The nuclear bomb in the public square.

Last week’s economic news could not have been better. Gross Domestic Product, the measure of the overall size of the economy, grew at an annualized rate of 3% over the second half of last year after having declined over the previous two quarters. While there are myriad measures of inflation, the most common measure, the Consumer Price Index, rose at an annualized rate of 1.8% over the same period – it actually declined by 0.1% in December – after having jumped 9.1% over the previous year. And despite over 200,000 layoffs in the tech sector over the last year, the unemployment rate continued to edge downward to an historical low of 3.5%, while wages grew by over 6%, and reached double digits for the lowest-income workers. 

All that news came in the face of the Federal Reserve Bank’s year-long efforts to bring inflation down by bringing the economy to heel. It is hard to imagine the economic news could have been stronger; inflation has come down, but the economy is continuing to roll along.

Six months ago, in a survey of 400 corporate leaders by KPMG, 90% believed that a recession in 2023 was inevitable and more than half thought the downturn was likely to be long and severe. Now, that sentiment has changed dramatically. As news over the past week suggests, it seems increasingly likely that we will avoid a severe downturn. Even Fed antagonist Larry Summers, who warned last summer that taming inflation would require unemployment north of 6% for several years, has tempered his predictions.

Against the backdrop of an economy that appears to be steadily emerging from three years of pandemic-induced turmoil, House Republicans sit with their finger on the trigger of a nuclear bomb, threatening to blow it all up. And the nuclear bomb analogy is an apt one. Moody’s Analytics chief economist Mark Zandi – who for decades has been among the most respected economic analysts – warned last week that a failure by Congress to raise the debt ceiling on a timely basis could have disastrous consequences. 

Specifically, Zandi suggested that even in the event of a brief impasse forcing the country to default on its obligations, GDP would decline by 4%, nearly 6 million jobs would be lost, and stock prices would slide by a third. And beyond Zandi’s numbers, the consequences of a U.S. default would ripple across the globe in less quantifiable ways. Much of the global economic system takes U.S. fidelity to its obligations for granted, as Treasury securities are the presumptive risk free obligations upon which systems of credit and collateral across the world are predicated.

Suffice it to say that there is little evidence that such dire consequences of a U.S. default have deterred the self-serving instincts of the radicals that Kevin McCarthy has put in charge of his caucus. For all their laudable talk about restoring “regular order” to Congress – the traditional system under which legislation is debated and passed through the committee process – they have no interest in the process of debate and compromise that is the essence of constitutional governance. Instead, they proved earlier this month that they are, at their core, hostage takers who will use any means at their disposal to get what they want. For Texas Congressman Chip Roy, this means using the debt ceiling vote to force changes in the Biden Administration border policies that he has been unable to win through the regular order that he says he stands for. For others in the oddly named “Freedom Caucus,” it means threatening Armageddon over a debt ceiling increase which never bothered them when Donald Trump was setting records running up the public debt. For Matt Gaetz, Andy Bigg, and Lauren Boebert, it is, like everything else, about little more than attention-seeking and fundraising. 

Yet for all the yelling and screaming, the threats and counter-threats in Washington DC, thus far the markets are paying little heed. When asked last week about his views on the debt ceiling, Ray Dalio, founder of the world’s largest hedge fund and a widely regarded observer on the state of the world, suggested that the debt ceiling crisis is a “farce,” a recurring event of performative political theater that is detracting attention from the genuine threat posed by the global rise of populist and nationalist forces, and the dangerous consequences of the “fading away” of the post-World War II dollar-based economic order.

In a similar vein, in an interview last week in Bloomberg, legendary contrarian investor Jeremy Grantham was surprisingly upbeat on market prospects – an unusual stance from a person for whom the sky is always falling. While Grantham believes there is some risk of a further 15% pullback, he emphasized several forces that could push markets higher over the coming year – including the increasing likelihood that the economy will not fall into recession, and that the Fed will end up pivoting on interest rates sooner than expected. He also noted that U.S. politics loomed to be a positive for the markets, as looking back over the past 100 years, the seven months beginning the October before midterm elections and ending the following April have produced far better stock market returns than any months in the four-year political cycle. As to the risk of an apocalyptic debt default? Nary a mention.

