Powell is No Volcker

By Doug Noland on February 4, 2023

From history, we know that once unmoored, inflation tends toward a cycle of unpredictability and destabilizing volatility that can extend for years and even decades. Burns and Miller have lots of company when it comes to ineffective half-measure responses to escalating price pressures. There are huge longer-term costs associated with failing to employ aggressive measures to quickly contain bursts of inflation. And, importantly, Volcker demonstrated how a focus on money and Credit becomes critical for effective inflation containment.

If there was any doubt, there’s now clarity: Powell is No Volcker. In fairness to Powell, he’s demonstrating typical early-cycle, wishful inflation-fighting timidity. Time will tell if he is viewed as ineffective in thwarting a nascent inflationary spiral, callously grouped with the likes of Burns and Miller.

But Powell was not cautious, especially considering the extraordinary market backdrop. Dovish Powell provided a highly speculative marketplace all the signals it fancied that the Fed is happy to soon conclude this brief monetary tightening cycle. Goldilocks, soft-landing and resumption of perpetual bull markets. It all fits – it’s coming together as planned!!!

Instant market relief: “And, of course, financial conditions have tightened very significantly over the past year.” No pushback. Additional confirmation was forthcoming. “Financial conditions didn’t really change much from the December meeting to now. They mostly went sideways or up and down – but came out in roughly the same place.” “We think we’ve covered a lot of ground, and financial conditions have certainly tightened.”

Speculative markets, luxuriating in arguably the loosest financial conditions since the Fed began raising rates last March, were bewildered. Commentators used “strange”.

After beginning 1968 at 3.6%, (y-o-y) CPI jumped to 6.2% to end 1969. “Disinflation” took hold, with CPI down to 2.7% by June 1972. What had been festering geopolitical risk erupted in 1973. In response to the Yom Kippur War, OPEC announced in October 1973 an embargo on oil exports to those countries supporting Israel.

Spiking energy prices fueled an inflationary surge, with CPI ending 1974 at 12.3%. The crisis subsided, with y-o-y CPI all the way back down to 4.9% by November 1976. But CPI shot back to 7.0% in April 1977, before settling back to 6.5% one year later. Another geopolitical crisis ignited what had evolved into an inflationary tinderbox, with CPI spiking to 14.8% by March 1980.

History is not kind to Federal Reserve Chairman Arthur Burns. Fed funds were at 9% when he became Fed Chairman, only for him to then slash rates to 3.5% by early 1971. Slow to respond to the inflationary surge, the Burns Fed belatedly hiked rates to 11.0% by August 1973. Rates were then slashed to as low as 4.75% to start 1976.

Fed funds were at 6.75% when G. William Miller was appointed Fed Chairman in March 1978. Miller is viewed as having been only somewhat less soft on inflation than his predecessor. His gradual rate increases to 10.5% by August 1979 (the month Paul Volcker replaced him) were ineffective in containing an inflationary spiral. The Iranian revolution, the Iraq/Iran War, and other factors combined for the painful 1979 oil shock.

With inflation deeply ingrained, it took Volcker’s punishing tightening measures to finally quash pricing pressures and inflationary psychology. Rates almost doubled in eight months to 20%. Deflecting political pressure, Volcker radically shifted the Fed’s focus from managing policy interest rates to directly targeting money and Credit.

A Volcker quote from a 1979 Board of Governors meeting days before public announcement of the policy shift: “I would emphasize that the broad thrust is to bring monetary expansion and credit expansion within the ranges that were established by the Federal Reserve a year ago.” And in a speech three days following the historic Saturday, October 6th announcement: “Those measures were specifically designed to provide added assurance that the money supply and bank credit expansion would be kept under firm control.”

Why is this history pertinent? For one, I believe we’re early in a new cycle of elevated inflation risk. General pricing pressures ebb and flow. And as much as we would like to believe the Fed can manage inflation with moderately higher (from a historical perspective) interest rates, they have limited control.

