James Bullard and @ChpBstrd were saying it!

[BicycleB]

...both charts show that even with the recent uptick, consumers are doing better managing debt than they've done throughout much of recent history. For every story you hear about people unable to afford housing or car/student loans, there are lots more people who locked in low rates on those same things over the past several years. So I don't think the origin of any future recession is going to be consumers running out of money, even if they do have to cut back on housing, credit card, and auto expenses. The origin is more likely to be a banking contraction, asset repricing, or an externality IMO. Consumers might actually be the force which bails out the other elements of the economy.

This seems very possible to me. It also goes hand in hand with the underlying deficit of willing workers, aka tight job market.

I've been supposing that the job market had more tightness in reserve than in past recessions, so that the recession takes longer to form than normal. Between that and consumers coasting on previous low-interest loans, how long can the recession be held off?

Is there a way to quantify these factors into a model that outputs plausible timeframes?


 

[ChpBstrd]

1) RV sales have plummeted by a greater percentage than we've seen since at least the late 1980s, and as we can see that's a great recession predictor. Maybe it's the hangover from the 2020 boom, but such a hangover didn't happen after the 2010 boom. It might be falling consumer confidence or it might have something to do with bank lending...

One caution reading this:  it's in the news because Thor recently reported.  But, there is a nuance.  *NEW* RV sales are down, but *USED* are up.
In its Q1 earnings call, Camping World reported new unit sales were 13,912; down 26% (5,108) vs. last year, but used unit sales were 12,432--up 13% from 10,976 last year.  So yes, RV sales did get a pandemic boost.  But a good part of the downturn seen by OEM's is really a tradeoff from new to used.

Maybe so, but for context I wonder how many new RVs get sold into the used market every year. Half of them? Some spendy people I know kept theirs for 2-3 years.

Powell finally said in his press conference today that we need "meaningfully positive real interest rates" in order to bring inflation down. This comment, in line with the Taylor Rule, would have been quite surprising in 2022! Although James Bullard and @ChpBstrd were saying it!

Yep, the FOMC is clearly looking to create some air space between the FFR and PCE, and hold it there for some indeterminate period of time. The Taylor Rule as cited on the Federal Reserve's website calls for a policy response a multiple of the size of the inflation-target gap when the output gap is zero. The output gap factor shrinks the prescribed FFR if your estimate is that today's GDP growth is less than the economy's potential, and JPow clearly stated in today's press conference that their currently estimated 1% GDP growth rate is under potential.

So with PCE=4.4% in April, and GDP growth far below potential, it wouldn't be hard to get a >6% result from the Taylor Rule.

FFRt=rLRt+πt+0.5(πt−π∗)+0.5(yt−yPt)
FFRt=2% + 4.4% + 0.5(4.4%-2%)+(assume -2% output gap)
FFRt=5.5%

Of course, Taylor's equation is highly sensitive to changes in the inflation rate. When PCE equals 4% maybe a month from now, it will spit out an FFRt of 5%. Hopefully you haven't hiked rates to 5.5% by then! This volatility is why we still have humans in charge of the decisions instead of just setting an equation as a rule. This specific scenario might be what the FOMC had in mind when they paused today.

JPow also said that as inflation falls, we can expect interest rates to fall too, in order to maintain a constant real interest rate. He was probably referring to the Taylor Rule as it will be recalculated in coming months as inflation falls (see illustration above). Of course, the journalists largely ignored this extremely interesting nugget and kept peppering JPow with the same old questions he refuses to answer about what the FOMC will do at the next meeting. But the speed at which rates come down is now THE big deal so they should have given JPow's 3rd factor more attention.

...both charts show that even with the recent uptick, consumers are doing better managing debt than they've done throughout much of recent history. For every story you hear about people unable to afford housing or car/student loans, there are lots more people who locked in low rates on those same things over the past several years. So I don't think the origin of any future recession is going to be consumers running out of money, even if they do have to cut back on housing, credit card, and auto expenses. The origin is more likely to be a banking contraction, asset repricing, or an externality IMO. Consumers might actually be the force which bails out the other elements of the economy.

This seems very possible to me. It also goes hand in hand with the underlying deficit of willing workers, aka tight job market.
I've been supposing that the job market had more tightness in reserve than in past recessions, so that the recession takes longer to form than normal. Between that and consumers coasting on previous low-interest loans, how long can the recession be held off?
Is there a way to quantify these factors into a model that outputs plausible timeframes?

This is why I'm keeping an eye on the labor force participation rate. The pandemic knocked a lot of people out of the workforce. These include women without childcare options or childcare employment, people disabled by long COVID, and people reluctant to work in jobs with high exposure risks. Since the pandemic, the labor force participation rate has slowly recovered. Thus, as the economy was generating more jobs, more people were coming back into the labor force.

But in March and April the labor force participation rate finally reached the range between 62.5% and 63% where it has usually been since April 2014. Given the low unemployment rate, this is probably very close to the maximum percentage of the population that can be mobilized for work, minus some amount of people between jobs.


This is not to say the economy cannot grow because we're going to run out of workers. The overall pie (population) keeps growing even if the percentage of the population that can work stays the same. So the size of the US workforce can grow, and the number of people who cannot work can grow, and the workforce participation rate can remain steady amid solid economic growth, as it was from 2014-early 2020. Perhaps it has something to do with those immigrants we hear being disparaged so often.

[Paper Chaser]

1) RV sales have plummeted by a greater percentage than we've seen since at least the late 1980s, and as we can see that's a great recession predictor. Maybe it's the hangover from the 2020 boom, but such a hangover didn't happen after the 2010 boom. It might be falling consumer confidence or it might have something to do with bank lending...

One caution reading this:  it's in the news because Thor recently reported.  But, there is a nuance.  *NEW* RV sales are down, but *USED* are up.
In its Q1 earnings call, Camping World reported new unit sales were 13,912; down 26% (5,108) vs. last year, but used unit sales were 12,432--up 13% from 10,976 last year.  So yes, RV sales did get a pandemic boost.  But a good part of the downturn seen by OEM's is really a tradeoff from new to used.

Maybe so, but for context I wonder how many new RVs get sold into the used market every year. Half of them? Some spendy people I know kept theirs for 2-3 years.

YoY can seem scary, but total sales are still fairly strong:

https://flo.uri.sh/visualisation/8668118/embed?auto=1

2022 saw total shipments of new RVs over 493k. If they're down 25% in 2023 that's still ~370k units which would be about what they sold in 2004 or 2015.

[achvfi]

It seems to me by indicating 2 more rate hikes this year Fed is trying to temper market's excitement for next phase. Will they actually do it? My bet is they don't want to but the door is open.

[Paper Chaser]

It seems to me by indicating 2 more rate hikes this year Fed is trying to temper market's excitement for next phase. Will they actually do it? My bet is they don't want to but the door is open.

"Hawkish pause" is a term I recently heard used to describe the situation.

[EscapeVelocity2020]

It seems to me by indicating 2 more rate hikes this year Fed is trying to temper market's excitement for next phase. Will they actually do it? My bet is they don't want to but the door is open.

"Hawkish pause" is a term I recently heard used to describe the situation.

The Fed seems to be getting the worst of all worlds in the short term - regional banks are back to taking it on the chin (PACW for example trending lower) while the rest of the market is in bullish rally mode and crude oil trending upwards.  Hard for me to imagine inflation will cool further while the labor market still seems so tight, although the Fed indicated their own data is showing loosening.  We are back to the wait and see phase, next PCE is Friday June 30...

Other than seeming firm that there are no plans to cut rates in the near future, I thought the message to raise further was given rather weakly.

[ChpBstrd]

It seems to me by indicating 2 more rate hikes this year Fed is trying to temper market's excitement for next phase. Will they actually do it? My bet is they don't want to but the door is open.

"Hawkish pause" is a term I recently heard used to describe the situation.

The Fed seems to be getting the worst of all worlds in the short term - regional banks are back to taking it on the chin (PACW for example trending lower) while the rest of the market is in bullish rally mode and crude oil trending upwards.  Hard for me to imagine inflation will cool further while the labor market still seems so tight, although the Fed indicated their own data is showing loosening.  We are back to the wait and see phase, next PCE is Friday June 30...

Other than seeming firm that there are no plans to cut rates in the near future, I thought the message to raise further was given rather weakly.

I think the FOMC knows there's about a 95% chance they've already engineered a recession, so there is little to lose by taking a wait and see approach and preventing the FFR from getting higher than absolutely necessary to bring inflation down. The last 11 months offer ample evidence that inflation is plummeting, inflation expectations remain low, and developments this year suggest credit is tightening. Plus, it is an emergency-level response to have a rate hike every single FOMC meeting, so we shouldn't take that as our baseline expectation. If the next PCE and CPI readings show a continued decline in inflation, look for JPow to shift the conversation to "significantly positive real interest rates". Rates are already significantly positive (5.25% FFR > 4% CPI), and they will get even more positive until the first set of rate cuts occur, probably next year. CPI has been falling faster than the Fed can raise rates, and will likely continue to do so.

