Soft Landings in Economic Helicopters
PHOTO: Photo by James Coleman on Unsplash
Have you ever tried to drive a remote controlled helicopter? It’s insanely difficult.
A few years ago I bought a small one on Christmas for my kids. None of us could fly the thing out of the living room. Heck, 99% of the time, we couldn’t get it off the floor and, when we did, it immediately shot in one direction or another, hitting the couch, me, my kids, stuff on our shelves, and so on. The thing seemed possessed.
After many, many hours – and much yelling from my wife as we destroyed the house – we managed to raise it up, make a small circle and land it again without a crash. We could do that about 50% of the time…okay, full disclosure, my kids could manage that about 50% of the time.
If we took it outside where there was any wind at all, we never succeeded. Those tiny movements that were used to send the helicopter shooting in one direction or the other were either insufficient to move it or were overkill, depending on the ever changing wind.
I think a lot about that when I watch the Fed and other central bankers moving interest rates to control inflation. They move the interest rate a little and inflation shoots off in one direction or the other. The next time, there’s a little wind and the interest rate movement seems to have no effect.
There is one huge difference, however, just to be fair. To make it a true parallel, my kids and I would have had to first take a picture of what the living room looked like, then turned off all the lights and then tried to fly it.
Flying Blind
Central banks only have OLD data. They are technically flying blind in a dark room. As an example, on September 28th, we finally got the third revised data for US GDP in the 2nd quarter. The second quarter. And that’s the third revision. Such statistics will never be 100% accurate.
The real analogy, then, for conducting monetary policy would be that instead of taking a picture of my living room, my kids would make hand-drawn sketches of the living room every few minutes for me, and I’d go to another room with the controller.
Even if we could collect all data exactly and accurately across every aspect of the economy, it takes time. People forget this in a world of instant information. All national statistics are estimates. And, the more aggregated the number, the longer it takes to get it, and the less accurate it will be.
Back to the Real World
Okay, who cares? What’s the point?
The point is that the Fed has the controller. They use it to set interest rates. The helicopter is the economic variable they are trying to control. And, actually, it’s technically two helicopters, one called unemployment and one called inflation, but they only have one controller to move them both.
But, the thing works like my possessed remote helicopter example, and the Fed’s FOMC meeting happens in a different room from where the helicopter is. And, they do it based on hand drawn pictures made by my kids every 15 minutes or so. Oh, and actually the helicopter is outside where there may or may not be some wind.
Right now, everyone is talking about a soft landing. We thought we would crash the economic helicopter as we raised rates too quickly. But it hasn’t happened yet. It might not happen. Maybe we are just landing softly instead… Maybe.
My best guess at this point, however, is that either something else we weren’t expecting will break, and we’ll get a sudden-onset recession. Or, due to massive and continued fiscal stimulus, we won’t have a recession, but then the fiscal winds pushing demand will keep inflation up until suddenly all that ends, and suddenly inflation will drop right past the 2% target.
The Possible Break(s)
The danger of something breaking is likely coming from high interest rates putting pressure on banks and banking-related businesses. That is, any business reliant on financing (real estate, etc.). We saw banking-related challenges this Spring with SVB, Credit Suisse and other banks collapsing. But we are not out of the woods. Banks still seem to be skating on thin ice, especially the banks that lend heavily in the commercial real estate industry, for example, which looks fragile these days.
We weren’t, however, expecting SVB to crash. We were underappreciating how sensitive Silicon Valley tech startups were to interest rates. The banking break also won’t be in the areas we expect today. So, maybe commercial real estate, maybe elsewhere. We don’t know.
The other dangerous, bank-like, heavily finance-dependent “business” is the US government. Because our debt to GDP is over 100% now, and we have to refinance something like half of all our debt in the coming couple of years, it’s super interest rates sensitive, and that’s a problem for the entire US economy. We borrowed initially at near zero interest rates, and are re-financing at near 5% interest rates. We additionally continue to borrow and spend more. Debt was 129% of GDP in 2022 and we spent A LOT MORE since then.
