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Human Behavior Counts

Economics is a social science.

Jay Powell recently scared the market – again – by reinforcing the need to stamp out inflation. To do this, he indicated that the Federal Reserve would do whatever was necessary even if it caused economic pain.

I could comment on the irony of reinforcing one of the Fed mandates (price stability) by trying to crush the other (employment) but let’s leave that out for now.

The question is really what will Powell do?

While I regard his words as important, we should all remember– despite the complicated econometric models employed by the Fed – that economics is a social science. Human behavior counts.

Powell knows this, so I primarily see his words as a message to the businesses and individuals who create economic activity to slow down. If he can reduce economic demand and inflation with words, then he doesn’t have to tighten financial conditions as much.

And to be sure, financial conditions are tightening for reasons beyond Fed rate hikes. Too strong a dollar acts as financial tightening. Additional taxes act as financial tightening. Increased regulation acts as financial tightening. Many of the companies I speak with have had good sales this year but are not going to engage in long term projects. Many banks are willing to lend money and have available credit, but costs for that money have risen and so activity is slowing.

Private equity deal flow has been slowing. Some companies who need funding have even had to take “down rounds”.

This all sounds like it is working in favor of “killing inflation” but not so fast. One of the best drivers to reduce inflation is vibrant economic activity.

Stronger supply chains, for example, promote better movement of goods and therefore better competition. Such competition promotes better technologies and/or operations.

Ultimately, it is this process that pulls cost out of the system and reduces inflation long term. If economic activity stalls and long-term project planning dries up, I believe, even if we do kill inflation, that it will be tough to kick start the economy again.

So, in my mind, Jay can talk tough, but he can’t create too much fear amongst us humans lest we enter a “short term mentality” from which it will be difficult to emerge in the longer term.

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