Markets, however, are envisioning profits from the shark-fin rally that often follows the end of a rate hiking cycle and precedes the start of recessions. A handful of tech, e.r. "AI" stocks have been rallying, while defensive sectors meandered behind. These are exactly the places not to be if you think a recession is nigh, so there is an element of musical chairs here. The broader market remains a lot more skeptical than "AI stocks" might have you believe, as evidenced by the massive gap between the performance of the S&P500 and the five largest companies in the S&P500.

My read is that the bandwagon is piling onto a momentum trade in a few narrative names like Nvidia (+200% YTD, PE=222), while the rest of the stock market remains largely flat. This is exhibit A in the case against naively reading stock market index performance as an indicator that the economy is doing well, as most people do.   

I think the more interesting thing to watch are the yield curves. For the past 12 months, about 385bp of the 500bp in rate hikes have been absorbed by reducing the yield curve rather than raising 10y rates. This reflects a certainty among most market participants that rates are going down soon. 

In the past 3 recessions, the Feds actually cut rates prior to what would become the official start date of the recession. In every case, rate cutting cycles started while CPI was far above the 2% level that would later become the Fed's official target. Can we expect the Fed to start rate cuts while inflation is far above target? Probably. They've done it many times before. The Fed has tended to engineer a recession to lower inflation, and then switch back to stimulation once it is clear economic metrics are deteriorating. I think the Fed's "data dependency" is about to have a lot less to do with actual CPI or PCE than it has to do with recession indicators like initial claims. Once we have crossed the threshold into the recessionary point of no return, the FOMC won't need to worry about the past 12 months of inflation any more.

[MustacheAndaHalf]

What is your source for 95% recession chance?  I looked on Ycharts and found a 70% recession chance within the next 12 months.  Their data is generally accurate, but I can't speak to this specific information.
https://ycharts.com/indicators/us_recession_probability

The argument against recession is a strong economy.  I think that means low unemployment, which is also cited as evidence of a mild to no recession.  If low unemployment prevents recessions, I don't see it in the St Louis Fed data:
https://fred.stlouisfed.org/series/UNRATE

Overall I'm getting more confident in my hypothesis of a "false soft landing".  Investors will think they're getting a soft landing until the plane's nose dives suddenly into a crash.  I expect the data to slowly get worse as the Fed repeats "mild recession".  Some day they'll relent, use a word other than "mild", and investors will use curse words in response.

[FIPurpose]

What is your source for 95% recession chance?  I looked on Ycharts and found a 70% recession chance within the next 12 months.  Their data is generally accurate, but I can't speak to this specific information.
https://ycharts.com/indicators/us_recession_probability

The argument against recession is a strong economy.  I think that means low unemployment, which is also cited as evidence of a mild to no recession.  If low unemployment prevents recessions, I don't see it in the St Louis Fed data:
https://fred.stlouisfed.org/series/UNRATE

Overall I'm getting more confident in my hypothesis of a "false soft landing".  Investors will think they're getting a soft landing until the plane's nose dives suddenly into a crash.  I expect the data to slowly get worse as the Fed repeats "mild recession".  Some day they'll relent, use a word other than "mild", and investors will use curse words in response.

I think there's still a possibility of a soft landing, but I don't have much confidence in the fed to actually manage it well. Inflation will come down eventually, and I think the fed will push a "wait and see if it sticks" narrative without lowering the fed rate quickly enough before it's already obviously a recession.

June 2022's inflation rate was quite high. So once that falls off the YoY markers, next month could see inflation close to 3%. Will that trigger the fed to finally start considering leveling off the fed rate closer to 4-4.5? I think based on the way they're talking they want to see even more than 12 months of settled inflation before lowering the rates. And seem to want all signs to point away from recession before lowering rates.

[Paper Chaser]

If you only look at headline CPI, then yeah inflation will be down YoY. But a huge part of that is volatile food and energy prices which shouldn't be counted on for any future inflation reduction. Hence the Fed's preferred metric of "Supercore" inflation which eliminates Food and energy prices  (due to volatility) and housing (due to lagging data and flawed methodology). That "Supercore" remains consistently high.

[reeshau]

Supercore has been and will remain high, but then again it never peaked as high as CPI, either.  What would the Fed have done with 6% inflation last summer, instead of people freaking out about 9%?

Part of it is they want to have it both ways.  But there are plenty of economically-ignorant "supervisors" in Congress and the administration putting pressure on them based in the headline number, too.  If it works one way, it will work the other.  Particularly as we head into primaries.

[ChpBstrd]

But there are plenty of economically-ignorant "supervisors" in Congress and the administration putting pressure on them based in the headline number, too.  If it works one way, it will work the other.  Particularly as we head into primaries.

This is another reason I shudder when people say "so-and-so was an accomplished business CEO, so they'll effectively manage the government's numbers too..."

[MustacheAndaHalf]

FIPurpose - In this thread 3 weeks ago, you thought recession might be avoided.  If you still think that, I would point to context beyond yield curve inversion.  We have a yield curve inversion during high inflation, and I believe that combination has always lead to recession.  I think adding "sharp rise in Fed funds rate" dramatically limits the number of data points, but also signals recession consistently.  From those three pieces of context, I expect recession.

As to inflation, looking at the CPI report page 2, I show the following 12 month inflation numbers:

all items  4.0%
energy  -11.7%
food  6.7%
"core CPI" - all items less food and energy  5.3%
https://www.bls.gov/news.release/pdf/cpi.pdf#page=2

The large drop in overall CPI is fueling optimism - inflation is half what it was in May 2022 (8.5% vs 4.0%, see page 2).  But look at core CPI: 6.0% to 5.3% in that same time period.  Core inflation isn't falling quickly, and the Fed focuses more on core (and super core) inflation.  The CNBC summary of the Fed meeting said the Fed now expects 3.9% super core inflation, up from 3.6%.  The median Fed dot plot expects 2 rate hikes (+0.50%), which fits with the rise in super core inflation (+0.30%).

The market seems to be ignoring the Fed dot plot, and expects 1 more rate hike.  The market also expects rates to fall sooner than the Fed predicts.  This divergence is a problem for the Fed, who uses forward guidance as a powerful tool.  Without forward guidance, they have to implement every rate hike and wait out the lag.

Many months ago, Fed Chair Powell said a "soft or softish landing" had a "high level of difficulty".  How much more difficult is that without forward guidance?  The market is very optimistic right now ("extreme greed" on CNN index), and not aligned with the Fed.  I think the risks are going up, not falling like all items inflation.

[FIPurpose]

@MustacheAndaHalf  I'm still somewhat optimistic that recession is avoidable.

My thesis lies in the assumption that this inflation is unlike any other in the commonly cited history of the past 70 years or so. This inflation is self-induced due to covid (and not a small part due to the Russia-Ukraine war either), so I see the inflation that we are still under still a lingering wave from covid era policies.

Supply line issues have almost completely settled back to pre-pandemic and special government subsidies have all run their course.

I don't know that we can point to previous periods of inflation and yield inversions because they are fundamentally different. Consumer spending is strong, unemployment is still strong though there are a few signs of unemployment claims, we haven't seen the unemployment rate budge yet.

I think if we see unemployment rise to 4-4.5% range relatively quickly, then my thesis is likely wrong.

If we see core-inflation follow the reduction CPI is seeing, then I think my thesis is likely right. And we may be back down in ~3% territory by EOY.

[Paper Chaser]

@MustacheAndaHalf  I'm still somewhat optimistic that recession is avoidable.

My thesis lies in the assumption that this inflation is unlike any other in the commonly cited history of the past 70 years or so. This inflation is self-induced due to covid (and not a small part due to the Russia-Ukraine war either), so I see the inflation that we are still under still a lingering wave from covid era policies.

Supply line issues have almost completely settled back to pre-pandemic and special government subsidies have all run their course.

I don't know that we can point to previous periods of inflation and yield inversions because they are fundamentally different. Consumer spending is strong, unemployment is still strong though there are a few signs of unemployment claims, we haven't seen the unemployment rate budge yet.

I think if we see unemployment rise to 4-4.5% range relatively quickly, then my thesis is likely wrong.

If we see core-inflation follow the reduction CPI is seeing, then I think my thesis is likely right. And we may be back down in ~3% territory by EOY.

With a large part of core-inflation being wage related, it seems to me that the only way it would follow CPI down is if there are widespread layoffs.

