Fed officials are meeting today to discuss the central bank’s next course of action amidst bank failures and persistent inflation. The financial press is busy pumping out articles lamenting the tough position Fed officials find themselves in as they debate another rate hike. That’s true, it is a tough position. But the blame for that lies squarely on the Fed’s own shoulders.
This often goes unsaid because the way people think about central banking is wrong. Most seem to imagine the national economy as a hot air balloon trying to get from point A to point B. The Fed is like the pilot whose job is to keep the balloon stable and at a safe altitude. When conditions demand it, the pilot can either blow hot air into the balloon (monetary expansion) or vent the hot air out (monetary contraction) to increase or decrease buoyancy. If the Fed does its job well, the economy would be guided gently along with occasional monetary interventions to account for economic fluctuations—just as the balloon pilot gently corrects for changing atmospheric conditions.
The quest for a “soft landing” makes sense in this view. The “balloon” climbed too high (inflation), and venting hot air (rate hikes) has yet to bring the balloon back down to the target altitude (2% inflation). But continuing to vent air risks sending the balloon into an unrecoverable descent to the ground (recession). The analogy seems to work well because we’re inundated with central bank discourse that uses this framing. But the framing is wrong. The Fed is not a gentle guide keeping the economy stable; it’s the culprit behind the inflation and imminent recession we’re now forced to deal with.
Recessions don’t come out of the blue. They have a cause—malinvestment encouraged by central bank credit expansion. Artificially low interest rates send a false signal to investors and producers to start, or continue, producing things that either customers don’t actually want—at least not in the quantity now being produced—and/or are unable to be completed with available resources. At some point, often when rates come back up, the precarious nature of these production lines becomes impossible to ignore, and a painful period of correction takes place. That’s a recession.
So we can see the problem with the typical framing of the Fed’s situation. Besides falsely identifying the Fed as an essential part of the economy, it presents a recession as possible to avoid. Not only is it impossible to avoid, it was the Fed who caused it. They may still have room to delay the correction, but the malinvestment that needs correcting is already here.
A better analogy than the hot air balloon would be a false shortcut. Imagine you’re running on a trail in the woods. Say it’s the second half of a trail marathon. You’re exhausted and desperate to get to the finish line when you round a corner and see a steep hill up ahead that seems to go up forever. You stop, devastated. You don’t feel like you have the energy to get to the top, much less all the way to the finish. Then out pops a Race Official. He says he can tell you’re exhausted and points excitedly to a small trail to the left of the hill. He explains that it’s a shortcut that avoids the hill. You don’t believe him. A shortcut? In a race? That can’t be allowed. But he insists. He is an official, after all. This shortcut isn’t just allowed, he says, it’s encouraged.
He’s persistent, and eventually, you’re convinced. You start down the trail and immediately feel much better. It’s shady and has a slight downhill. Your pace increases, you stand taller, and you feel more energized. But above all, you feel grateful that the Race Official happened to find you at the base of that hill. However, what you don’t know yet but will eventually figure out is that you were fooled. There is no shortcut. You’re running off course. Every step you take brings you further and further from your goal. At some point, you will need to recognize this, turn around, and run all the way back up to the base of the first big hill you were misled into thinking you could skip. And because you’re now running downhill and every mile you run not only doesn’t count towards your race but will need to be re-run just to get back to where you initially went off course, correcting your mistake will be extremely painful. But it’s necessary. And the longer you refuse to face that, the worse the eventual correction will be.
Now imagine you realize your mistake. You turn around and start your painful climb back up to the trail when, again, out jumps the Race Official. He reassures you that you’re on the right path and should continue down this trail. The climb is painful, so you’re inclined to believe him. You keep on down the trail, occasionally turning around when your doubts return, only to have the Race Official again usher you back down his false shortcut.
By now, I hope it’s obvious what this analogy represents. The hill is the economic pain made inevitable by the lockdowns in 2020 and 2021. The Race Official is the Fed, and the false shortcut is the artificial boom and malinvestment caused by the $7 trillion created out of thin air and injected into the credit markets. I hope it’s also clear that the worst thing you, as the runner, could do would be to continue seeing the Race Official as a helpful guide. Correcting for malinvestment is always painful. But ignoring or aggravating it is worse.
We’re running off course. Don’t have pity for the people who got us here. And certainly don’t look to them to get us out.