None of this is to suggest that brinkmanship at the federal level will not take its toll; it is simply that, as Ray Dalio observed, this is the 79th time since 1960 that the debt ceiling will have been reached, and far from the first time that there has been political posturing in advance of dealing with it. This week, in Guggenheim Investment’s report “10 Macro Themes for 2023,” the debt ceiling issue crept in at number 10: Divided Government and Narrow Majorities Will Spur Debt Limit Drama. The report’s conclusion reflected the sanguine market attitude to date:

“While we do not expect a default, the standoff is likely to go until the last minute, possibly resulting in a reprise of the 2011 debt limit debate, which led to a U.S. credit rating downgrade and a market selloff. The debate could also result in a government shutdown, which would worsen the market impact.”

The simple fact is that if Republicans want to be a credible governing party, Kevin McCarthy cannot allow the United States to default on his watch, and over the weeks ahead, there are two people who will likely play outsized roles as he navigates his way to a solution. One is Marjorie Taylor Greene. Greene is McCarthy’s link to the MAGA wing of the party, which she has accurately described as now representing 70% of the GOP. But she was not one of the party rebels against McCarthy’s speakership; instead, she was perhaps his most important wingwoman. She had already made her deal with McCarthy, and he is her path to power. So when the time comes that McCarthy has to round up the votes to move a debt ceiling deal forward – particularly as it is likely to mean allowing a deal to pass with Democrat votes – he must fully expect Greene to have his back. 

The second person is Ken Griffin. Griffin, the founder of Citadel Asset Management, is among the wealthiest people in the financial world. With the death of Sheldon Adelson, Griffin has become the largest contributor to Kevin McCarthy’s Congressional Leadership Fund PAC. More a globalist of the Dalio school than MAGA Republican, Griffin supported Barack Obama in 2008 and Mitt Romney four years later, but declined to contribute to Trump’s campaign in 2016. 

Raising and distributing money to Republican congressional candidates has been the key to Kevin McCarthy’s rise to Speaker. And in the 2022 campaign cycle, when McCarthy raised and distributed $260 million, Ken Griffin contributed almost 10% of those funds. As the manager of a gigantic, multinational hedge fund, Griffin’s focus over the years, like Dalio’s, has been on the impact of actions in Washington on global markets and the stability of the US dollar. Indeed, in 2018, he famously lashed out at Donald Trump for his attacks on Fed Chair Jerome Powell, which Griffin feared were eroding the “stature of our currency in global markets and to the faith and confidence people have in the value of the dollar.” And nothing would contribute to the erosion of faith and confidence in the dollar more swiftly than a U.S. default in the wake of a failure by Congress to address the debt ceiling. 

Last week, the markets pushed upward as the news was pouring in that the economy was outperforming expectations. Yet, the closer to the brink the grandstanding goes, the more volatile the markets are likely to become. Not because the Ray Dalios or Jeremy Granthams of the world are going to panic, but because much of the rest of us may. At the end of the day, although we may get to the brink, we will not go over it. One has to imagine that at some point, before the nonsense on Capitol Hill is allowed to crater the economy and accelerate the unraveling of the dollar-based economic order, Kevin McCarthy’s phone is going to vibrate, and Ken Griffin will be on the line. And when that moment comes, McCarthy will understand that whatever price might have to be paid, it will be time to get the deal done. 

 Artwork by Joe Dworetzky.  Follow his cartooning on Instagram at @joefaces and his journalism at authory.com/JoeDworetzky

Brazil Riots Could Mark a Sea Change in Our Politics.

