A headline this week from National Review: “The Fed’s Half-Hearted War on Inflation – It has the power, but does it have the will?”
Is the Fed all inflation bark and no bite? After all, CPI (y-o-y) surged to over 8% – and has been above the Fed’s 2% target now for 15 months – yet the target policy rate is today at only 0.75% to 1.0%. Inflation is exacting a heavy toll on the population; politicians are under the gun and vocal. The Fed, of course, is compelled to present steely resolve. “Fed Minutes Show Urgency…” “Fed Minutes Show Strong Commitment…” “Officials ‘noted that a restrictive stance of policy may well become appropriate.’”
How much of this is just superficial stuff – an expedient bordering on a ruse? Does the Fed have the resolve necessary to mount a serious inflation fight, one that would invariably unfold with significant market and economic turmoil? That the leading FOMC “hawk” would last week raise the possibility of rate cuts next year suggests some weakened knees. Bullard: “The more we can front-load and the more we can get inflation and inflation expectations under control, the better off we will be. In out years — ’23 and ‘24 — we could be lowering the policy rate because we got inflation under control.”
It’s way too early to advertise the possibility of pauses and even rate cuts. If the Fed is determined to actually restrain inflationary expectations and regain lost institutional credibility, it is imperative to insulate its inflation-fighting policy resolve from the unavoidable pressures associated with market instability. Bubble markets, by their nature, are acutely unstable and susceptible to any tightening of financial conditions. Is the Federal Reserve truly committed to reining in inflationary forces before they become more deeply ingrained – or not?
Powell’s post-meeting press conference suggested the Fed was becoming concerned by heightened market stress. Markets were heartened that Wednesday’s minutes from the FOMC’s May 4th meeting implied ample wiggle room in Fed resolve.
Bloomberg: “There were hints of a possible pause: an ‘expedited’ tightening would leave the Fed ‘well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.’”
“As I said, inflation is too high and must be addressed. The Federal Open Market Committee’s overarching goal is to return inflation to our target range without triggering significant economic dislocation. While that will be a delicate undertaking, I believe economic conditions… are strong enough to allow us to achieve that outcome. Still, uncertainties shroud the economic outlook on virtually every front, from the pandemic to war in Ukraine to supply constraints. Monetary policy makers must be mindful of those uncertainties and proceed carefully in tightening policy. So as we expeditiously return monetary policy to a more neutral stance to get inflation closer to our 2% target, I plan to proceed with intention and without recklessness. We have seen throughout the pandemic that events and market shifts can happen quickly and in ways that dramatically alter the prevailing economic dynamic, in both good ways (the rapid rebound in employment right after the initial lockdown) and bad (the rapid rise of the delta and omicron variants). We all must be ready for the unexpected to occur, assess how risks have changed when it does, and stay aware of shifts in the strength of the economy. Given the very high level of inflation, some might be surprised by my injecting some caution here. But remember this: even firetrucks with sirens blaring slow down at intersections lest they cause further preventable trouble.” From Atlanta Fed President Raphael Bostic’s Tuesday speech, “Monetary Policy Amid Changing Labor Market Dynamics.”
“Overarching goal is to return inflation to our target range without triggering significant economic dislocation.” “Monetary policy makers must be mindful of those uncertainties and proceed carefully in tightening policy.” “…I plan to proceed with intention and without recklessness.” “Even firetrucks with sirens blaring slow down at intersections lest they cause further preventable trouble.” Not Volcker-esque.
I was adamantly opposed to market “tinkering” when Alan Greenspan began dabbling with this seductive policy departure in the early nineties. Similarly, “the maestro’s” asymmetric approach (ease aggressively while tightening timidly) was clearly a slippery slope of Bubble accommodation. Today, the Fed needs to be mindful of remaining too cautious in getting rates to a restrictive level in a timely manner. And “recklessness”? Where was that concern when the Fed injected $5 TN of liquidity into egregiously speculative markets over a two-year period?
And I have particular disdain for the “sirens blaring firetrucks slowing at intersections” analogy. Emergency vehicles engage their flashing lights and blaring sirens with the objective of arriving as quickly as possible to begin administering emergency operations. A single minute could be the difference between life and death.
Fed policy has certainly not been speeding hurriedly to pull us from the wreckage wrought by runaway inflation. Good grief, they’re afraid to even approach a conventional speed limit, content to yield to pedestrians waiting at crosswalks and keen to slow down at intersections in anticipation of traffic lights turning amber. In a severe drought, local officials should never have so actively promoted the use of fireworks. Seeing the community madly buying up all the available bottle rockets, they’d better have the available resources, planning and resolve to quickly get the situation under control. And if the community is at perilous risk, emergency responders are duty-bound to blow right through red traffic lights (and classroom doors).