[ChpBstrd]

May housing starts were reported today and they offer another counterpoint to the recession narrative. Starts increased across regions for SFH's and buildings with 5 or more units. Buildings with 2-4 units declined in May, but the overall trend was up.

Steep declines in housing starts preceded the '70, '73, '80, '81, '90, and '08 recessions, with some false positive signals such as 1966. This indicator also did not predict the 2001 or 2020 recessions. I'll grant some leeway to any indicator in the case of 2020, which was a blindside hit from an externality. So overall, housing starts is one of our best predictors.

If housing developers either cannot obtain financing or do not believe they will be able to sell/rent units at completion time, they will build fewer housing units.


Apparently May housing starts shot upward.


What's interesting here is that May featured a series of major regional bank failures. One might be forgiven for thinking credit conditions would have tightened as depositors were fleeing and banks like SVB and First Republic were collapsing overnight, but apparently the opposite happened. The developers who announced starts in May probably arranged financing at least a month earlier. Are banks eager to replace low-yielding assets with new loans at higher interest rates, and so they're actually loosening credit?

One way to answer this question is to look at the National Financial Conditions Index. The NFCI ranks high among economists' lists of recession predictors, and it is also trending away from the zero bound that typically predicts recession:


I remain in the camp that thinks we have a recession coming in the next 12 months, but these metrics related to credit conditions suggest otherwise. Economics is always messy and every recession in history has had some contradictory predictors. Plus, many early indicators have thrown false positives in the past. Today I think the majority of indicators suggest recession, but I'm trying to be more open minded to the soft landing possibilities. I'm trying to see the narrative for the economy escaping recession. One version goes something like this:

The US government's program offering loans against treasury collateral at face value may have saved the banks that were in trouble, and stimulated the banks that weren't. With their ratios restored, perhaps many banks went on a lending spree to raise the average yields of their portfolios instead of hunkering down as I had expected. This shot of adrenaline to the financial system might have reversed a developing credit crunch (see NFCI trend) and preserved a lot of jobs in credit-dependent industries. It could have thrown off the cadence and synchronization of recessionary developments, so that now higher rates do not directly lead to tighter credit which leads to supply and demand destruction. And maybe with loans in ample supply, the much-feared real estate bubble fails to burst, companies roll their debts and slowly deleverage themselves, low-yielding loans and treasuries steadily roll off of bank balance sheets, and under-leveraged consumers in a still-low-unemployment environment increase their demand. Then, some months from now, the FOMC announces the first rate cut, saying real rates are getting too high, and we're off to the races.

[MustacheAndaHalf]

@FIPurpose - You claim this time is fundamentally different partly because of low unemployment.  In the graph below, unemployment falls before each recession (gray areas).  Is lower unemployment common before recession?  And if so, this time would not be fundamentally different, unless you see it differently.
https://fred.stlouisfed.org/series/UNRATE


I assume by rapidly falling inflation, you're comparing the "all items" CPI of 8.6% in May 2022 to the 4.0% CPI now.  That belief comes from lumping energy in with other inflation.  Back in May 2022, energy added 2.4% to "all items" inflation - check page 31 for the data.  More recently, May 2023, energy subtracted 1.0% from overall inflation [page 32 of May 2023 CPI].
https://www.bls.gov/news.release/archives/cpi_06102022.pdf
https://www.bls.gov/news.release/pdf/cpi.pdf

By my calculation, "all items less energy" has dropped from 6.2% to 5.0%.  But all numbers I used came directly from CPI reports - I just subtracted.  Without energy, CPI inflation is not falling that quickly.


I assume "we may be back down in ~3% territory by EOY" means without recession?  Recession could certainly hit inflation hard.

I suspect people have forgotten what energy experts said 6 months ago.  Their big concern wasn't inflation from last winter, but what happens to energy prices next winter.  If "all items less energy" is falling slowly, and then energy prices reverse direction and rise again... that could spoil an expectation of inflation "in ~3% territory".

[FIPurpose]

FIPurpose - You claim this time is fundamentally different partly because of low unemployment.  In the graph below, unemployment falls before each recession (gray areas).  Is lower unemployment common before recession?  And if so, this time would not be fundamentally different, unless you see it differently.
https://fred.stlouisfed.org/series/UNRATE

That graph shows that periods of economic expansion have a decreasing unemployment rate and periods of recession have increasing unemployment rates. But there's nowhere on the graph that says you can predict when periods of rising unemployment begin. Take around Aug 2016 for example. There was a plateau and that would've been a typical sign that unemployment might trend back up. Or the 4 year period in the 60's where unemployment remained under 4% for a sustained period of time.

Unemployment by itself doesn't seem predictive. That's why I couched my prediction in that if unemployment actually does start rising, then I'm likely wrong. But if unemployment remains steady at < 4%, then I don't think we'll have a recession in the next 2 years.

[Financial.Velociraptor]

I'm baffled but tilt towards the view of @FIPurpose . 

Yes, low unemployment precedes recession (usually).  But have we ever seen a scenario where labor continues to tighten as the Fed constricts money supply?  Powell is on record that one of the things the Fed was seeking was to cool the labor market.  They have clearly been frustrated in that effort (and probably mightily confused as well!)  If they can't figure it out with a gaggle of Ph.D.s in Finance and Economics, my wee undergrad in Econ and MBA leave me woefully ill equipped to second guess them.  But I'll try anyway!

The pause/skip is the elephant in the room.  The Fed doesn't know anymore.  and the Fed KNOWS it doesn't know.  So they are stepping back to let data accumulate.  This time is truly different (famous last words) but in which direction?  I'm personally of the opinion that the Congress should provide some guidance to the Fed on its double bind mandate to promote full employment and low inflation at the same time.  Previously, that has always been mutually exclusive.  As a citizen/investor, I'd rather have full employment with moderate inflation than high unemployment with low inflation.  It is a consumer economy and I need consumers for the businesses I am invested in!

I also think the Fed is well aware that since Nixon, every action it has taken (except the Volker heroics) has ultimately proven to be an over reaction and they are gun shy about over tightening, yet again.

In the late 90s, I was a Friedman and Chicago school guy on monetary policy.  These days, I think we have been too quick to dismiss Mosler and MMT.  FIPurpose noted the supply chain issues from Covid easing.  That would be a key point under MMT.  The inflation boogeyman the Friedman aligned economists told us was coming "any day now", didn't until (like Mosler said), there was a supply constraint.  Hindsight being 20/20, that assertion should even be controversial whether you are a cost-pull or demand-push advocate.  If there is "slack", it will absorb liquidity until the rubber band is stretched tight. 

So to bring it all home, I think the thing to watch is what percent of capacity producers are running at.  If there is widespread surplus capacity, but not demand destruction, inflation will fall on its own and the unicorn of a soft landing will be achieved.

[ChpBstrd]

I'm baffled but tilt towards the view of @FIPurpose . 

Yes, low unemployment precedes recession (usually).  But have we ever seen a scenario where labor continues to tighten as the Fed constricts money supply?  Powell is on record that one of the things the Fed was seeking was to cool the labor market.  They have clearly been frustrated in that effort (and probably mightily confused as well!)  If they can't figure it out with a gaggle of Ph.D.s in Finance and Economics, my wee undergrad in Econ and MBA leave me woefully ill equipped to second guess them.  But I'll try anyway!

The pause/skip is the elephant in the room.  The Fed doesn't know anymore.  and the Fed KNOWS it doesn't know.  So they are stepping back to let data accumulate.  This time is truly different (famous last words) but in which direction?  I'm personally of the opinion that the Congress should provide some guidance to the Fed on its double bind mandate to promote full employment and low inflation at the same time.  Previously, that has always been mutually exclusive.  As a citizen/investor, I'd rather have full employment with moderate inflation than high unemployment with low inflation.  It is a consumer economy and I need consumers for the businesses I am invested in!

I also think the Fed is well aware that since Nixon, every action it has taken (except the Volker heroics) has ultimately proven to be an over reaction and they are gun shy about over tightening, yet again.

In the late 90s, I was a Friedman and Chicago school guy on monetary policy.  These days, I think we have been too quick to dismiss Mosler and MMT.  FIPurpose noted the supply chain issues from Covid easing.  That would be a key point under MMT.  The inflation boogeyman the Friedman aligned economists told us was coming "any day now", didn't until (like Mosler said), there was a supply constraint.  Hindsight being 20/20, that assertion should even be controversial whether you are a cost-pull or demand-push advocate.  If there is "slack", it will absorb liquidity until the rubber band is stretched tight. 

So to bring it all home, I think the thing to watch is what percent of capacity producers are running at.  If there is widespread surplus capacity, but not demand destruction, inflation will fall on its own and the unicorn of a soft landing will be achieved.

