I had the pleasure of sitting down with Lyn Alden to record an episode of TFTC this morning. It was good timing considering the fact that Jerome Powell was getting grilled by Senator John Kennedy on Capitol Hill right before we were set to begin our conversation. Senator Kennedy's line of questioning provided a great jumping off point for the conversation with Lyn because he was really leaning into the repercussions of the Fed's aggressive interest rate policy, mainly its implicit goal of driving up the unemployment rate to destroy demand for goods, which theoretically should drive down the price of goods. It is something that Jerome Powell and crew aren't able to explicitly say, so they are forced to use vague terms like "demand destruction" and setting up a "growth recession". Sitting in front of the American people and telling them that the end goal of your policy is to destroy enough jobs to make it so there are less people with enough money to compete for goods and services throughout the economy would be career suicide.
Nonetheless, this is the ultimate goal of the Federal Reserve as they are forced to over-index on the "price stability" side of their mandate as inflation gets out of hand. Maximum employment be damned. One thing that this implied, yet pretty obvious, strategy assumes is that the inflation rate and unemployment rate are perfectly connected and extremely reflexive to each other. Lyn pointed out during our conversation that historically the connection between the rate of inflation and the unemployment rate that the Fed is assuming will manifest hasn't always been there. And when one looks at the state of the economy and the fiscal situation here in the US it isn't hard to believe that this period in monetary history may be one of those scenarios where the connection fails to emerge.
As we wrote yesterday, it doesn't seem that the Fed's aggressive rate hikes have done much to quell inflation, especially as it pertains to food and energy. And when one takes into consideration the ballooning federal debt and the runaway interest expenses associated with that debt coupled with the increased cost of capital to invest in critical infrastructure that is necessary to bring more goods to market, it is easy to see a future in which the Fed successfully induces demand destruction but does very little to solve the inflation problem, and actually exacerbates it. Failing to achieve both price stability and maximum employment. Double whammy.
Two examples that have been top of my mind for me when trying to imagine this scenario play out are the oil and gas and railroad industries. Oil and gas is a very capital intensive business that can become very sensitive to interest rates if they reach a certain point. The industry is already stressed from the after effects of the economic lock downs that pushed much of their skilled labor to the sidelines or other industries. Those problems were exacerbated in 2021 and 2022 by the economy opening back up and then Europe scrambling to diversify away from Russian natural gas. It's hard to lock down a drilling team to bring more supply to market. The prices of crude and natural gas have come down quite a bit from their highs, but this could be a temporary lull that is disrupted by China reopening their economy and India increasing their drive to modernize their economy, which will both increase the demand for hydrocarbons. In a high interest rate environment, it becomes prohibitively expensive to break ground on new wells and refineries. This problem is made worse by the climate hysterics and the politicians who enable them who are disincentivizing the build out of new refineries by signaling that they plan to decommission them in relatively short order. And worse yet by the lack of skilled labor on the market that can actually get the energy to market. All of this points to a looming supply side problem in the market for reliable hydrocarbons, which would lead to more inflationary pressure.
Similarly in the railroad industry, which has been a big topic in the headlines this year following the derailment in East Palestine and the subsequent derailments across the country that followed. While many jumped to the conclusion that the US was under some type of attack as all of the derailments were unfolding, it seems that the public was engaged in a bit of recency bias. Train derailments have become a very common thing in the US in recent decades. There are well over 1,000 derailments a year in the US, and a significant percentage of them are caused by track defects that have become more common and investments in track maintenance have declined significantly over the last few decades. A high interest rate environment only exacerbates this problem because railroad companies become even less inclined to invest in maintenance projects because the cost of the debt needed to make them happen is too high. The end result is railroad companies running their tracks to the point where they become inoperable and add fuel to the supply side problems we are experiencing right now.
Long-winded spiel condensed into one sentence; a high interest rate environment can actually make the inflation problem worse because it can perturb the supply-side of the equation to the point where there are massive shortages. With a second sentence addendum; especially in a world where Debt:GDP is reaching astronomical levels and we find ourselves living in a country where the politicians don't have the political will to help the problem from their end.
If this scenario does come to fruition, Lyn cautions that the Fed will become a hyper-politicized institution and calls for it to be more tightly managed by the government will grow. At this point, it will be all but over for any semblance of autonomy for the Federal Reserve and likely the dying breath of the US Dollar as the reserve currency of the world.
As the headline states, the Fed is in an impossible position. Dead man walking.
Wrote this rag while sitting in the middle seat of a flight in the buffer row between first class and the heathens. Had to type with the in-seat trey table above the keyboard. Feeling like a wizard.