“I think the Fed is going to have to decide between two policy mistakes: Hit the brakes too hard and risk a recession or tap the brakes in a stop and go pattern – including a pause in the September meeting would be an example of that – and risk having inflation well into 2023.” Mohamed El-Erian, Bloomberg TV, May 27, 2022
There’s a lot of talk these days of the potential for a Fed policy mistake. A string of historic misjudgments and policy blunders have already been committed. Damage from a requisite tightening cycle will be the unavoidable consequence of past monetary sins. Clearly, the Fed’s neglect of inflation risk has been an epic policy failing. Garnering less attention, the Federal Reserve’s doctrine of relying on so-called “macro-prudential” policies to address speculative excess and asset market Bubbles has been a similar abject failure.
I have great respect and admiration for Mohamed El-Erian. I agree that the Fed’s likely “stop and go pattern” would only add to a series of policy shortcomings. The risk, however, is much greater than “having inflation well into 2023.” That’s a given. The stakes seemingly couldn’t be much higher.
A lack of Federal Reserve fortitude risks unleashing a secular shift to high and unmanageable price pressures. Grave economic, social, political and geopolitical instabilities are at stake. At this point, a Volcker-type “slamming on the brakes” is likely the only course that would significantly reduce the likelihood of years of elevated (4-6% minimum) general price inflation. Volcker’s “policy mistake,” reviled in real-time, is canonized with the benefit of hindsight.
Labor markets today remain extremely taut, with Wage/Price Spiral Dynamics well on the way of becoming entrenched. Moreover, a new cycle of geopolitical instability, anti-globalization, and pressing climate change issues will act as an enduring supply shock and inflation boost.
There’s a further major risk with “stop and go.” It’s “tinkering” with dysfunctional markets with a dangerous proclivity for speculative excess and acute instability. It’s no coincidence Bullard comes out with his “we could be lowering the policy rate” as early as next year, with the market in serious trouble. I doubt Bostic this week invokes “reckless” policy tightening if not for sinking equities prices. Are Fed officials relieved by this week’s 6.6% surge in the S&P500 (Nasdaq100 7.1%)?
High-yield CDS prices collapsed 66 this week to 457 bps, the largest weekly decline since early-June 2020. “Biggest Junk-Bond ETF Sees Comeback With Best Rally Since 2020.” Investment-grade CDS dropped 12 to 79 bps, the biggest decline since November 2020. “Muni Market Posts ‘Stunning 180’ in Biggest Rally Since 2020.”
A Friday afternoon Bloomberg headline was spot on: “Big Up Week for Everything Is Latest Sudden Twist for Traders.” The Philadelphia Oil Services Index jumped 11.8% this week, the KBW Bank Index 9.2%, the Semiconductor (SOX) Index 8.1%, the Nasdaq Industrials 7.8%, the Nasdaq100 7.2%, and the NYSE Financial Index 7.1%. The “average stock” Value Line Arithmetic Index gained 6.2%. The SPDR S&P Retail ETF (XRT) surged 10.1%, reversing last week’s 9.4% drubbing. The Direxion Semiconductor Bear 3X sank 22.4%
Why the sudden burst of enthusiasm? First of all, option expiration surely contributed to last week’s acute selling pressure, the culmination of a seven-week selloff and resulting deeply “oversold” condition – conducive to an abrupt upside reversal. Reassessment of the Fed’s tightening cycle provided the catalyst. In general, this week’s economic data played into the “peak inflation” and wavering tightening cycle narrative. The weak Services PMI, putrid New Home Sales, and a downshift in Personal Income growth all fit well.
There’s always an ebb and flow to Crisis Dynamics. Things tend to proceed slowly, but, at some point, kick into the Acceleration Phase, as I titled the CBB from two weeks ago. And we’ve seen this play out repeatedly over the years (decades): the revelation of Crisis Dynamics prompts some degree of policy accommodation – rate cuts, emergency meetings or, more recently, shock and awe QE announcements.
While the typical policy menu is inappropriate in today’s backdrop, the Fed has offered faltering markets something crucial. Federal Reserve officials have affirmed the “Fed put,” and, importantly, they have signaled they will not wait for financial panic or deep recession.
The Fed had been talking tough on inflation – as if acting decisively to control it had become the overarching policy priority. Powell repeatedly invoked Paul Volcker. Even the doves were talking hawkish. Only a few weeks ago, FOMC officials were discussing the potential for 75 bps hikes. Bill Dudley, Larry Summers and others were discussing a 5 to 6% Fed funds rate.
Understandably, markets were initially skeptical of the notion of their well-being supplanted by the Fed’s newfound inflation focus. The Fed wouldn’t dare, would they? We’ve got them trapped, don’t we? But, for the most part, it was easy to dismiss the Fed’s inflation fixation – and ramifications for the “Fed put” – so long as the great bull market remained intact.
At this point, the bull is anything but intact. In particular, the latest incarnation of a historic “tech” Bubble is deflating. Credit and financial conditions tightened dramatically in high-yield, leveraged loans and risky finance more generally, with huge consequences for thousands of uneconomic enterprises having sprouted up over years of egregiously loose and speculative financial conditions.
Acute market fragilities were laid bare, and the Fed has done what the markets have long presumed: once again, they’ve essentially caved to the markets. This started with Powell’s press conference and gained momentum this week. And I expect the general response will be, “Say what, they haven’t changed anything – they’re still tough on inflation.”