It was such a familiar story. The president of a country insisted that the opposition party is preparing to steal an upcoming election. After the president lost, mobs of supporters heeded their leader’s call and stormed the capital, seeking to overturn the election results. Now, the battle continues, pitting the nation’s judiciary, which aims to uphold the nation’s election results, against partisans of the defeated leader. Who will ultimately win, as is so often the case, rests with the military.

When we look at Brazil, it feels like we are looking through a window at the history of Latin America. The juntas. The coups. The assassinations. The long history of authoritarian rulers trampling nascent democratic institutions. 

But this time, it is not a window we are looking through, but rather a mirror reflecting back on ourselves. Jair Bolsonaro’s strategy of seditious insurrection was right out of Donald Trump’s playbook. Bolsonaro’s team of seditious conspirators were given aid and comfort from Donald Trump’s top tier, most notably campaign strategist Steve Bannon and communications director Jason Miller. 

A seditious conspiracy is easier to recognize from a distance. As it turned out, few, if any, national Republicans of note seized the moment to offer moral support to the rioters in Brasília. Few, if any, watched the mayhem in the capital of the largest country in South America and argued, as they did in the days following January 6th, that the rioters were peaceful protesters expressing their free speech rights. 

Only Tucker Carlson, as one might have predicted, was prepared to go full MAGA and embrace the obvious parallels between Brasília on January 8, 2023 and Washington DC on January 6, 2021. Carlson asserted that the November election had been rigged, and millions of Brazilians were rightfully protesting because they "know that their democracy has been hijacked." The Big Lie had gone global.

Coming in the wake of Republican underperformance in the midterm elections, and a day after Kevin McCarthy’s abject surrender to the MAGA wing of the GOP as the price of winning the Speaker’s gavel, events in Brazil may help to bend the arc of our politics away from the downward spiral we have been on for years now. 

Although the Republican Party has had its battles over the years, such as those between progressives and conservatives in the 1920s, and between moderates and conservatives in the 1960s and again in the 1980s, today’s battle between traditional and MAGA Republicans is of a different order. 

If you are unclear about the distinction between the two groups, the dividing line is simple: you are a traditional Republican if the words “I don’t like Donald Trump, but I like his policies,” have ever crossed your lips. But if Trump speaks to you regardless of his policies, if you believe the 2020 election was stolen, and if you are sympathetic to the suggestion that leading Democrats are pedophiles and sex traffickers, you likely fall into the MAGA camp. It is a long leap from questioning the inherently messy nature of elections to buying into QAnon conspiracies made up out of whole cloth, but today’s GOP has gone a long way down that road.

Traditional Republicans in today’s GOP are akin to the proverbial frog who failed to respond as the water around it got hotter and hotter, until finally it found itself in boiling water and could not understand how it got there. For decades, the Republican coalition has in large measure comprised two groups: traditional economic conservatives primarily focused on lower taxes and less government, and social conservatives brought into the Republican coalition beginning in the 1970s with promises around social issues – guns, abortion, “religious liberty,” and the like. While for years, traditional Republicans tolerated social conservatives in their midst as the price of winning their tax cuts and business deductions, the rise of Donald Trump flipped the power dynamic in the GOP, to the point where polling now suggests that nearly half of the party consists of self-identified MAGA Republicans.

For those traditional Republicans who have turned a blind eye to the MAGAfication of their political party, hoping that the rise of Trump would be a passing annoyance, the insurrection in Brazil should be a tipping point. Images of Steve Bannon’s shock troops in the streets of Brasília are a stark reminder that they have been in common cause with seditious conspiracists and abject lunatics for years now. As evidenced by a recent Economist/YouGov poll, 70% of their GOP brethren have bought into Donald Trump’s Big Lie, and believe that Joe Biden sits illegitimately in the White House; two-thirds have a favorable view of QAnon conspiracy theories; and fully half believe that Democratic Party leaders “are involved in elite child sex-trafficking rings.” Now, as Matt Gaetz flexes his power in the House, and Jair Bolsonaro spreads his own Big Lie and mimics Trump’s insurrection, those traditional Republicans who have remained silent through all that has ensued have no choice but to confront the world of their creation.