As we ask ourselves "what's taking so damn long" let's bear in mind how deep a hole the Fed dug for itself in 2021-2022. In February 2022, the FFR was 0.25% and CPI had reached almost 8%.

The Taylor Rule prescribes a FFR significantly higher than inflation if you want inflation to go down. However, the FFR only exceeded the rate of inflation LAST MONTH. So from a TR perspective, we have only just begun to have an even slightly restrictive policy! The FOMC was being incredibly cautious by not raising rates in June, and they appear to expect QT and the existing trend to do the work from here.


Then how did inflation nonetheless fall over the past 11 months? I think it has something to do with QT, exhaustion of pandemic stimulus payments, and relief of supply chain problems. As I've stated here before, I think QE/QT is more powerful medicine than JPow seems to be aware of, and inflation could keep falling as long as QT continues. Money supply has never in history contracted as much as it has since March 2022. That's what Friedman would point to anyway :)

Too lazy to dig through posts and quote myself, but about a year ago I was optimistic that the FOMC would lean more heavily on QT to contain inflation rather than using interest rates. That optimism is returning now that inflation has fallen despite months of stimulative interest rates. We'll still have a recession, but it might not be as bad because the FOMC let QT do some of the lifting this time and rates never rose to 6-10% like they would if rates were the only tool.

[MustacheAndaHalf]

FIPurpose - I thought you had more to say than just that unemployment will rise in a recession.  Yes, historically that happens.

[MustacheAndaHalf]

@ChpBstrd - You linked to indicators that economists rank highly to predict recessions, and I thought I'd run down that list.  All quotes are from this research article:
https://www.chicagofed.org/publications/chicago-fed-letter/2019/425

Up to nine months in advance, the Conference Board Leading Economic Index for the U.S. does the best at signaling coming recessions and expansions.

LEI predicted the dot-com and great financial crisis.  It flipped to recession about the same time recession hit in 2020, so not much leading there.  It flipped negative about a year ago, signaling another recession.
https://www.conference-board.org/topics/us-leading-indicators

Far in advance of a recession or expansion, the long-term Treasury yield spread (i.e., ten-year minus three-month Treasury yields) is the best predictor.

The 10 year / 3 month Treasury yield curve inverted in Oct 2022 and remains inverted.  Note the paper mentions combining measures, which I strongly recommend even for the inverted yield curve.
https://fred.stlouisfed.org/series/T10Y3M


The graphs and articles of "Brave-Butters-Kelley Indexes" (BBKI) left me confused -I don't know what it signals right now, or even what it signaled last year.  I think it signals recession when it drops below -1, but I'm not sure.  That happened in the first half of 2022, according to this graph:
https://fred.stlouisfed.org/series/BBKQLEIX

[ChpBstrd]

The graphs and articles of "Brave-Butters-Kelley Indexes" (BBKI) left me confused -I don't know what it signals right now, or even what it signaled last year.  I think it signals recession when it drops below -1, but I'm not sure.  That happened in the first half of 2022, according to this graph:
https://fred.stlouisfed.org/series/BBKQLEIX

Perhaps you're not alone in finding these indices confusing. According to the Chicago Fed,

We have discontinued producing the Brave-Butters-Kelley Indexes (BBKI) following the July 5, 2022, release. The instructions and files needed to run the BBKI model are now available online.

The BBKI is now published by Indiana University.

The idea was to develop a number "from a collapsed dynamic factor analysis of a panel of 500 monthly measures of real economic activity and quarterly real GDP growth." That is, throw a shitload of datasets into a "big data" model, use factor analysis to weigh the predictive value of each dataset on GDP growth, and make it spit out numbers. This logically made sense as a way to let statistical techniques rather than humans sort out and detect influential trends in the data, but apparently the output looks a lot like... noise.

The paper I cited was published in 2019 and was written by the same David Kelley as the K stands for in BBKI. So perhaps Dr. Kelley does find the model developed by Dr. Kelley influential, but you and I both see noise and I've literally never heard of anyone else referencing the BBKI.

I'm not sufficiently familiar with receiver operating characteristic analysis to evaluate their claim that the BBK coincident index is "highly accurate" at predicting recessions, but a quick view of that chart reveals a couple of nearly false positives just above the -1 threshold, false positives in the 70's, and a failure to predict in advance the 1990, 1981, 1973 recessions. So I see nothing in the BBKI that the yield curves doesn't tell me in a much cleaner way. Frankly, it looks like data torture.

Still, there is something interesting in the observation that such an index turned out so noisy. Factor analysis should have worked if our ideas about correlation and the causes of economic downturns are consistently correct. Instead, perhaps differences between the antecedent conditions of each recession thwarted this attempt to fit GDP growth to big data sets. Sometimes recessions are caused by rising rates, sometimes by asset bubbles, sometimes by supply shocks, sometimes by external factors, and maybe in the future by factors we've never encountered. And even within those categories, each instance occurs in a very different environment. Maybe it's true that "this time is different" every time. Such a conclusion aligns with my observation that before each recession there are always some metrics that indicate the economy is doing fine, and others predicting recession. Different recession indicators seem to fail each time too.

[Financial.Velociraptor]

The American consumer is very healthy.  Credit card delinquencies are near an all time low.  And it isn't because consumers are 'dis-saving'.  Personal savings rate has begun to trend up again as well.  Can there really be a recession if the consuming public is strong? 

[MustacheAndaHalf]

ChpBstrd - Thanks for pointing that out - that clarifies why BBKI is included in the list of important indicators.  It was included because the purpose of the article was to advertise BBK index - in an article written by the "K" in the BBK index.  I think there are too few people who care about BBKI, which could also be why it wasn't explained well in the articles I read.

I think it tracks the business cycle, and detects "below GDP" situations, and classifies those into regular (recession) and irregular (temporary?).  But the colored graph that made it clear was replaced by a line graph that is too confusing for me to follow.  Like you, I thought it was noisy for the past 10 years.

But Dr Kelley claimed it was 99% accurate.  I'd actually prefer lower accuracy, because that suggests curve fitting was involved.  With 500 inputs, adjusting weights can give you whatever result you want.  I could use their raw data and different weights, and predict sports events or elections - just by fitting the data.  But who knows, if they practiced restraint and got their model peer reviewed in some manner, maybe they have something truly new.

[MustacheAndaHalf]

The American consumer is very healthy.  Credit card delinquencies are near an all time low.  And it isn't because consumers are 'dis-saving'.  Personal savings rate has begun to trend up again as well.  Can there really be a recession if the consuming public is strong? 

Savings rates are near 4%, when they averaged 7-8% in the past decade.  I view the lowest savings rate in 10 years as unhealthy.
https://fred.stlouisfed.org/series/PSAVERT

Credit card payments might not be late, but their balances are growing.
https://www.cnbc.com/2023/05/15/credit-card-debt-is-at-a-record-high-how-to-pay-down-your-balance.html

And there may be more recent data, but bankruptcy filings rose Jan-Mar this year.

NEW YORK – April 3, 2023 – New bankruptcy filings in March 2023 registered year-over-year increases across all U.S. major filing categories for the third month in a row, according to data provided by Epiq Bankruptcy, the leading provider of U.S. bankruptcy filing data.

https://www.epiqglobal.com/en-us/resource-center/news/bk-filings-increase-across-all-chapters

[ChpBstrd]

The American consumer is very healthy.  Credit card delinquencies are near an all time low.  And it isn't because consumers are 'dis-saving'.  Personal savings rate has begun to trend up again as well.  Can there really be a recession if the consuming public is strong?

Good question.

Looking at credit card delinquencies, there has been a small to moderate uptick before each of the past 3 recessions, and one large uptick that did not lead to a recession.

Here's a list of the size of pre-recession increases in the delinquency rate, alongside the recent increase:
1994-1997 false alarm: +1.56%
1Q2000-2Q2001: +0.51%
1Q2005-1Q2008: +1.23%
1Q2015-1Q2020: +0.58%
3Q2021-1Q2023: +0.89%

My conclusion is that small increases in CC delinquencies, less than 0.6%, can precede recessions but also large increases in CC delinquencies like in the 90s can happen without a recession. The current increase is larger than 2 out of the past 3 recessions, so there is reason to be concerned. How does a +0.89% increase in CC delinquencies happen even as unemployment hovers near record lows? Is it due to rising CC interest rates?

I would be hesitant to say the absolute level of CC delinquencies means a recession can't happen, because the absolute level may be affected by interest rates, changes in CC marketing or eligibility, better controls on who gets credit, and technological changes in how payments are made (e.g. autodraft has to be more reliable than mailing a check, and no doubt lowered the baseline for delinquencies).

