The “Fed-amental” Attribution Error

Labor has always been fundamentally tied to American destiny, and now it will take center stage in the Federal Reserve’s priority list. For the past few years, it has been focused squarely on the inflation side of the mandate, and now it will move to the labor side. Inflation reports have moved in the right direction and some of the labor data has been moving in the wrong direction. The Jackson Hole subject that was picked this year is even a sort of retrospective on how to assess the effectiveness of monetary policy over the last cycle. It’s almost a declaration of victory, and though many on Wall Street may disagree, it is a well deserved one in my opinion.

Jay Powell gives his much anticipated Jackson Hole speech on Friday. If you don’t know what Jackson Hole is, then you shouldn’t be making punk rock trades. The investor community we are constructing is for the more sophisticated side of the Street, and is for people who can successfully implement our sophisticated trades. This column is our Fed column, and in it we discuss the Federal Reserve in a much more direct way than you will typically find.

The theme of this year’s Jackson Hole Conference, hosted by the Kansas City Fed, is "Reassessing Effectiveness and Transmission of Monetary Policy.”. There is something I like to call the “Fed-amental Attribution Error” which is really just the fundamental attribution error applied to the Federal Reserve. Let’s pose it in a different way. Does the Fed have the most powerful tool in financial markets by wielding the Federal Funds rate? Yes.

Is it more powerful than say the supply chain becoming ungummed after the largest economic interruption in modern history? No. Is it more powerful than the consumption power of America’s increasingly concentrated wealth? No. Is it able to bring the economy to its knees? No, because the majority of Americans are not as directly exposed to interest rates as they were in the past. As you can see above, the vast majority of Americans pay much lower rates on their mortgage than the current Federal Funds rate.

Remember that mortgage debt is one of the largest components of the consumer wallet. If America was on a floating rate mortgage then the Federal Reserve would have wrecked the economy, but it isn’t. Household debt service and financial obligation ratios remain not only subdued, but below historic trend.

The official Jackson Hole materials ask the question quite directly in terms of Fed speak. It asks the question in a statement, “the resilience of growth through this period raises questions about the transmission of monetary policy and the lessons to be learned from this extraordinary episode.” The Fed is quite plainly assessing that the impact of its bazooka may be altered from previous cycles. The implications of this fact are quite profound.

As you can see above, corporations and households both mainly dodged the effects of higher interest rates this cycle. While there is undoubtedly a psychological impact of the Fed having rates at such a restrictive level, it didn’t seem to have much of a practical impact on the economy. And that is basically the topic of Jackson Hole this year. What do we do, now that we know our primary tool is a lot less effective in the modern economy? Part of the reason is wealth concentration. The Fed’s bazooka round bounces off the spending power of America’s wealthiest quintile like American bazooka rounds bounced off the German Tiger Tank.

So, this economic picture is very different from the past. As human beings we are constantly using heuristics for efficiency. However, it is important to remember that the economy is really just a reflection of collective human activity. When wealth was more equally distributed and credit markets were less sophisticated, the Federal Reserve’s main tool was a lot more effective at getting more people to engage in economically frugal behavior.

Not only that, but during the age of Volcker the Federal Reserve was a lot more powerful. One example was the Regulation Q interest rate ceilings which have since been removed. The Federal Reserve used to be able to set the interest rates higher on money market funds than it was on bank accounts and cause a mini banking crisis. This mechanism was geared at affecting the behavior of market participants. As awe inspiring as the Federal Reserve’s power is relative to other financial market participants, it is nothing in comparison to the awesome economic power of COVID and how that great event affected collective economic behavior.

I postulate that the economic impact of COVID is somewhat hard to see. However, it is not that different from the historic impact of many plagues. The Keynesian intervention of the US government has shown that when you give the poor a break, they sure as hell know what to do with it. It appears they have fixed their balance sheet and made themselves more economically resilient. Developments in the labor market suggest many reconsidered their productive capacity as well, and switched out of lower paying industries.

In the wake of the Second World War, it was probably a pretty safe assumption that the nuclear bomb was going to result in disastrous consequences for the human race. Instead, it made direct conflict between nuclear states unthinkable and no direct stand-off between nuclear armed states has occurred since the bombs were dropped on Nagasaki and Hiroshima. This reality underpinned the period of extraordinary post-war growth. Hydrogen bombs should have been decidedly bad for economic growth, but instead they provided a measure of stability. The pandemic has cleared out the dead wood in the economy. Weak entities failed, unproductive staff were fired, and whole industries had to operate without any revenue for quarters at a time.

Overall, the Fed’s question about why monetary policy has been less effective is an incredibly bullish answer: the economy is simply stronger than it was in the past. It is more resilient. One consequence of the dramatic wealth inequality is that it is very hard to get the richest Americans to stop consuming. This supports labor markets, and is part of the reason why we’ve been able to achieve the soft landing that will be complete when Powell makes the first cut in September. I suspect Powell’s speech may include some deference to the Hawks, but ultimately, he will be laying out the plan for loosening monetary policy, whether it was effective over the last few years, or not.