Powell’s Double Challenge: A Slowing Economy and Vanishing Liquidity

August 29, 2022 Updated: September 8, 2022

Commentary

The hawkish tone of Federal Reserve Chairman Jerome Powell on Aug. 26 was unequivocal.

Powell’s most important sentence, in my view, was the following: “With inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.”

What does this mean? The Fed will do what it takes to cut inflation if the labor market remains strong. These strong messages sent ripple effects through markets. Stocks and risky assets fell in unison, and the relative strength of the U.S. dollar created another widespread depreciation of weaker currencies.

The Fed knows that inflation is fundamentally a monetary phenomenon and that the central bank must correct the mistake made in 2020 by dramatically increasing the money supply and sending rates to even lower territory.

Inflation is the destruction of the purchasing power of a currency. One or two prices may rise because of an exogenous factor, but all prices can’t go up at the same time if the amount of money in the economy is unchanged. Other prices would fall with the same amount of currency.

However, the Federal Reserve may be too complacent about the strength of the economy and dangerously optimistic about liquidity in markets.

It’s impossible to create a monetary tsunami by slashing rates and pumping trillions of newly printed dollars into the economy and expect it to correct with a small splash of water in the face. It’s worse; it’s impossible to create a soft landing with an overheated engine. The monetary excess of 2020–21 wasn’t just the Fed’s creation, but that of every single developed economy’s large central bank.

Therefore, it’s even worse. Powell needs to believe that multiple monetary tsunamis engineered at the same time are going to be controlled with no damage to a bloated and indebted economy.

The first challenge Powell faces is that rate hikes aren’t even enough to address inflation. Rate hikes reduce the growth in new money creation but do nothing to avoid all the excessive currency issuance coming from fiscal policy. While Powell may rein in the rate of inflation, the United States and European administrations are still consuming trillions of newly created currencies via deficit spending.

The latest anti-inflation plan precisely shows this: It’s an anti-inflation program that will be financed with debt and newly created currency. Fascinating. It’s even more fascinating to read that the recently announced student loan forgiveness program will be “fully financed” by deficit reduction. How can something be “fully funded” by a “deficit reduction” that easily means a half-trillion U.S. dollar deficit anyway? Are we insane?

Powell and Fed officials should be concerned by a tightening of monetary policy that will perpetuate bloated government spending, and the productive sector, families, and businesses will be the only ones suffering the normalization.

Powell’s second challenge is liquidity. While money supply globally remains stable, the depreciation of key currencies against the U.S. dollar is creating two negative flows: faster destruction of purchasing power of currencies and outflows of capital from global economies and into the U.S. dollar.

Within this second challenge comes another problem: central banks that can’t be hawkish enough, and even when they are, the vacuum effect of the U.S. dollar continues. This is caused by years of excessive and careless money creation.

In the eurozone, for example, money supply (M2) growth remains much higher than in the “Draghi bazooka” years, yet liquidity is vanishing rapidly in the riskier asset classes, high yield, and nonsecured loans.

Liquidity limits to bank lending are already evident in an economy that still needs 2 trillion U.S. dollars in reverse repo programs. Reuters stated that “the trillions of dollars in overnight cash tucked away daily at the Federal Reserve could turn into a major headache for banks that could squeeze their balance sheets and impair their ability to lend.”

The Fed should be aware that massive reverse repo programs aren’t a sign of an adequate function of markets but are instead a warning sign of a lack of confidence that can create a credit crunch in what continues to be a sea of liquidity.

Can you imagine? Vanishing liquidity for the credit system because of previous excess liquidity created by years of money printing.

Powell and the Fed may also be too complacent about the global and U.S. economy. The manufacturing purchasing manager’s index (PMI), both in the United States and in the European Union, shows weakness. Furthermore, the global manufacturing PMI has been falling since March and is close to contraction. The United States is at 51.3 points, 50 being the level of contraction, while the euro area is at 49.7, already in contraction.

The Organization for Economic Co-operation and Development leading indicator of economic activity has also been in contraction for three months in the European Union and the United States. In the United States, the University of Michigan consumer confidence index has only bounced back from a very low level.

If we look at all leading indicators for the U.S. economy, they show weakness and elevated inflation.

Powell can’t perform miracles. There’s no way that rate hikes alone will solve the inflation problem if governments continue to spend new currency as if nothing has changed.

The current path of normalization means that the burden of tightening will be fully paid by families and small businesses while government size continues to expand in the economy, and that means less growth, more taxes, and probably more persistent inflation for longer.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”