The Personal Savings Rate data are very noisy and the absolute level varies across decades. In theory, a sudden increase in the PSR would indicate a pullback in consumption. As the PSR declines, that might indicate fast growth in consumer spending and higher monetary velocity, but also that consumers are running out of cash to grow their spending further. I.e. as the PSR approaches zero, consumers don't have any more money to spend. The PSR declined in 2021 as inflation outgrew wages, and now it is recovering as wage growth slowly catches up with inflation. I think this is about as far as one can take the narrative, because historically recessions have occurred after a wide variety of PSR trends - up, down, or sideways.



The data suggest credit card delinquencies and the personal savings rate are not very reliable as advance recession indicators, but they also do not provide evidence we will avoid recession. As noted above, recessions can occur for reasons other than a downtrend in consumer spending growth that starts months prior to the recession start date. I would not expect these metrics to pick up the signal for a recession caused by an asset bubble, credit crunch, too-high interest rates, currency crisis, or an externality like drought, war, trading partners, or pandemics.

[Financial.Velociraptor]

https://www.reuters.com/world/us/fed-members-shaping-2024-campaign-economy-head-capitol-hill-2023-06-21/

[BicycleB]

....Factor analysis should have worked if our ideas about correlation and the causes of economic downturns are consistently correct. Instead, perhaps differences between the antecedent conditions of each recession thwarted this attempt to fit GDP growth to big data sets. Sometimes recessions are caused by rising rates, sometimes by asset bubbles, sometimes by supply shocks, sometimes by external factors, and maybe in the future by factors we've never encountered. And even within those categories, each instance occurs in a very different environment. Maybe it's true that "this time is different" every time. Such a conclusion aligns with my observation that before each recession there are always some metrics that indicate the economy is doing fine, and others predicting recession. Different recession indicators seem to fail each time too.

^ This seems very realistic!

Along the line that intellectual honesty means avoiding overconfidence (including avoidance of false pattern recognition), Noah Smith writes at Noahpinion that conventional economists ought to:

1. Acknowledge that while microeconomics often has reliable predictions, macroeconomics is wrong often enough that we should consider that it does not have a very accurate understanding
2. Therefore, be more welcoming of "heterodox" macroeconomic theories
3. Apply similar methods and standards of proof to both conventional and heterodox macroeconomics
4. Not consider hand waving and a plausible story as proof

https://www.noahpinion.blog/p/heterodox-vs-mainstream-macroeconomics?publication_id=35345&post_id=128443245&isFreemail=false

If the above is true, should investors assume economic predictions are not worth basing decisions on, and simply invest with methods such rebalancing to a fixed allocation?

Or, given examples such as Jan '22 (the low interest and high inflation, interest rates likely to raise per macroeconomic theory (?), bond puts or inverse bond fund a logical choice that paid off big), should we study the data and with judgment occasionally make investments on the basis of specific information (informed market timing / informed changes to investment allocation)?

Just musing - aware that no one can offer an authoritative answer.

[Paper Chaser]

In yesterday's testimony, Powell confirmed what the Dot plot told us. More hikes coming before the year end.
If anything is going to test the strength of the consumer, it's going to begin in Q4 after a couple more rate hikes, continued balance sheet reduction, and student loan repayments begin again. Could be a pretty rough holiday season for lots of businesses and people.

[ChpBstrd]

....Factor analysis should have worked if our ideas about correlation and the causes of economic downturns are consistently correct. Instead, perhaps differences between the antecedent conditions of each recession thwarted this attempt to fit GDP growth to big data sets. Sometimes recessions are caused by rising rates, sometimes by asset bubbles, sometimes by supply shocks, sometimes by external factors, and maybe in the future by factors we've never encountered. And even within those categories, each instance occurs in a very different environment. Maybe it's true that "this time is different" every time. Such a conclusion aligns with my observation that before each recession there are always some metrics that indicate the economy is doing fine, and others predicting recession. Different recession indicators seem to fail each time too.

^ This seems very realistic!

Along the line that intellectual honesty means avoiding overconfidence (including avoidance of false pattern recognition), Noah Smith writes at Noahpinion that conventional economists ought to:

1. Acknowledge that while microeconomics often has reliable predictions, macroeconomics is wrong often enough that we should consider that it does not have a very accurate understanding
2. Therefore, be more welcoming of "heterodox" macroeconomic theories
3. Apply similar methods and standards of proof to both conventional and heterodox macroeconomics
4. Not consider hand waving and a plausible story as proof

https://www.noahpinion.blog/p/heterodox-vs-mainstream-macroeconomics?publication_id=35345&post_id=128443245&isFreemail=false

If the above is true, should investors assume economic predictions are not worth basing decisions on, and simply invest with methods such rebalancing to a fixed allocation?

Or, given examples such as Jan '22 (the low interest and high inflation, interest rates likely to raise per macroeconomic theory (?), bond puts or inverse bond fund a logical choice that paid off big), should we study the data and with judgment occasionally make investments on the basis of specific information (informed market timing / informed changes to investment allocation)?

Just musing - aware that no one can offer an authoritative answer.

I enjoyed that read. My suggestion to economists would be to accept that there are many types of recession, and to try building recession warning indices for each known category. Of course, then you have a small dataset, because the modern economy, the modern Fed, and several metrics have only been around for a few decades and in that span of time some categories of recession have one or zero instances. So such indices would lean more on theory than on old data and mathematical inference, and I think that's OK because the "big data" approach has troubles too. Making generalizations based on 4 or 6 recessions of differing types should not lead to stronger inferences than one or two similar recessions, especially when the data are varying all over the place and fail to support a model that actually predicts things.

Furthermore, one could argue that a few modern decades of quarterly or monthly data is not really "big data" either; we do not have millions of monthly CPI measurements or M2 calculations, we have... hundreds. A statistician used to working with census records or retail transactions data who started to work with economists might be shocked at the broad theoretical generalizations that are made with such tiny observations. Seen this way, the statistics and models which never seem to predict reality are less like logical proofs and more like Trojan horses used to smuggle theoretical assumptions past our intellectual guards.

Noahpinion is right to point out the apples-to-oranges standards we apply to mainstream vs. hetereodox theories, but what nobody seems to be saying is that consistently predicting macroeconomies to the precision implied by the math is (a) probably not possible with the limited data we have, (b) probably not possible given the constant evolution of economies and cultures into new forms, (c) probably not possible given the interdependency of multiple worldwide economies, many of which lack equivalent and reliable data to feed our models, and (d) probably not possible due to extreme numbers of chaotic inputs. I can't mathematically prove that to the satisfaction of people who are impressed by mathematical models, but I think this humility is justified by the results we've seen so far. This is not to say macroeconomics is a lost cause or impossibility with nothing to contribute, but rather than macro theories should probably look more like theories in psychology than mathematical proofs. It should predict in general terms rather than striving for a precision that can only be false.

[wageslave23]

I stopped following the recent comments in this thread but was curious about the Taylor Rule. Is it safe to say that the Taylor Rule didn't ring true this time?  Inflation has definitely decreased since last year and we never increased interest beyond 9% inflation as the Taylor Rule suggests must happen in order for inflation to decrease. Am I summarizing that correctly? For the first two pages of this thread, every other post was about the Taylor ruler, with inflation at 7-9%, I assumed that interest rates must reach 8-10% for inflation to come down based on the discussion.

[Financial.Velociraptor]

I think the Taylor Rule requires a CP assumption.  If you only try to resolve inflation with changes to interest rate, it makes a certain amount of intuitive sense that negative real interest rates will not resolve inflation.   But if you engage in tightening, change the bank reserve requirement, throw in removal of fiscal stimulus (end of student debt pause anyone?) or have fundamental changes in the velocity of money, anything can happen. 

Clearly the fiscal situation, the QT situation are obvious.  What has happened to velocity of money as wealth trickles up and it goes offshore to die instead of circulate is harder to model.

[ChpBstrd]

I stopped following the recent comments in this thread but was curious about the Taylor Rule. Is it safe to say that the Taylor Rule didn't ring true this time?  Inflation has definitely decreased since last year and we never increased interest beyond 9% inflation as the Taylor Rule suggests must happen in order for inflation to decrease. Am I summarizing that correctly? For the first two pages of this thread, every other post was about the Taylor ruler, with inflation at 7-9%, I assumed that interest rates must reach 8-10% for inflation to come down based on the discussion.

I've been saying for a while I think QE/QT have proven to be much stronger medicine than most economists think. It's the only explanation that fits the data. The Taylor Rule works, but it has the limitation of not being adapted for a world of QE/QT. I think QT might be equivalent to 200-300bp at current levels instead of the 25bp JPow mentioned last year. If you plug that into the TR, I think rapidly falling inflation makes more sense. And it might be more accurate to think of QE/QT as a cumulative factor, with an effect size that grows each month.

