Jerome Powell – Jonathan Ernst/Reuters
Monetary tightening is like pulling a brick across a rough table with a piece of elastic. Central banks tug and tug: nothing happens. They tug again: the brick leaps off the surface into their faces.
Or as Nobel economist Paul Kugman puts it, the task is like trying to operate complex machinery in a dark room wearing thick mittens. Lag times, blunt tools, and bad data all make it nigh impossible to execute a beautiful soft-landing.
We know today that the US economy went into recession in November 2007, much earlier than originally supposed and almost a year before the collapse of Lehman Brothers. But the Federal Reserve did not know that at the time.
The initial snapshot data was wildly inaccurate, as it often is at inflexion points in the business cycle. The Fed’s “dynamic-factor markov-switching model” was showing an 8pc risk of recession. (Today it is under 5pc). It never catches recessions and is beyond useless.
Fed officials later grumbled that they would not have taken such a hawkish line on inflation in 2008 – and therefore would not have set off the chain reaction that brought the global financial edifice crashing down on our heads – had the data told them what was really happening.
One might retort that had central banks paid more attention, or any attention, to the drastic monetary slowdown underway in early-to-mid 2008, they would have known what was going to hit them.
So where are we today as the Fed, the European Central Bank, and the Bank of England raise interest rates at the fastest pace and in the most aggressive fashion in forty years, with quantitative tightening (QT) thrown in for good measure?
Monetarists are again crying apocalypse. They are accusing central banks of unforgivable back-to-back errors: first unleashing the Great Inflation of the early 2020s with an explosive monetary expansion, and then swinging to the other extreme of monetary contraction, on both occasions with a total disregard for the standard quantity theory of money.
“The Fed has made two of its most dramatic monetary mistakes since its establishment in 1913,” said professor Steve Hanke from Johns Hopkins University. The growth rate of broad M2 money has turned negative – a very rare event – and the indicator has contracted at an alarming pace of 5.4pc over the last three months.
It is not just the monetarists who are fretting, though they are the most emphatic. To my knowledge, three former chief economists of different stripes from the International Monetary Fund have raised cautionary flags: Ken Rogoff, Maury Obstfeld, and Raghuram Rajan.
The New Keynesian establishment is itself split. Professor Krugman warns that the Fed is relying on backward-looking measures of inflation – or worse, “imputed” measures (shelter, and core services) – that paint a false picture and raise the danger of over-tightening.
Adam Slater from Oxford Economics said central banks are moving into overkill territory. “Policy may already be too tight. The full impact of the monetary tightening has yet to be felt, given that transmission lags from policy changes can be two years or more,” he said.
Mr Slater said the combined tightening shock of rate rises together with the switch from QE to QT – the so-called Wu Xia “shadow rate” – amounts to 660 basis points in the US, 900 points in the eurozone, and a hair-raising 1300 points in the UK. It is somewhat less under the alternative LJK shadow rate.
He said the overhang of excess money created by central banks during the pandemic has largely evaporated, and the growth rate of new money is collapsing at the fastest rate ever recorded.
What should we make of last week’s blockbuster jobs report in the US, a net addition of 517,000 in the single month of January, which contradicts the recessionary signal from falling retail sales and industrial output?
The jobs data is erratic, often heavily revised, and almost always misleads when the cycle turns. In this case a fifth of the gain was the end of a strike by academics in California.
“Employment didn’t peak until eight months after the start of the severe 1973-1975 recession,” said Lakshman Achuthan, founder of the Economic Cycle Research Institute in the US. “Don’t be fooled, a recession really is coming.”
Is the Fed’s Jay Powell right to fear a repeat of the 1970s when inflation seemed to fall back only to take off again – with yet worse consequences – because the Fed relaxed policy too soon the first time?
Yes, perhaps, but the money supply never crashed in this way when the Fed made its historic mistake in the mid-1970s. Critics say he is putting too much weight on the wrong risk.
It is an open question whether the Fed, the ECB, or the Bank of England will screw up most. For now the focus is on the US because it is furthest along in the cycle.
All measures of the US yield curve are flagging a massive and sustained inversion, which would normally tell the Fed to stop tightening immediately. The Fed’s preferred measure, the 10-year/3-month spread, dropped to minus 1.32 in January, the most negative ever recorded.
“Inflation and growth are slowing more dramatically than many believe,” said Larry Goodman, head of the Center for Financial Stability in New York, which tracks ‘divisia’ measures of money.
Broad divisia M4 is in outright contraction. He said the fall now dwarfs the largest declines seen during Paul Volcker’s scorched-earth policy against inflation in the late 1970s.
The eurozone is following with a lag. This threatens to set off a North-South split and again expose the underlying incoherence of monetary union.
Simon Ward from Janus Henderson says his key measure – non-financial M1 – has fallen in outright terms for the last four months. The three-month rate of contraction has accelerated to 6.6pc, the steepest dive since the data series began in 1970. The equivalent headline M1 rate is contracting at a rate of 11.7pc.
These are startling numbers and threaten to overwhelm the windfall relief from tumbling energy costs. The sharpest contraction is now in Italy, replicating the pattern seen during the eurozone debt crisis. Eurozone bank lending has begun to contract too in what looks like the onset of a credit crunch.
This did not stop the ECB raising rates by 50 basis points last week and pre-committing to another 50, as well as pledging to launch QT in March.
Mr Ward says the Bank risks a repeat of its epic blunders in 2008 and 2011. “They have ditched their monetary pillar and are ignoring clear signals that money is much too restrictive,” he said.
It is just as bad in the UK, if not worse. Mr Ward says the picture is eerily similar to events in mid-2008 when the consensus thought the economy would muddle through with a light downturn and no need for a big change in policy.
They were unaware that the growth rate of real narrow M1 money (six-month annualised) was by then plummeting at an annual rate of around 12pc.
That is almost exactly what it is doing right now. Yet the Bank of England is still raising rates and withdrawing liquidity via QT. I hope they know what they are doing at Threadneedle Street.
And no, the apparent strength of the UK jobs market does not mean that all is well. The employment count kept rising in the third quarter of 2008, after the recession had begun. It is a mechanical lagging indicator.
One can argue that the economic convulsions of Covid have been so weird that normal measures no longer have much meaning in any of the major developed economies. The whole nature of employment has changed.
Firms are holding onto workers for dear life, which could prevent the normal recessionary metastasis from unfolding. But labour-hoarding cuts two ways: it could lead to sudden lay-offs on a big scale if the recession does happen, accelerating a destructive feedback loop. In the meantime, it eats into profit margins and should give pause for thought on stretched equity prices.
Personally, I am more Keynesian than monetarist, but the monetarists were right in warning of an unstable asset boom in the mid-Noughties, they were right in warning about the pre-Lehman contraction of money that followed, they were right about pandemic inflation, and I fear that they about right the monetary crunch developing in front of our eyes.
We are told that almost “nobody” saw the global financial crisis coming in September 2008. So at the risk of journalistic indecency, let me recall the news piece that we ran in The Telegraph in July 2008. It cites several leading monetarists.
“The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk,” it began.
That was two months before the sky fell. The monetarists most assuredly saw it coming. So tread carefully.
This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday.