When Monetary and Fiscal Policies Collide

California is nuts…

On Aug. 25, the California Air Resources Board voted to ban the sale of gas-powered cars entirely by 2035…

And it appears to be contagious…

New York, Massachusetts, Vermont, Maine, Pennsylvania, Connecticut, Rhode Island, Washington, Oregon, New Jersey, Maryland, Delaware, Colorado, Minnesota, Nevada, Virginia, and New Mexico have all chosen to opt into California’s standards instead of federal requirement.

Many of these defections to the “green side” come as a result of states’ implementation of the “Clean Air Act” which is…

…a federal law requiring states to implement federal vehicle emissions standards or opt under Section 177 to follow California’s more stringent requirements.

(I’d like to point out how this kind of legislative lunacy works. Legislators spread lies with impunity (see my article from a few months back about the G’s Great Green Energy Lie) and then they write laws based on those lies, which end up driving the economy off a cliff…)

There should be no irony lost here…

California’s electric grid has been crippled under the demands of the current heat wave. So much so, the California Independent System Operators, the nonprofit that runs the state’s power grid, warned of the risk of rolling blackouts and urged electric consumers (basically everyone) to dial back their usage during peak energy demand hours…

“The top three conservation actions are to set thermostats to 78 degrees or higher, avoid using large appliances and charging electric vehicles, and turn off unnecessary lights.”

And…

While urging consumers and businesses to keep conserving, the grid operator has been primarily concerned with the late afternoon and evening hours, when the sun sets and solar power is no longer available.

Go figure… 

Not surprisingly, rising electricity demands in the face of shortages has led to sharply higher energy prices throughout the state…

Power prices at the Palo Verde hub in Arizona and SP-15 in Southern California rose to $850 and $505 per megawatt hour, respectively. That was their highest levels since hitting record highs of $1,311 in Palo Verde and $698 in SP-15 in August 2020 when the ISO last imposed rotating outages.

Looking at the Future

You could argue that California’s EV law is 12 years into the future and that the grid would be substantially reinforced by then to accommodate the millions of additional cars which will be demanding energy to fill their batteries. Of course California’s goal is to cut carbon emissions which means they’ll have to reinforce the grid using “renewable” sources of energy.

And we can easily see into THAT future by looking at what’s happening in the UK today…



As well as the EU…

And…

European Commission President Ursula von der Leyen, a member of Germany’s centrist Christian Democratic Union (CDU) Party, made the announcement earlier this week during a press conference.

“We see there’s a global scarcity of energy. So whatever we do, one thing is for sure, we have to save electricity, but we have to save it in a smart way – so what we have to do is flatten the curve and avoid the peak demands,” she said.

We all can remember what happened the last time we tried to “flatten a curve”

That’s what a 20-plus year commitment to going fully green, while relying on your (not-so-nice) neighbors to fill in the gaps will get ya…

Soaring Energy Prices

I bring this up, because legislative behavior (fiscal policy) is squarely at odds with what the Fed is trying to do on the monetary policy side these days. I talked about it in your last weekly update.

Legislatively, fiscal policy is massively expansive. More free money for more green infrastructure. You can be sure the $370-plus billion the government is pledging to the donor class private sector will be claimed and spent without any promise of results for the effort. 

On the monetary policy side, the Fed has basically turned into its own version of the Vienna Boys Choir all singing from the same sheet music…

At the Fed’s recent Jackson Hole symposium, Chairman Powell came right out and said the Fed was all in on defeating inflation. Even worse, he said the coming rate increases will likely result in “a sustained period of below-trend growth” while also bringing “some pain to households and businesses.”

What’s worse, in spite of Powell’s new-found hawkishness, he has also previously admitted that their tools aren’t necessarily the right tools for the job they’re facing. But… they’re the only tools the Fed has. And when your only tool is a hammer, every problem may as well be a nail.

So for the time being, higher rates it is…

The other question is how high and at what point will the Fed finally capitulate pivot and start easing again? I’m not sure they will. 

I’ve said in the past I believe they’ll have to hold rates higher for longer than a lot of investors would like. This battle with inflation is one they have to appear to win. If for no other reason than their credibility hangs in the balance. Their mission is to provide price stability. And if they can’t do that, 

Beyond appearing to beat back inflation, the Fed’s other problem is they have to normalize rates — I would say in the 4%-5% range. 

Their recent bout of easing has really cemented a mindset in the market that free money is the norm. That zero interest rates and bailouts are an expected fact of life. As a member of the FOMC back in 2012, then governor Powell expressed the problem in a nutshell…

I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

The Fed blinked first the last time they tried to normalize rates back in 2018 (to be fair, responding to the economic shutdown did take some precedence.)

But if they want to get the economy anywhere close to back on its feet, they have to hold the interest rate line. 

And they’ll be doing it in the face of a crumbling economy. 

Fighting Inflation in a Hostile Economy

Hiking rates will eventually lead to lower inflation. But it won’t be pretty (or painless). 

I’ve said this again and again, the cure for high prices is high prices. The only way to kill demand is by pricing it to death.

But that comes with its own set of side effects (and by side effects I mean direct effects you just don’t want to acknowledge) namely that high prices crush consumers — the barely-beating heart of our consumer driven GDP.

And speaking of GDP, are we in a recession yet?

If not,  it’s coming. The 10-year-2-year yield curve spread has been forecasting one for the past 5 months.

Source: The Federal Reserve Bank of St. Louis

So far this year, we’ve seen two quarters of negative growth. Currently the Atlanta Fed’s GDPNow measure is forecasting growth of 1.3% for the third quarter. 

Should the official advance estimate due out in October come out positive, Wasington will undoubtedly claim it as a victory (along with the 10 million jobs they “created” after reopening the economy) and declare we are nowhere near recession-ville. 

And speaking of jobs, let’s not hang our hats on the very misleading employment numbers being reported of late.  While jobs added in the economy increased by 315K last month, the total number of multiple job holders jumped by 114K. Overall, multiple job holders have increased by 10% year-over-year, which basically suggests that fewer people are working more jobs in an effort to make ends meet… not a glowing economic picture.

I mention all this because it puts our economy on a very precarious path.

The recession is coming (it’s probably already here). 

And with fiscal and monetary policy working toward opposite ends, inflation is likely to be stickier than the Fed or Washington would hope. The Fed can dial back and start talking up PCE inflation which, for reasons I’ve explained before, shows a lower rate of inflation than the CPI. But just because they say it’s so won’t make a difference to folks punished by higher prices across the board.

All this combined with a shrinking labor pool and you’ve got the perfect storm for something I haven’t mentioned since last year — stagflation.

We’ll be tracking all the developments for you…

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential