The ‘7% fix’ for interest rates could come back to haunt the Federal Reserve

A trader watches as Federal Reserve Chairman Jerome Powell speaks on a screen on the floor of the New York Stock Exchange (NYSE), Nov. 2, 2022.

Brendan McDermid | Reuters

St. Louis Federal Reserve President James Bullard suggested Thursday that the central bank should raise short-term interest rates to as much as 7% to make inflation go away.

Again, Bullard and other Fed officials say the central bank cannot repeat the policy mistakes of the 1970s.

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Former US Treasury Secretary Larry Summers and others have also supported this view, putting increasing pressure on the Fed to solve a problem that has no historical analogue.

Bullard noted that the policy would become restrictive if the federal funds rate were anywhere from 5% to 7%, and that it may have to stay that way before the Fed can declare inflation dead.

His “7% solution” is utterly and utterly absurd in my opinion.

A rate hike of up to three full percentage points from the Fed’s current target of 3.75% to 4% would create a very deep recession. It would cause something to break somewhere, with the risk of a systemic market or economic event that will shake the financial markets or the economy to the core.

That, in turn, would force the Fed to cut rates to avoid the kind of systemic risk that could quickly become global and catastrophic.

Signs that inflationary pressures are easing

Inversion of the yield curve

Perhaps even more telling is the steepening yield curve inversion.

The three-month T-bill now yields almost half a percentage point more than the 10-year bond.

Former New York Fed economist Arturo Estrella, whom I quote often and who pioneered the predictive power of that particular spread, says that unless the curve gets that steep in the coming weeks when the 10-year bill yields more than the three-month bill, a recession sometime in 2023 is a certainty.

There is almost no scenario in the next two weeks that would suggest a steeper yield curve, based on any observable measure.

The question now becomes how wide and how deep will next year’s recession be?

Which brings me to my claim that not only Jim Bullard, but nearly all panels of voting Fed officials are suffering from some kind of mass delusion.

A radically different time than the seventies

This economy is nothing like that of the 1970s. A policy mistake that is far too restrictive rather than too easy is the critical mistake the Fed risks.

If the Fed raised rates to 7%, well above inflation that could fall to 3% or lower, next year would be historically tight. This would risk creating a bigger problem than the one the Fed is trying to solve and the central bank desperately trying to prevent it from happening again.

Compared to the 1970s, the energy intensity of the economy has changed radically, as has the composition of the labor market.

As the US moved off the gold standard, experienced two major oil shocks and felt the ill effects of bad policy decisions, increased sensitivity to changes in energy prices and stronger unionization of the workforce created fertile ground for the wage/price spiral. fears today.

Those fears continue to guide current policy decisions, despite the marked improvement in inflation rates themselves, expected future inflationary pressures, declining consumer demand and the clear shift in financial market concerns from inflation to recession.

The conditions that drove inflation a generation ago simply do not exist today. This makes comparisons with the many and varied factors that drove up inflation from 1964 to 1980 a gross misconception.

Supply chain disruptions have eased, as measured by a crash in the cost of shipping containers from China to the west coast of the US.

Stocks of unsold goods continue to hurt the country’s retailers Target demonstrated earlier this week. Meanwhile, even economically sensitive companies like FedEx are reducing employee hours and employment ahead of the usually busy holiday season, a sign of a weakening economy and easing consumer price pressures.

The current policy of the Fed is one of fear and not at all forward-looking.

By simply trying to avoid the mistakes of the past, the plant is committing a mistake that will affect our future.

You can’t drive a car looking through the rearview mirror, and you can’t drive an economy with outdated equations.

If short-term interest rates rise to 7%, that solution will be much more painful than the current problem it hopes to address.

I remain deeply puzzled by the policy judgment of this Federal Reserve.

It seems to have abandoned its reliance on the so-called “reaction function” of markets and instead focuses solely on the phantoms of past inflation.

As we approach the holiday season, it may be appropriate for the Fed to take a more charitable view of the economy. If central bankers don’t do this, not only will they take the punch bowl away, but it will be nearly impossible to refill it once the party has come to a halt.

Ron Insana is a CNBC contributor and a senior advisor to Schroders.

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