Pro Perspectives 1/26/23

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January 26, 2023
As I said in my Tuesday note, we are in a hot economy, where demand is being throttled by the Fed. 
This was intended to be a reminder, with all of the recession talk, that this is not the economy of the post-financial crisis decade.  It's a not a sputtering economy with a demand problem.
The Fed is holding the beach ball under water.
With that, I posed the question, "what happens when the Fed backs off (let's go)?"
Some say that's precisely why they won't.
That makes sense, assuming they had a choice.  They don't.
They have this thing called debt service to think about it.
Let's take a look at what the Congressional Budget Office (CBO) has said about the sensitivity of debt service to the Fed's tightening campaign. 
If rates rose faster than their projections, they estimated that each 100 basis points higher would equate to $187 billion in additional annual interest costs.
Indeed, they have undershot a Fed that moved 425 basis points in nine months. 
The result:  About a quarter of a trillion dollars in additional interest payments for 2022.  And this year, if the Fed does what it projected in December (5.1% on the Fed Funds rate), and if the 10-year yield reverts to its historical average spread of 90 basis points (above the Fed Funds rate), the  Fed will have inflicted another $600 billion of interest payments on the U.S. government
That will be funded by larger and larger deficits.  And that compounds an already massive, and unsustainable, government debt-load.  
Ironically, this unsustainable debt problem is precisely why we need inflation.  We need to inflate away the value of the debt.  But it only works if, simultaneously, we have hot growth.  And it only works if wages reset/adjust to maintain the standard of living.
So, if we're lucky, we've just seen phase one of this inflationary environment, where the Fed normalizes interest rates.  Now, phase two should be a Fed that sits tight, let's growth bounce back (driven by the mountain of new money created over the past three years), inflation will bounce back with it, and, as they are doing in Japan, policymakers should encourage employers to raise wages.