Events since the 2022 midterms appear to suggest an ebbing of the MAGA tide. Many on both sides of the aisle yearned to see the House stalemate resolved by a coalition of centrist Democrats and Republicans coming together to elect a Speaker rather than by Kevin McCarthy caving into the demands of the far right. Indeed, a CBS News poll this month suggests the GOP is split right down the middle between those who want Congressional Republicans to cooperate with Democrats and those who want Congressional Republicans to investigate Democrats with a vengeance. Nonetheless, there have been signs of successful efforts to push back against hyperpartisanship at the state level across the country. 

This month, in Pennsylvania and Ohio, Democratic and Republican legislators came together to elect a moderate Democratic and Republican speaker, respectively, undermining the power of right-wing legislators in both states. Even in deep red South Carolina, Republicans holding an overwhelming majority rejected the demands of the South Carolina Freedom Caucus and chose a more moderate course. 

Images of turmoil on the streets of Brasília could not have been more timely. Coming in the wake of the MAGA victory on the House floor, those images – not a warning of what might happen in our country at some point in the future, but rather a reminder of what has already happened here – have forced traditional Republicans to confront the damage that has been done to our country as they have sat silently by. Brazil on January 8th is what January 6th here at home looked like to the rest of the world, despite what Republicans might want to believe. 

Perhaps this moment will pass as the House investigations ramp up, Brazil fades into the rearview mirror, and Donald Trump seeks to regain his grip over the Republican Party. But the evidence is already there that Republicans are giving renewed attention to the political center. Faced with underperformance among moderates and independent voters in the midterm elections, as well as the success of state-wide votes preserving abortion rights in red states, Republicans who have long since sworn off the mainstream media have begun showing up on CNN and MSNBC. 

There has been no sea change yet, so far just ripples suggesting that the tides of our politics may be shifting. You will know that sea change has come when 2024 Republican presidential hopefuls like Ted Cruz, Josh Hawley and Tom Cotton begin to show up for interviews with Anderson Cooper or on the Rachel Maddow show.

Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky.  Follow him on Twitter @joedworetzky or Instagram at @joefaces. And thanks to Damon Langlois https://www.damonlanglois.com/ for summing up our current state of affairs in his sandcastle sculpture of one-time Republican Abraham Lincoln.

After this week, the GOP will never be the same.

It all seems so inevitable in retrospect. Back in the 1960s, Republican Party strategists made a few simple calculations and decided to build what would become the modern GOP coalition of disparate voter groups, each with their own distinct set of priorities. And for the better part of a half century, it has worked. The model of single-issue politics – notably including anti-tax, pro-gun, and anti-abortion voters – delivered Republican victories and offset whatever demographic advantages Democrats might have expected to give them an advantage.

The GOP pivot in the 1960s and 70s came in the aftermath of Richard Nixon’s narrow victory over Hubert Humphrey in 1968. In that election, Nixon outpolled Humphrey 43.4% to 42.7%, while Alabama’s segregationist Governor George Wallace took 13.5% of the vote running as a third party. 

As Nixon political strategist Kevin Philips explained at the time, the election math was straightforward: the numbers of voters that had flocked to George Wallace far exceeded the potential Black vote for a Republican Presidential candidate, particularly as Democrats had made great inroads into the Black vote beginning in the New Deal and with Harry Truman’s integration of the military. If the GOP was prepared to walk away from its brand as the Party of Lincoln, it could build a new Republican majority for decades to come. And it was a strategy, Phillips argued, that would build upon itself, “The more Negroes who register for Democrats in the South, the sooner the Negrophobe Whites will quit the Democrats and become Republicans. That’s where the votes are.”