> QE from 2020 to early 2022 with no change in rates = fast rising inflation, fast growing demand
> QT from mid-2022 to mid-2023 with negative real interest rates = fast falling inflation, no appreciable hit to demand

Inflation started falling in June 2022, which aligns perfectly with the June 1, 2022 start of QT. Just try to imagine a clearer signal!

The risk, of course, is that the FOMC still thinks QT is a minor factor even after all this experience with whipsaw money supply and inflation. QT still doesn't get much attention in FOMC statements or releases, despite money supply being a key component of monetary velocity. I'm envisioning a scenario in which the FOMC holds rates steady, but waits until August or October to even start talking about tapering QT perhaps 6 months later. Until then the foot is on the brake pedal.

By November, annualized CPI could fall another 2% as it did in 4 months from Jan 2023 to May 2023, which would put us at 2% CPI. Yet the FFR in this 2% inflation environment would still be 5.25% or 5.5%. As real risk-free rates (which are near zero in normal times) approach +3.25% to +3.5%, the incentive to spend collapses and everyone starts saving. Instead of pulling forward consumption like they did during high inflation, consumers and businesses start delaying consumption because they are being paid in real terms to do so!

E.g. a business owner who is considering buying $10k worth of excess inventory that will cost $10,200 a year from now has the alternative of buying treasuries or CDs and earning 5% or $500 a year from now. She can then buy the inventory a year from now and pocket the $300 difference risk-free. A savvy consumer considering a big purchase faces similar math. Both make the decision to delay their purchases, and so do their trading partners. The whole supply chain slackens, leading to price cuts and production cuts.

If inflation falls faster than the FOMC cuts rates, a feedback loop occurs and real interest rates get bigger and bigger. At a FFR of 5.25% and 2% inflation, the real rate is 3.25%. At an FFR of 5.25% and 1% inflation, the real rate becomes 4.25%. That means bigger cuts, taking more time to occur, will be needed to return the economy to neutral where the FFR is close to the rate of inflation.

I predict the FOMC dawdles on ending QT, just like they dawdled 6-12 months in 2021-22 when inflation first got out of hand. If the Taylor Rule paradigm seems to be falling apart because inflation fell faster than the TR said it would due to interest rates alone, and if the FOMC members still don't understand the cause of rapid disinflation, they will again "wait for more data."

In the meantime the patient is absorbing far more medicine than the doctors understand, and so the situation gets out of hand quickly. 2% inflation becomes 0% inflation as inflation falls faster than the Fed can cut rates in early 2024. The still-shrinking money supply isn't noticed as a factor until people really start to worry about deflation (just as the rapidly expanding money supply didn't get attention until late 2021). Everyone thinks rapidly falling inflation is good news, but they aren't accounting for the 6-12 months it takes the Fed to change course, or the 6-12 months of rate cuts that might be required to return real rates to near zero. That's a long time when annual CPI is falling at a rate of 0.5% PER MONTH as it did from January to May!

So my signal for a possible "soft landing" would be if the Fed announced the end of QT this summer, and their taper-down period to zero QT was no longer than a couple of months. If QT goes longer than that, I think we'll overshoot to the downside, because QT is apparently very strong stuff.

[MustacheAndaHalf]

ChpBstrd - The Fed ramped up quantitative tightening (QT) to $95 billion/month, which is where it has been for the past 9+ months.  What confuses me is the pace relative to their balance sheet.  Ignoring different types of assets, $95B/mo takes about 8 years to work off a $9 trillion balance sheet.  What do you think is the Fed's end goal with QT?

(1) If the Fed runs QT for 8 years, that will drag on the recovery (of the economy).  I assume they don't plan to have QT during recovery.
(2) Crazier idea, they expect 8 years of inflation.  Since that would be a failure on their part, this doesn't make sense, either.
(3) They want to keep their balance sheet!  This makes the most sense to me, suggesting they only plan to run off "a few trillion", and keep several trillion in the Fed's accounts.  This also gives them the option of QT later.

I think the Fed is doing (3), and plans to keep trillions of bonds ready for QT during the next crisis.

One key clarification: QE/QT may be new approaches, but the Fed did not start easing and tightening with QE/QT.  Many decades ago, the Fed did "open market actions" in secret, which had similar effects.  Markets had to guess what the Fed was doing, and now the Fed prefers to disclose it's tightening and easing.  But that does not mean QE/QT is new - just a new form of tightening and easing.

[Paper Chaser]

Just posting because they seem related to the current convo:

[ChpBstrd]

ChpBstrd - The Fed ramped up quantitative tightening (QT) to $95 billion/month, which is where it has been for the past 9+ months.  What confuses me is the pace relative to their balance sheet.  Ignoring different types of assets, $95B/mo takes about 8 years to work off a $9 trillion balance sheet.  What do you think is the Fed's end goal with QT?

(1) If the Fed runs QT for 8 years, that will drag on the recovery (of the economy).  I assume they don't plan to have QT during recovery.
(2) Crazier idea, they expect 8 years of inflation.  Since that would be a failure on their part, this doesn't make sense, either.
(3) They want to keep their balance sheet!  This makes the most sense to me, suggesting they only plan to run off "a few trillion", and keep several trillion in the Fed's accounts.  This also gives them the option of QT later.

I think the Fed is doing (3), and plans to keep trillions of bonds ready for QT during the next crisis.

One key clarification: QE/QT may be new approaches, but the Fed did not start easing and tightening with QE/QT.  Many decades ago, the Fed did "open market actions" in secret, which had similar effects.  Markets had to guess what the Fed was doing, and now the Fed prefers to disclose it's tightening and easing.  But that does not mean QE/QT is new - just a new form of tightening and easing.

I agree with you that 3 is the most likely possibility. Having a balance sheet gives the Fed "dry powder" and credibility to soak up excess liquidity by selling assets if doing so is ever necessary in the future. It supports the USD as a currency because economic actors can see the Fed has a huge amount of ammunition to extinguish inflation. However the Feds are also concerned about their balance sheet becoming too large relative to the economy. I.e. At what point is the treasuries market government-controlled, and unable to provide clean economic signals? At what point in the government assets to private assets ratio does a country start experiencing the loss of dynamism and growth characteristic of communist states? I doubt they have an optimal level in mind, but they feel a vague need to reduce the balance sheet. Hence the 2018 balance sheet reduction, which was not even done in reaction to any significant inflation.

I am entertaining several possibilities, but my main stream of thought right now is that the Fed doesn't have a plan or even a theoretical basis for quantifying QE/QT; they're just reeling in some fraction of the excess dollars created in 2020-2022 when M1 quintupled. QE/QT isn't new, but QE was never used on the scale of the post-2008 or the post-2020 campaigns. Mobilization for WW2 comes close, but that was a very different intervention than having the Fed increase or decrease a balance sheet of mortgages and treasuries.

QE/QT at the multi-trillion dollar scale doesn't fit into established quantitative formulas like the Taylor Rule or others. It just hasn't been done at this scale until that past 15 years, so the theory has yet to catch up to the practice. The failure of QE to raise inflation in the years after the GFC seems to have convinced many economists it is weak medicine.

Why $95B/month ($1.14T/year)? That number was probably more an outcome of a committee discussion than a calculation. It's probably an amount they judged would not drain too much liquidity from treasury markets and cause a seizure.

QE and QT don't get much attention compared to interest rates. JPow's comment last year about QT's effects being unquantifiable and worth maybe 25bp of rate hikes suggests that he sees it as a minor factor, with limits set by the amount of liquidity changes the market can absorb. If the FOMC thinks QT is a minor factor but balance sheet reduction is a vaguely desirable goal, then we might see several more months like June when we didn't get a rate hike but QT continued running in the background. If Fed officials really don't see QT as disinflationary, we could see continued QT well into next year, or a weird combination of QT and rate cuts!

[EscapeVelocity2020]

ChpBstrd - The Fed ramped up quantitative tightening (QT) to $95 billion/month, which is where it has been for the past 9+ months.  What confuses me is the pace relative to their balance sheet.  Ignoring different types of assets, $95B/mo takes about 8 years to work off a $9 trillion balance sheet.  What do you think is the Fed's end goal with QT?

(1) If the Fed runs QT for 8 years, that will drag on the recovery (of the economy).  I assume they don't plan to have QT during recovery.
(2) Crazier idea, they expect 8 years of inflation.  Since that would be a failure on their part, this doesn't make sense, either.
(3) They want to keep their balance sheet!  This makes the most sense to me, suggesting they only plan to run off "a few trillion", and keep several trillion in the Fed's accounts.  This also gives them the option of QT later.

I think the Fed is doing (3), and plans to keep trillions of bonds ready for QT during the next crisis.