Much has changed. Market fear of a “tone deaf” Fed willing to hike rates irrespective of market dynamics has been allayed. The Fed put is alive and well. Not only have 75 bps hikes been taken off the table, the Fed has also signaled a desire to quickly return to its standard little 25 bps “baby step” approach (with pauses so everyone can catch their breath). Inflation has not, in reality, supplanted market wellbeing in the eyes of the FOMC. Not only is the Fed wishing for a “pause,” they will surely back off their balance sheet unwind (QT).
It would be poor analysis to focus only on the Fed and U.S. markets. Christine Lagarde’s ECB is in stiff competition these days with Haruhiko Kuroda’s BOJ for the most reckless major central bank. Stocks were up 5.3% this week in Spain, 3.7% in France and 3.4% in Germany. Europe’s high-yield (“crossover”) CDS index collapsed 57 bps this week, the largest decline since June 2020. Greek 10-year yields dropped 23 bps (to 3.48%), as “periphery” bond spreads to German bund yields narrowed meaningfully. A toned-down Fed tightening cycle, it’s assumed, takes heat off global central bankers.
From my perspective, it all points to Inflation Acquiescence. The dollar index dropped 1.4% this week, certainly contributing to the 39 bps drop in EM CDS (to a 6-wk low 266bps). The Bloomberg Commodities Index jumped 2.5%, increasing y-t-d gains to 35%. Gasoline’s 4.7% advance boosted 2022 gains to 80%. Natural Gas surged another 8%, with y-t-d gains up to an astonishing 134%. The Treasury five-year “breakeven” inflation rate rose nine bps this week to 2.99%, the largest weekly advance since March.
Risk markets were overdue for a rally, and a decent countertrend advance would not be shocking. The S&P500 mustered a 14% rally in the Spring of 2008. But I don’t see the Bubble being resuscitated. I’ll be curious to observe how a confluence of recovering markets and Inflation Acquiescence would sit with the bond market. While “peak inflation” is music to the ears for equities, bonds face years of persistent price inflation. It’s also worth noting that the investment-grade bond issuance boom runs unabated that together with general inflationary pressures are poised to spur sufficient system Credit expansion to sustain inflationary pressures.
For global inflation and growth dynamics, China remains a major wildcard. Panic may be too strong, but Beijing is clearly increasingly alarmed by its deflating Bubble. Monday, “China rolled out a broad package of support measures” and “33-point plan”. Expect massive fiscal spending and bank lending directives.
May 25 – Bloomberg: “China’s Premier Li Keqiang gave his starkest warning yet about the economy, as it comes under severe strain from Covid outbreaks and lockdowns, suggesting the government’s growth target is moving further out of reach. Li held an emergency meeting on Wednesday with thousands of representatives from local governments, state-owned companies and financial firms, calling on them to do more to stabilize growth. He said the economy is in some respects faring worse than in 2020 when the pandemic first emerged and urged more efforts to reduce a soaring unemployment rate.”
Meanwhile, the geopolitical backdrop appears more ominous by the week.
May 26 – Bloomberg: “The US rejected a plan by Russian President Vladimir Putin to facilitate grain and fertilizer exports only if sanctions on his country are lifted, pinning the blame on the Kremlin for blocking shipments and stoking concerns of global food shortages.”
May 27 – Bloomberg (Iain Marlow and Peter Martin): “Secretary of State Antony Blinken said the US will seek to influence China’s behavior by shaping the world around Beijing in remarks that took direct aim at President Xi Jinping’s performance leading the world’s second-biggest economy. ‘Under President Xi, the ruling Chinese Communist Party has become more repressive at home and more aggressive abroad,’ Blinken said… ‘We cannot rely on Beijing to change its trajectory. So we will shape the strategic environment around Beijing to advance our vision for an open, inclusive international system.’ Blinken warned that China is seeking to dominate the industries of the future and said the US response will be to bolster investment at home; work closely with allies, particularly in the Indo-Pacific region; and compete with China on a ‘level playing field.’ He said Xi’s government is actively undercutting the international system that aided China’s own rise. ‘Rather than using its power to reinforce and revitalize the laws, agreements, principles and institutions that enabled its success, so that other countries can benefit from them too, Beijing is undermining it,’ Blinken said.”
May 24 – Financial Times (Demetri Sevastopulo, Kathrin Hille and Kana Inagaki): “Chinese and Russian strategic bombers flew over the Sea of Japan as Joe Biden attended a Quad summit in Tokyo, in a joint exercise the Japanese government denounced as ‘unacceptable’. The nuclear-capable bombers conducted a joint flight on Tuesday that began over the Sea of Japan as the US president was meeting his counterparts from Japan, Australia and India, Japanese and US officials said. Moscow said the 13-hour flight was carried out ‘strictly in accordance with the provisions of international law’ and was not directed against third countries. But Nobuo Kishi, Japan’s defence minister, condemned the exercise as ‘provocative’ and ‘unacceptable’.”
Original Post 28 May 2022
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