And the proof was in the pudding. In short order – beginning with Nixon’s overwhelming victory in 1972, twelve years of Ronald Reagan and George Bush in the White House, and culminating with the GOP finally winning the House in 1994 after 40 years of Democrat control – the power of that new coalition overwhelmed whatever loyalty long-time Republicans might have had to their long-time Black comrades-in-arms, and their identity as the Party of Abraham Lincoln.

For the better part of the last half-century, the strategy has worked perfectly. Business elites who long comprised the core of the Republican Party, have won power through the votes of less educated white voters motivated by guns, religion, and racial resentments. But for most of those years, as Lee Atwater had explained in 1981, Republicans learned to speak in code: "You start out in 1954 by saying, 'N–ger, n–ger, n–ger.' By 1968 you can't say 'n–ger' -- that hurts you. Backfires. So you say stuff like forced busing, states' rights and all that stuff. You're getting so abstract now [that] you're talking about cutting taxes, and all these things you're talking about are totally economic things and a byproduct of them is [that] blacks get hurt worse than whites.” 

Over the ensuing years, the strategy became more abstract, as Atwater suggested, but the underlying message endured. In the mid-1980s, while Reagan Lieutenant Grover Norquist refined the GOP playbook into the anti-tax, pro-gun, and anti-abortion messaging, while the use of wedge issues to draw anti-gay voters to the polls, and racially coded language endured. 

By the time Donald Trump grabbed the playbook, all the nuance was out the door, as racial code was replaced with a bullhorn. With the emergence of Trump’s MAGA followers as the unchallenged base of the party, the GOP leadership literally did away with a policy platform, suggesting instead that it stood for whatever Donald Trump stood for. A half century after George Wallace ran as a populist channeling white resentments against establishment elites, the politics of race and resentment has subsumed any last vestiges of the GOP as the party of personal responsibility, and White and Christian Nationalists came out of the closet and pranced proudly on the White House lawn. 

The internet changed everything, and it changed nothing. It changed nothing because it has only amplified the effectiveness of resentment and hate as organizing principles in politics. It changed everything because it freed politicians with social media skills from dependence on the leaders of political parties for funding.

To watch Matt Gaetz and Lauren Boebert on the floor of the House this week has been to see the fulfillment of the MAGA dream. The Republican Party is in turmoil, as the political progeny of the George Wallace voters have come of age. Lured into the Republican Party a half-century ago to serve as the election day tools of business elites, this week MAGA consumed the host. The 90% of the House Republicans who sat quietly in their allegiance to Kevin McCarthy seethed in resentment every time Gaetz stood up to speak. 

Yet the Matt Gaetz that stood before him would not bend the knee; he was a man fulfilled. Ridiculed for years for his Elvis hair and his apparent interest in sex with underage women, he ruled the roost this week. In 2020, Gaetz explained his ethos as a member of Congress in an interview with Vanity Fair. “If you aren’t making news, you’re not governing.” Being on social media, being on Fox, that is governing, according to Gaetz. Garnering attention is the job. Getting clicks is the mission. Because attention and clicks equals money, and money means no one can tell you what to do. 

Standing before his colleagues, taking on Kevin McCarthy, was the moment Matt Gaetz has dreamed of, and that Lauren Boebert lives for, because they both live only for the attention. Once Donald Trump’s foot soldiers, they have found their own voices. This week, when Trump came to Kevin McCarthy’s aid and declared that it was time for Boebert and Gaetz and the rest of those blocking McCarthy to fall into line, they were unmoved. Donald Trump, Boebert was quick to declare on the floor of the House, was her favorite president, but they were not going to do his bidding. Instead, the time had come for him to do what she demanded, and tell McCarthy it was time to withdraw.