One key clarification: QE/QT may be new approaches, but the Fed did not start easing and tightening with QE/QT.  Many decades ago, the Fed did "open market actions" in secret, which had similar effects.  Markets had to guess what the Fed was doing, and now the Fed prefers to disclose it's tightening and easing.  But that does not mean QE/QT is new - just a new form of tightening and easing.

I agree with you that 3 is the most likely possibility. Having a balance sheet gives the Fed "dry powder" and credibility to soak up excess liquidity by selling assets if doing so is ever necessary in the future. It supports the USD as a currency because economic actors can see the Fed has a huge amount of ammunition to extinguish inflation. However the Feds are also concerned about their balance sheet becoming too large relative to the economy. I.e. At what point is the treasuries market government-controlled, and unable to provide clean economic signals? At what point in the government assets to private assets ratio does a country start experiencing the loss of dynamism and growth characteristic of communist states? I doubt they have an optimal level in mind, but they feel a vague need to reduce the balance sheet. Hence the 2018 balance sheet reduction, which was not even done in reaction to any significant inflation.

I am entertaining several possibilities, but my main stream of thought right now is that the Fed doesn't have a plan or even a theoretical basis for quantifying QE/QT; they're just reeling in some fraction of the excess dollars created in 2020-2022 when M1 quintupled. QE/QT isn't new, but QE was never used on the scale of the post-2008 or the post-2020 campaigns. Mobilization for WW2 comes close, but that was a very different intervention than having the Fed increase or decrease a balance sheet of mortgages and treasuries.

QE/QT at the multi-trillion dollar scale doesn't fit into established quantitative formulas like the Taylor Rule or others. It just hasn't been done at this scale until that past 15 years, so the theory has yet to catch up to the practice. The failure of QE to raise inflation in the years after the GFC seems to have convinced many economists it is weak medicine.

Why $95B/month ($1.14T/year)? That number was probably more an outcome of a committee discussion than a calculation. It's probably an amount they judged would not drain too much liquidity from treasury markets and cause a seizure.

QE and QT don't get much attention compared to interest rates. JPow's comment last year about QT's effects being unquantifiable and worth maybe 25bp of rate hikes suggests that he sees it as a minor factor, with limits set by the amount of liquidity changes the market can absorb. If the FOMC thinks QT is a minor factor but balance sheet reduction is a vaguely desirable goal, then we might see several more months like June when we didn't get a rate hike but QT continued running in the background. If Fed officials really don't see QT as disinflationary, we could see continued QT well into next year, or a weird combination of QT and rate cuts!

I also agree that Option 3 (keep the balance sheet) is where we will be for years.  The first big question is how many trillions is 'healthy' for the Fed to hold?  The second is how low bank reserves are going to be allowed to go before we have another repo rate blowup. 

There are probably dozens more good questions that I haven't even thought of, but being this far in to the 'unknown' and only inching back to shore makes me nervous.  I believe QT was a contributing factor to Japan's lost decade(s), just not sure how much so.  It's impossible to isolate the effects of aging population, preference for hoarding cash, etc.

But if Japan's example as well as the 2019 repo implosion suggest we'll need QE well before we get back to a 'normalized' Fed balance sheet (e.g. pre-Covid levels), then I suppose the most important question is what the implication of carrying excess trillions on the Fed balance sheet for years will mean?

[MustacheAndaHalf]

ChpBstrd - It sounds like M1 isn't useful by itself, according to Investopedia.  I don't know of economists use M1/M2/M3, or just don't use M1 at all.

"The M1 is no longer used as a guide for monetary policy in the U.S. due to the lack of correlation between it and other economic variables"
https://www.investopedia.com/terms/m/m1.asp#:~:text=M1%20is%20no%20longer

[MustacheAndaHalf]

Just posting because they seem related to the current convo:

The first graph in Paper Chaser's post shows the Fed balance sheet.  In March 2023 you'll see a sharp spike, which I believe was the Fed backstopping banks like SVG to avert a wider crisis.  But if I look at it in terms of tightening (QT), the Fed reversed 1/3rd of their overall QT.  I think of this as resetting QT and starting it 3 months later... so instead of Sept reaching full QT, it's like Dec hitting full QT (of $95B/mo).  Could that delay the day of reckoning?  (Recession and/or control of inflation)

[ChpBstrd]

@MustacheAndaHalf I agree M1 is a less relevant metric than broader money supply measures like M3, which rose over 40% between February 2020 and July 2022. Maybe M1 is too dramatic to be accurate. But any way we look at it money supply increased rapidly and money lost its value rapidly. This supports the monetarist position that government money-printing is "always and everywhere" the cause of inflation. To the extent FOMC members are even moderately persuaded by the theory and recent correlated events, they will try to reel back money supply in order to reduce inflation. However they cannot reel in money supply as fast as they increased it during the crisis because as @EscapeVelocity2020 points out QT comes out of bank reserves and a liquidity crisis can occur if the banks cannot refill their reserves quickly enough and must refuse to sell any treasuries.

A lot of the increase in money supply between 2020 and 2022 was from helicopter money (M1), not just QE. Payments direct to consumers had the desired economic effect of stimulating spending, whereas QE only shored up banks. Banks can hoard liquidity as they did in the post-GFC era. I think the Fed will have a harder time reeling in the excess money supply without causing a freeze-up because (a) the helicopter money didn't all go into bank deposits, and (b) the QE was invested by banks in ways that are now underwater, including long-duration bonds and low-interest real estate loans.

The first graph in Paper Chaser's post shows the Fed balance sheet.  In March 2023 you'll see a sharp spike, which I believe was the Fed backstopping banks like SVG to avert a wider crisis.  But if I look at it in terms of tightening (QT), the Fed reversed 1/3rd of their overall QT.  I think of this as resetting QT and starting it 3 months later... so instead of Sept reaching full QT, it's like Dec hitting full QT (of $95B/mo).  Could that delay the day of reckoning?  (Recession and/or control of inflation)

I'm not sure I understand the milestones in September/December or the term "full QT". Because the increase in money supply includes a combination of helicopter money plus QT plus economic growth, the overall money supply will remain much higher than in early 2020 even if the Fed's QT eventually equals the size of the QE it is reversing (I think that's the point you were exploring by adding in the bank loans).

By my accounting, 2020-2022 QE amounted to $2.325T, but QT so far has only amounted to $1.0925T. QT would have to continue at the current pace until July 2024 to equal the size of the post-pandemic QE.* I guess that could happen if the Fed left QT on autopilot until PCE=2%.

Money supply will remain much higher than the pre-pandemic growth trendline. I don't know how that translates into an inflation rate, because my understanding is that the change in money supply affects the change in the purchasing power of money, rather than the absolute level of money supply affecting the change in the purchasing power of money. Still, it politically sounds good to say "we reversed 100% of the 2020-2022 QE". Doing so clears the theoretical plate to analyze the remaining factors. So it might happen.

I wonder if the banks borrowing from the Fed with treasuries as collateral (at par value) are holding those debts long term or if they'll exit as they strengthen their balance sheets over time. When the banks exit these loans, the Fed's balance sheet could shrink even faster than what QT is causing. I'm thinking banks will hold onto these loans because it's a good deal, because risks are still out there, because the program might end, because it's something other than flighty deposits, and because they have plenty of opportunity to invest the proceeds and earn back the cost of the debts, even if they are tightening lending standards. I.e. worse comes to worse, use the loan proceeds to buy new treasuries and cover your cost of interest while greatly increasing your liquidity and solvency ratios.

*Handy copy/paste table to calculate QE/QT sizes, in billions:
Jun-20   120
Jul-20   120
Aug-20   120
Sep-20   120
Oct-20   120
Nov-20   120
Dec-20   120
Jan-21   120
Feb-21   120
Mar-21   120
Apr-21   120
May-21   120
Jun-21   120
Jul-21   120
Aug-21   120
Sep-21   120
Oct-21   120
Nov-21   105
Dec-21   90
Jan-22   60
Feb-22   30
Mar-22   0
Apr-22   0
May-22   0
Jun-22   -47.5
Jul-22   -47.5
Aug-22   -47.5
Sep-22   -95
Oct-22   -95
Nov-22   -95
Dec-22   -95
Jan-23   -95
Feb-23   -95
Mar-23   -95
Apr-23   -95
May-23   -95
Jun-23   -95
Jul-23   -95
Aug-23   -95
Sep-23   -95
Oct-23   -95
Nov-23   -95
Dec-23   -95
Jan-24   -95
Feb-24   -95
Mar-24   -95
Apr-24   -95
May-24   -95
Jun-24   -95
Jul-24   -95

---------------

Maybe I shared this already but here's a quick and dirty model around the 10y/FFR yield curve inversion:   
      
First inversion   Recession Start   Days till recession   
4/2/1968           12/1/1969   608
2/13/1973   11/1/1973   261   
8/30/1978   1/1/1980           489   
9/29/1980   7/1/1981           275   
11/14/1988   7/1/1990           594   
3/30/2000   3/1/2001           336   
3/24/2006   12/1/2007   617   
3/27/2019   2/1/2020           311   
11/15/2022   ?   

