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Peter Morici: The Fed should manage the yield curve to put out the inflationary fire

The Federal Reserve has shifted from cultivating a hot labor market to curbing 7% annual inflation. That task will require a lot more than the expected three or even five quarter-point boosts in the federal funds rate FF00, +0.01% this year and several more in 2023.

Omicron has cemented hybrid work. Pressures will persist on housing prices in suburbs and communities far from major job centers. Boosting mortgage rates a percentage point or so will hardly tame rents or home prices.

The shift in consumer spending from goods to services will persist, and household balance sheets are still flush with unspent stimulus cash. Supply chains remain brittle and chip shortages will constrain manufacturers of motor vehicles, electronic gadgets and other durable goods into 2023.

The combination of buyers with ready cash and shortages for critical components will keep inflationary pressures strong.

Restaurants and other services must pass along higher costs for materials, labor, COVID restrictions, and periodic shutdowns or slack traffic imposed by new COVID strains. Otherwise, they fold.

Better distance-collaboration software is coming. Real eye contact and a genuine sense of presence from innovations like Google’s Starline will prove precursors of a metaverse that’s a workplace more than a destination for gaming and fantasy lives. The payoffs will be big, and tech companies won’t need to borrow to invest.

In 1979, Paul Volcker became Fed chairman, and inflation was almost 12%.

A more forceful figure than his predecessor, William Miller, and less political than Chairman Jerome Powell or European Central Bank President Christine Lagarde, Volcker jacked the federal funds rate nearly 7 percentage points in eight months. The economy slipped into recession, he eased back to accommodate recovery and then he boosted the key policy rate to 19%.

These days such radical action isn’t likely, but a 1 percentage point increase at each meeting until inflation is 2% would be more appropriate than what Powell appears inclined to do.

It’s hard to say the labor market isn’t at full employment with the jobless rate at 4% and nearly 11 million jobs unfilled. It’s equally hard to say we are at full employment with so many folks displaced from old-line service jobs still sitting on the sidelines.

Interest rates will have to be pushed enough to cause some additional joblessness, or inflation will continue to outrun wages, exacerbate inequality for many years and tax the elderly who disproportionately rely on fixed-income investments.

The availability of workers—and the overall adult labor-force participation rate—could be improved through relocation and retraining incentives and grants to enroll in Labor Department apprenticeship programs.

We don’t need another round of supplemental unemployment benefits that exceed lost wages. Rather, state unemployment benefits should be portable for those who move cross-country for training and to mitigate relocation costs for those who take new jobs.

Volcker-like increases in the federal funds rate could flatten or invert the yield curve and hasten further bank consolidation

Simply, banks rely on the spread between long rates on mortgages and the like and short rates for what they pay for deposits and other loanable funds. Small banks rely more on loan income, while big banks rely more on fees on trading, electronic payments and the like. 

The last thing America needs—other than more COVID shutdowns—is for more community and regional banks to sell out to Wall Street behemoths and lessen financial-sector competition.

Since 2008, the Fed has paid commercial banks interest on reserves they keep at the central bank. Tipping the yield curve could make the interest the Fed pays banks greater than it collects on bonds and throw it into deficit.

While the Fed could work around this problem, it would prove quite embarrassing and erode confidence in the dollar BUXX, -0.16%.   

The Fed should supplement bigger increases in the federal funds rate by selling off some of its long-term Treasury and mortgage-backed securities to boost long rates.

This would steepen the yield curve to avert central bank losses and suck liquidity out of the system where it does the most harm—too much demand for big ticket items like cars and homes and business borrowing in the junk loan and bond markets.

Instead, the Fed is inclined to rely primarily on the federal funds rate to effect tightening and wait at least several months after this process commences to begin running down its holdings of Treasury and mortgage-back securities.

It would be better to target a floor—a minimum but not a maximum—for the 10-year treasury rate TMUBMUSD10Y, 1.929% to maintain a suitably upward-slopping yield curve both for the health of the banking sector and effectiveness of monetary policy.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

More from Peter Morici

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Stocks still look attractive even with the Fed tightening

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