On Friday, as McCarthy came within a few votes of victory, Gaetz lashed out once more. Kevin McCarthy is the LaBron James of special interest fundraising, he declared. The issue of special interest fundraising is central to the MAGA view of Washington DC as a swamp, and the MAGA mission to drain the swamp. And this is Gaetz’s sweet spot as well. In 2020, he was the first Republican member of Congress to refuse to take any PAC contributions. After Gaetz’s attack on McCarthy, #sellout trended on Twitter, and those who have been supporting McCarthy – even those with MAGA cred like Dan Crenshaw and Margorie Taylor Greene – found themselves scurrying to defend themselves against MAGA rage.

Kevin McCarthy may yet win the votes this week, and be sworn in as Speaker of the House, but Matt Gaetz and Lauren Boebert have already won the war. Whoever emerges as Speaker of the House, that person will serve at their pleasure.  The tail is now wagging the dog.

Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky.  Follow him on Twitter @joedworetzky or Instagram at @joefaces. And thanks to Damon Langlois https://www.damonlanglois.com/ for summing up our current state of affairs in his sandcastle sculpture of one-time Republican Abraham Lincoln.

As It Barrels Ahead, Is the Fed Flirting With Disaster?

The stock market has rallied nearly 9% over the past two weeks, proving that even in this grimmest of seasons, hope springs eternal. The hope, in this case, rested on the suggestion by Mary Daly, the President of the Federal Reserve Bank of San Francisco, and member of the Federal Reserve’s rate-setting Federal Open Market Committee, that the Fed should begin to consider how and when to reverse course from its unrelenting drive to push the nation’s economy into recession. It is on such modest suggestions that market rallies hinge these days.

For months now, the Governors of the Federal Reserve have insisted that they would not be deterred from raising interest rates until there is strong evidence that inflation is coming down, and since the release of the inflation numbers for September, the Fed has been barreling toward another large increase in interest rates. Then, seemingly out of the blue – with no particularly positive news on the inflation front to point to – a few Fed Governors started whistling a different tune. Perhaps, Fed Vice Chairwoman Lael Brainard suggested in a speech in Chicago on October 10th, they should act more judiciously, and pause to see the effect of the steps the Fed had already taken. This was not a radical suggestion. After all, as any student of monetary economics could tell you, it will take time to gauge the full impact of the steps that the Fed has already taken to tighten the screws. 

Surely, the Fed Governors all know this to be the case, as the existence of a time lag between monetary policy actions and outcomes – generally viewed to be in the range of nine months to two years – is axiomatic. And Fed Chair Jerome Powell, Lael Brainard, and their colleagues have experienced this time lag first hand, as the inflation they are fighting today is at least in part a product of the actions they themselves took two years ago, when they increased the money supply by trillions of dollars to keep the economy afloat in the wake of the Covid pandemic.

If, in their zeal to prove themselves equal to the task of preventing a 1970s-style inflationary cycle – and perhaps along the way sidestep blame for a mess at least in part of their own creation – Fed Governors lost sight of that most basic truth of monetary economics, it was thrown in their face by a meme that rocketed across the financial community even as Vice Chair Brainard was speaking in Chicago. Sometimes, when people are closeted in their own information bubble and immune to reasoned discourse, ridicule can wake them up. And so it was when market analyst Peter Boockvar gave up debating the nuances of monetary economics and offered instead “The Weed Gummy Theory” to explain the seeming inability of the Fed Governors to consider the risks they are running as they continue to raise interest rates without pausing to assess the impact of their actions. 

According to Boockvar, the Fed is like “an eager but inexperienced consumer of weed gummies, which, notoriously, take longer than anyone expects to kick in… In other words, we may find ourselves in 2023 doing the macroeconomic equivalent of curling up in the fetal position on the couch, murmuring to no one in particular that that last gummy was too much, man.”

If Boockvar’s parody helped some here at home understand the risks inherent in the pace of Fed rate hikes, the rest of the world has not needed weed analogies to understand the potential adverse impacts from the pace of Fed rate hikes, as the Fed actions to date have already ignited a tsunami of consequences across the rest of the world.