The average time from FFR/10y inversion to the start of a recession is 436 days.
If a recession started 436 days from the 11/15/22 inversion, it would start on 1/25/2024.
So if you think the financial media's soft landing / mission accomplished articles are jumping the gun now, bear in mind this might continue for another seven months or more and it would only be an average scenario. The evidence will pile up for no recession until the recession.

[MustacheAndaHalf]

To clarify, I didn't remember exactly when QT began, so I only mentioned when it reached $95B.  Thanks for providing those details.  But my post mentioned QE in 2023, so excluding that kind of misses a key point.  In March, the Fed bought $390 billion of bonds from troubled banks to avoid a crisis.  Buying bonds is the definition of QE, and if you divide $391.5 / $95.0 = 4.1 months of QT reversed.  Whatever QT's effects, 4.1 months of those have been reversed by the Fed actions of March 2023.

Looking at FRED data on M1, M2, M3 doesn't clarify it much for me.  Looking at the past two major crashes, in both the dot-com and great financial crisis the money supply was growing.  Back in the 1970s, same thing.
https://fred.stlouisfed.org/series/M1SL
https://fred.stlouisfed.org/series/M2SL
https://fred.stlouisfed.org/series/MABMM301USM189S

Given that I don't see anything, and that Investopedia claims the above data is no longer used by economists, where is the evidence that M1, M2, and M3 help predict recession?

[MustacheAndaHalf]

First inversion   Recession Start   Days till recession   
4/2/1968           12/1/1969   608
2/13/1973   11/1/1973   261   
8/30/1978   1/1/1980           489   
9/29/1980   7/1/1981           275   
11/14/1988   7/1/1990           594   
3/30/2000   3/1/2001           336   
3/24/2006   12/1/2007   617   
3/27/2019   2/1/2020           311   
11/15/2022   ?   

I organized this data by putting it in order, then dividing neighboring lengths.  That causes 489 days to emerge as an outlier, separating fast arriving recessions (261, 275, 311, 336) from slow arriving recessions (594, 608, 617).  Ignoring the outlier, there's a cluster of recessions at 10 months and 20 months after yield inversion.

Mapping those onto Nov 2022, a quick arriving recession could appear in Aug/Sept/Oct 2023 (within 4 months).  A slow arriving recession would hit in July/Aug 2024.  The outlier maps to late March 2024.

Recessions used to be announced long after the market drop, so I can't depend on the recession itself for investment timing.  But I could split the time period up into three parts, with a different strategy for each:
* next 4 months, brace for market drop
* no market drop by Nov, switch to bullish until May-June 2024.
* May-June 2024, brace for market drop again

[FIPurpose]

First inversion   Recession Start   Days till recession   
4/2/1968           12/1/1969   608
2/13/1973   11/1/1973   261   
8/30/1978   1/1/1980           489   
9/29/1980   7/1/1981           275   
11/14/1988   7/1/1990           594   
3/30/2000   3/1/2001           336   
3/24/2006   12/1/2007   617   
3/27/2019   2/1/2020           311   
11/15/2022   ?   

This data is also cherry picking inversions that led to recessions. I think it should also include
May 1966 - No recession
Aug 1998 - No recession

[EscapeVelocity2020]

Not sure if anyone was watching the ECB Forum on Central Banking, but Powell stated that he doesn't see 2% core inflation until 2025 (headline inflation will be lower).  He wasn't clear on how the 'restrictive' policy will be implemented, other than if inflation rates were coming down more quickly then the Fed would loosen this stance, but he definitely thinks that this is a long way off.  Earlier on, he also emphasized that social stability is more affected by reaching this 2% target than anything else (e.g. weakening employment picture)...

By the way, Japan is in position to use these global economic tail winds to weaken the yen and watch the Nikkei continue to soar!  Highest in 3 decades.

[ChpBstrd]

Given that I don't see anything, and that Investopedia claims the above data is no longer used by economists, where is the evidence that M1, M2, and M3 help predict recession?

You have to go back to the Great Depression and earlier to find instances where money supply growth has gone negative, which is farther back than FRED will chart and also beyond living memory:


Source: https://twitter.com/nickgerli1/status/1633536085308366866?s=20
Each of the past 4 instances of money supply contraction occurred alongside double digit unemployment. The last time the Fed hiked rates while money supply was falling was 1931. I could have been more accurate by saying a falling money supply predicts depressions.

This data is also cherry picking inversions that led to recessions. I think it should also include
May 1966 - No recession
Aug 1998 - No recession

Good point. Recessions were 3ish years away in both cases. Most people would call that a false positive, but if we included those numbers in the average, it would significantly increase the average and muddy the waters. These instances illustrate the risk of betting on a recession after FFR/10y inversion - sitting in defensive or market-inverse positions for 3 years before the recession comes would likely cost more money than could be made by the successful prediction!

I organized this data by putting it in order, then dividing neighboring lengths.  That causes 489 days to emerge as an outlier, separating fast arriving recessions (261, 275, 311, 336) from slow arriving recessions (594, 608, 617).  Ignoring the outlier, there's a cluster of recessions at 10 months and 20 months after yield inversion.

That's an intriguing insight, though I'd be reluctant to make any short-duration market timing decisions based on only 8 observations. Another interpretation of the 1978-80 inversion to recession timeframe of 489 days is that it opens up the possibility of one's risk off-on-off timing being exactly wrong, multiplying the damage. Good point about the shape of the distribution being a double camel hump though. Also worth noting is that the 1980 recession timeframe is both an outlier and also the only deliberately engineered recession in the data set. Maybe Paul Volker forced the recession sooner than it would otherwise have occured?

We could include the false positives in the dataset for a total of 10 observations, and then sort them by length to calculate the declining historical probability of a recession after each date. E.g. at the following milestones, the historical odds of the 10y/FFR inversion predicting a recession within 3ish years are...

Days Post-Inv   Probability Of Accurate Recession Prediction If No Recession Yet
261                   80%   (i.e. Until day 261, 8/10 historical observations predicted a recession starting between today and 3y post observation)
275                   78%   (i.e. Until day 275, 7/9 historical observations predicted a recession starting between today and 3y post observation)
311                   75%   ...
336                   71%   ...
489                   67%   ...
594                   60%   ...
608                   50%   ...
617                   33%   (i.e. Until day 617, 1/3 historical observations predicted a recession starting between today and 3y post observation)
>617                0%     (i.e. after day 617, 0/2 historical observations predicted a recession within 3y)

We are at day 225 as of 6/28/2023, so the implied odds of recession within 2.5ish years according to this one metric are 80%.
   
Seen this way, the odds of a recession remain elevated well into the 2nd cluster of timeframes but the odds of a soft landing increase as time passes. If the odds of recession are currently 80%, it makes sense to take the risk-free rate, such as agency bonds yielding 5.99% today, rather than investing in a stock market that will probably go down in a probable recession. But if you do that logical thing, you might watch time pass and watch your odds of being wrong increase. At 21 months post-inversion, if a recession hasn't happened yet there's a 100% historical chance that you experienced a false positive.

Of course, by the time a false positive is clear, it might be a horrible time to invest, as it was after both historical false positives. Twenty-one months after the May 1966 false positive was February 1968, and if you invested at this point you'd be down about 21% by mid-1970. And 21 months after the August 1998 false positive was April 2000, and you'd be down about 24% a year after going all-in at that point, with more losses on the way.

That doesn't mean this time won't be another outlier. I think monetary and fiscal policy is more activist and prone to unconventional action now than it's ever been in the past. The Fed put is very real, rules are routinely made and broken to bail out banks, and QE/QT appear to be reducing the US's reliance on damaging interest rate changes. Overall the US government is working very hard to moderate economic cycles. These newish factors could mean the historical odds overstate the risks. E.g. had the Fed not stepped in with its lending program this Spring, covered uninsured deposits, and brokered the purchase of FRC, would we already be in recession? I think probably yes. I also think 40 years ago some of these actions would probably not have happened, but they were inevitable by 2023. How can one plan for events like this, or the cycles of a very government-managed economy? Perhaps the focus is on guessing the reaction to the government's current policies. E.g. Poor underwriting standards led to the housing crash of 2008. Pandemic QE and stimulus checks led to the inflation of 2021-2023. The higher inflation of 2021-2023 led to QT and higher rates. The QT and higher rates can be expected to lead to... falling demand, jobs, and prices... UNLESS the government does something else unexpected.