That means, the government is using its proverbial Visa to pay its old Mastercard bills each month and it is doing that at much higher interest rates. And, it continues to run up new bills as well. Not a wise financial strategy. Or, better put, it’s a crisis strategy, but we aren’t in a crisis anymore.
That is a recipe for financial disaster, and it’s starting to show up in interest rates, in my opinion. They are rising rapidly on US debt now. Google “bond market concerns” or something similar, and you’ll see tons of articles about exactly this over the last 2 months in particular. Rates on longer-term US debt have been rising rapidly since mid-summer.
They rose by 25% since just June this year. On June 1st the Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity was 3.66, today (October 4th) it’s 4.58. Check this FRED graph, if you like: (I added a red line at June 1) https://fred.stlouisfed.org/graph/fredgraph.png?g=19GPm )
Government debt and spending is particularly problematic for many reasons, not the least of which is that it also heavily distorts GDP estimates. Massive government spending, financed by more debt, makes the economy appear much stronger than it is. The basic formula for GDP is GDP=C+I+G+NX. The C is consumption, I is investment, G is government spending and NX is net exports.
When you increase the G but pay for it by more taxes today, then something else must drop, like C or I. The money for taxes comes from someone’s pocket and people can’t both pay more taxes and consume more out of the same income. Something must give. So more G doesn’t push up GDP as much when it’s not deficit financed.
But, if you increase G without raising taxes, say by borrowing in global capital markets from people in other countries, then it feels like a “free lunch”: more G without the cost.
What is G? It’s government expenditure. That is, it is the government’s own purchase of goods and services in the economy. Hight G increases demand for goods and services. That feels like a growing economy to all the businesses selling such goods. But there is no free lunch. It’s “fake” demand in the sense that it’s not coming from more personal income and robust economic growth. It’s a “fake” addition to growth[1]. And when it stops, it not only ceases to exist, it must also be paid for. So, there’s a double whammy when it ends: 1) the government’s demand stops and 2) the government needs more taxes to pay its bills. And, you can’t pay your MasterCard with your Visa forever.
As interest rates rise, the cost when the bills come due is bigger and bigger every month. This means that any boost to GDP today that comes from deficit-financed government spending will hit the economy tomorrow. The higher the interest rates, the harder the hit.
As interest rates rise in the markets for US debt, the US fiscal authorities – i.e., Congress – will feel this pinch and will come under ever more pressure to cut spending and raise taxes to lower deficits and reduce the debt burden.
It is not sustainable. It will have to end. “When?” is the only question.
Summarizing the Policy Helicopter Problem
The Fed controlling interest rates to target inflation is very much like my helicopter example. One time you raise them a little and the thing shoots off in one direction. The next time, winds are blowing and interest rates don’t seem to move inflation at all.
The fiscal wind has been blowing for some time in the US and in many countries. We have run up debt to GDP higher than we did in WWII, and continue to add to it. Many of the Covid emergency measures are only now going away in the US. Students didn’t have to pay their loans, and certain businesses were still getting support. Most of that is finally ending. Our American fiscal stimulus has continued, however, just under a new guise called the Inflation Reduction Act. That has continued to blow “fake” wind into the economy’s sails, clouding the picture of real growth.
Okay, you might wonder, what’s all this mean?
I expect inflation will possibly not fall due to continued fiscal stimulus, but then the crash in, say a year, will be much worse. When that crash comes, or when a soft landing occurs, inflation will suddenly fall faster than people currently predict. In particular, I think it will drop right past the Fed’s 2% target. In other words, I think the chance that it slowly lands right at 2% as the economy gently cools without any hiccup is near zero. It’s possible, but highly unlikely.
I’m watching everything with a skeptical eye right now. I do not like the sudden rise in bond rates. It could be market participants finally coming to terms with the reality that US policy rates are high and will be high for longer than initially expected. It could also be that people are buying less US bonds out of concern for our fiscal mess at the same time we are issuing more, driving bond prices down and yields up. Why are they buying less? We don’t truly know. It worries me. Something’s not right.
For now, let’s keep watching.
Thank you for reading.
[1] “Real” demand, by way of comparison, is when production and, especially, productivity, is increasing which drives up incomes so people have sustainably more money to buy goods and services with.