As the Fed pushed interest rates upward over the past six months, it has shifted the flows of capital across the world into the U.S. dollar and out of other currencies. As illustrated in the graph below, Fed interest rate hikes since the beginning of the year have triggered declines of 20% or more in the value of other currencies. Among other consequences, the dramatic rise in the value of the dollar has amplified the inflationary impact of increases in the cost of energy and agricultural commodities caused by Vladimir Putin’s war. Because those commodities are priced in dollars, inflation in those countries now reflects both the higher cost of the commodities on world markets, as well as the cost of converting their currency into dollars. As a result, inflation across much of the world is higher than it is here at home, in part due to the actions of the Fed: CPI inflation in the U.S. remained just over 8% in September, but it has reached 11% in the European Union, while in Egypt, one of the world’s largest consumers of Ukrainian and Russian agricultural products, it now stands at 15%. 

The response of central banks across the globe has been swift, as they have found themselves forced to raise interest rates, both to mute the inflationary impact of the rise in the dollar, and to stem the pace of capital flight. The result has been that central banks in countries that had barely rebounded from Covid-related recessions are now raising interest rates, with the likely consequence of throwing their local economies back into recession, and, ultimately, severely cutting back economic growth across much of the globe. 

It was not that long ago that Fed chair Ben Bernanke embraced the role of “central banker to the world” in the face of the 2008 global financial crisis. As the global financial system teetered on the verge of collapse, countries around the world looked to the United States for leadership, and the Federal Reserve in turn assured that resources were available to prevent the collapse of financial institutions across the globe. Two years ago, as the spread of Covid-19 similarly threatened to collapse economies across the globe, the Fed again stepped into the breach, assuring access to dollar reserves and liquidity for central banks around the world. 

This time, however, things feel different. It is fair to say that the Fed now finds itself between a rock and hard place. While Fed Chair Jerome Powell and Vice Chair Brainard publicly  acknowledge the impact of Fed policies on other countries, the persistence of domestic inflation and the emergence of inflation as the paramount focus of midterm elections seem to have left them with little wiggle room to moderate Fed policies with an eye to the impact on the world beyond our borders. Yet, it is the Fed’s singular focus on its domestic 2% inflation target that may yet bring a tsunami of unintended consequences to our shores.  

2% inflation has become synonymous in the public imagination with the “good old days.” However, like many things today that we have come to view as normal – double-digit annual stock market returns, a world awash in capital, and 3% home mortgages among them – the Fed’s 2% inflation target has not been around that long, and simply may not be a prudent objective. 

The Fed’s 2% target was established in 2012, four years after the introduction of zero and negative interest rate policies by central banks across the globe in response to the near collapse of the global financial system. It was a time when deflation, rather than inflation, loomed as the major threat to global economies. While inflation remained below 2% for the ensuing decade – leading people to see it as “normal” – there was little normal about it. Indeed, the last decade prior to the 2010s when inflation averaged 2% or lower was the 1950s. 

Even inflation in the range of 2.5 to 3% – the average rates of inflation during the 2000s and 1990s, respectively – may be an unrealistic target, as so many of the factors that enabled the past four decades of low inflation are quickly slipping away. Perhaps as much as any other factors, inflation in the 2 to 3% range over the past three decades was made possible by the fall of the Berlin Wall, the opening of China under Deng Xiaoping in 1978, and China’s entry into the World Trade Organization in 2001. 

Together, those events brought more than a billion people into the global, market-based economic system, and engendered a global competition in labor costs. Among the impacts of the ensuing process of global economic integration were the shipping of millions of American manufacturing jobs overseas and downward pressure on domestic wages, which together helped keep inflation in check. Now, with the combination of domestic (and global) labor shortages, support for trade unions at the highest level in 60 years, increased tensions with China, and post-Covid moves toward “onshoring” and “friend-shoring” of corporate supply chains, those trends appear to be reversing. 

Perhaps the Fed can succeed in pushing back against that tide. A restoration of stable, 2% inflation is achievable, former Treasury Secretary Larry Summers insists, through a deep and long recession of sharply elevated unemployment over several years. 

