Jay Powell now so smart he can also do fiscal policy too, and an aside on services ISM

The Fed’s adoption of Average Inflation Targeting (AIT) in August 2020 might have been benign to pointless.  As former Fed Vice Chair Richard Clarida formally modeled the actual implications in real time, the Fed would have been stopped out of the need to average just two months into the subsequent inflation spike. The real problem was the reaction function announced at the September FOMC meeting, which committed the Fed to getting well behind on both sides of their mandate, thereby tossing time consistency.  In the wake of some admittedly bad luck, it looks like that unforced error caused a bit of reality denial on the FOMC followed by some unseemly scrambling to renege belatedly without admitting to doing so. In hindsight especially, it was a striking policy error, even by the Fed’s own lights.

The recent steep – and surprising to me – decline of core inflation in the goods and services markets has probably made Fed Chair Powell start to feel a bit more confident that he can get that mistake into the past, where it will be averaged against some legitimate successes.  We could tell from the tone of the Press Conference last week, if not the rates commentary itself, that Powell is indeed feeling better. And then on the weekend, he really showed that his confidence has returned by starting to lecture the politicians on how they should do fiscal policy. Apparently, the debt/GDP ratio is on an unsustainable path, and it is time to have an “adult conversation” about the burdens we are placing on “future generations.”  Surely, that is “uncontroversial.”  Apparently, Jamie Dimon is part of this fake centrist campaign, inevitably.

I am in favor of an adult conversation and would like to weigh in on that basis.  Whether the US has even enough public debt — or the prospect for same – is a function of the future path of r* relative to g*, for reasons that people seemed to understand as recently as a year ago.^[1]Right now, forward r* is above estimated g*, although it looks to be a near call, and forward rates may be slightly inflated by a term premium.  

Market now hints that r* is possibly expected to rise above conventional estimates of g*

The conventional way of measuring spot r* vs g* suggests that there is still a huge gap there and that we may need significantly more federal debt. This is not my unique opinion. It is just a straightforward application of the logic of Ponzi Public Finance, not disparagement implied by the term.

New York Fed hosted approach suggests there is not nearly enough public debt

So, I disagree with Jay Powell. His comment about fiscal sustainability is indeed controversial, and not just because the conventional take is uncertain.  With fiscal sustainability analysis, his view is not even conventional, certainly not in the categorical terms he expresses it.  Powell is again winging it based on a gut feel, and he should know better. 

True, with a continued rise of the federal debt, there is a good chance that the forward path of r* will rise meaningfully above g*, which would be a signal that fiscal consolidation is in fact required.  If fiscal consolidation is not delivered in a timely way, which I concede is a risk, then trouble could arise in one of three ways.

• The Fed might find itself in a position where it is pressured to inflate away the debt. I don’t think that risk is high, but sensible people disagree.
• Bond holders, overrepresented by the higher end, might decide that the risk of inflation or formal default had risen in which case, they would force real yields up in a way that would be unhelpful on efficiency and cyclical grounds.
•  There might be the need for a sudden fiscal contraction, which would most likely be most damaging to the most vulnerable members of society.

But the correct political lens through which to look at those three prospects involves class conflict, not intergenerational warfare, whose invocation is almost inevitably designed to obscure class issues. Sorry, to sound Marxist, but they started it. The burdening of future generations stuff is pablum, and certainly not part of an “adult conversation.”

This is not to say that fiscal policy is a non-issue.  The case for letting the debt rip is now more ambiguous than it was, as the top chart above suggests. Fiscal tightening might be helpful on cyclical grounds here. And the long odds against it imply upward pressure on the term premium in the yield curve, due to portfolio balance, not fiscal sustainability, considerations.  But Powell speaks with far more confidence than is appropriate here and the tell is the lazy bromide about “future generations.”

An aside on the Non Manufacturing ISM prices index

I fully admit to cutting off the time scale to show only the period during which it very roughly “works.” But there is an imperfect correlation between that diffusion index and what I have called the MPO version of the “Powell Supercore,” as it is sometimes called, with some people taking some liberties in the labeling there.  There is no need for a lot of words. The chart tells you roughly what I know. 

 Very tentative support for the arguably still kicking 2 Stage Disinflation Take

^[1] My complaint here has nothing to do with MMT, which I view as fraudulent.