But Summers' suggested roadmap raises a second factor that the Fed cannot afford to ignore, which is the dependence of the United States on the support of nations across the globe, and the potentially catastrophic consequences of the Fed failing to take into account the impact of its actions on other countries. Since the Second World War, and in particular since the early 1970s, when the United States reached an agreement with the Kingdom of Saudi Arabia providing for the U.S. commitment to defend the Kingdom in exchange for the recycling of “petrodollars” into the U.S. economy, we have benefitted from the “exorbitant privilege” of living in a world where the dollar is the global reserve currency and trade is conducted in dollars. It is a privilege that for decades has protected the United States from consequences that other countries routinely face for running trade deficits, budget deficits, or, as we see today, being captive of inflation driven by escalation in value of a foreign currency. 

We have come to treat that privilege as an entitlement, yet it rests, spoken or otherwise, on the consent of the rest of the world. Should the Fed fail to take into account the distress that its actions are causing in other countries, and should a consensus emerge across the globe that our actions have become too nakedly self-interested, we should not be surprised to see a fraying of that consent. 

Over the past few weeks, we have been given a glimpse of what such an erosion of support might look like. Largely unreported outside of the financial press in recent weeks has been the sudden exit of major global buyers from the U.S. Treasury market, putting upward pressure on U.S. bond rates. Japan, which surpassed China in recent years as the largest holder of Treasury securities, has reduced its holdings by 10% over the course of this year, and stopped purchases of new securities, due to the high cost of hedging yen-dollar risk as the dollar has continued to rise. For its part, China has not been a net buyer of Treasury securities for more than a decade. Farther down the list, Russia, once among the largest holders of treasuries, completely exited the market following its annexation of Crimea in 2014, while Saudi Arabia's decoupling from its alliance with the US has trimmed its holdings by 50%.

The possibility of a continued dislocation in the Treasury market should shake people up, as the consequences of Treasury bonds falling out of favor globally would have significant domestic ramifications. Like the Fed’s 2% inflation target, the world of 2% to 3% long-term Treasury interest rates that we have come to view as “normal” over the past decade has been the exception, not the rule, and only came about in the context of the global recovery from the 2008 collapse. 

Yet, in its ten-year budget projections, the Congressional Budget Office continues to assume that Treasury yields will remain in the 2.9 to 3.8% range for the balance of this decade. Should, however, long-term Treasury yields return to the range of 5% to 7% – the rate environment that prevailed for the two decades preceding the 2008 collapse – the impact would be significant, as cost of interest on the national debt would rise from $350 billion last year to around $1.5 trillion five years from now, an amount exceeding the combined cost of Medicaid and Defense spending. 

As the Fed continues its single-minded pursuit of restoring 2% inflation, it may be pursuing an unsustainable goal, given the emerging trends in a de-globalizing economy. And as Peter Boockvar suggested, and much of the rest of the world already understands, it may be risking dramatic, unintended consequences for the world, and ultimately for us. Given the deterioration of our politics during what objectively have been the best of times, one can only imagine how we will manage should that outcome come to pass. 

Yet it could happen. While events may yet force a change in the Fed’s thinking – such as cascading defaults in emerging market countries, or perhaps growing political instability – the Fed appears to be undeterred. Perhaps, before a tsunami of adverse, unintended consequences reverberates back on our shores, someone should remind Jerome Powell that when Paul Volcker left office in August 1987, inflation was 4.7%, and it remained in the 5% range for the next two decades. While the Fed’s 2% inflation goal has acquired almost mystical significance, the single-minded pursuit of that objective may instigate reactions that will be far more difficult to control.

Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky.  Follow him on Twitter @joedworetzky or Instagram at @joefaces. And thanks to Damon Langlois https://www.damonlanglois.com/ for summing up our current state of affairs in his sandcastle sculpture of one-time Republican Abraham Lincoln.