Especially in the current backdrop, inflation is a global phenomenon. The pandemic made it clear that factors beyond U.S. policies can trigger profound inflationary consequences. And Russia’s invasion of Ukraine underscores today’s extraordinary geopolitical risks and inflationary impacts. The U.S. is not today dependent on oil imports as it was in the past, and energy prices don’t have quite the overall inflationary impact as before. At the same time, inflationary risks associated with climate change weren’t factors in the seventies and eighties. And I would further argue that U.S. monetary policy command over inflation dynamics has diminished as financial conditions and inflationary effects have become more global phenomena. For example, Beijing policymaking – along with Chinese Credit and economic dynamics – now exert major influences on global inflation dynamics. It’s nice to imagine painless Fed rate tinkering doing the trick.

If I had to venture a guess, Powell believed his press conference remarks were balanced. He strived for balance.

Hawkish Powell: “It would be very premature to declare victory or to think that we’ve really got this.” “We believe ongoing rate hikes will be appropriate to attain a sufficiently restrictive stance of policy to bring inflation back down to 2%.” “Reducing inflation is likely to require a period of below trend growth and some softening of labor market conditions.” “The labor market remains very, very strong, and that’s job creation – that’s wages.” “The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.” “We see ourselves as having a lot of work left to do.” “And why do we think that’s probably necessary? We think because inflation is still running very hot.” “We’re going to be cautious about declaring victory and sending signals that we think that the game has won because we’ve got a long way to go.”

Powell’s hawkish gab was effortlessly brushed aside after his response to the initial question from AP’s Christopher Rugaber: “As you know, financial conditions have loosened since the fall, with bond yields falling, which has also brought down mortgage rates, and the stock market posted a solid gain in January. Does that make your job of combating inflation harder? And could you see lifting rates higher than you otherwise would to offset the easing of financial conditions?”

Powell: “So, it is important that overall financial conditions continue to reflect the policy restraint that we’re putting in place in order to bring inflation down to 2%. And, of course, financial conditions have tightened very significantly over the past year. I would say that our focus is not on short-term moves, but on sustained changes to broader financial conditions. And it is our judgment that we’re not yet at a sufficiently restrictive policy stance, which is why we say that we expect ongoing hikes will be appropriate. Of course, many things affect financial conditions, not just our policy. And we will take into account overall financial conditions along with many other factors as we set policy.”

Speculative markets, luxuriating in arguably the loosest financial conditions since the Fed began raising rates last March, were bewildered. Commentators used “strange”. Markets had no idea what measure of financial conditions Powell was using; and whatever it was, it surely lacked credibility. But they loved it! No more worry that tight financial conditions might be a Fed inflation fight prerequisite. No more fretting that the Fed would put the kibosh on things. And with markets now really in the mood, Powell proceeded to deliver more pillow talk.

“I will say that it is gratifying to see the disinflationary process now getting underway, and we continue to get strong labor market data.” “So, I would say it is a good thing that the disinflation that we have seen so far has not come at the expense of a weaker labor market. But I would also say that that disinflationary process that you now see underway is really at an early stage.”

It was market fantastic! Not only was the Fed keen to turn a blind eye to the return of market froth, but the marketplace could now rest assured that strong jobs data wouldn’t cause a Fed rethink of the level required for a restrictive policy rate (Friday’s stunning report of 517k jobs added in January forced a little market rethink).

And why on earth would Powell use “disinflation” 15 times during his 45-minute press conference – after stating that inflation was “still running very hot.” Balanced Powell strayed into Tangled Powell.

But there was more to love: “At the same time, if the data come in in the other direction, then we’ll make data dependent decisions at coming meetings, of course.” “If we feel like we’ve gone too far, we can certainly – and inflation is coming down faster than we expect, then we have tools that would work on that.”

It was kind of crazy. Rather than pushing back against market expectations of a pivot later in the year, the Chair several times seemed to suggest the Fed would be willing to consider cutting rates if inflation comes in below the committee’s forecast.

Greg Robb from MarketWatch: “In the minutes of the December meeting, there was a couple of sentences that struck people as important. When the committee said participants talked about this unwarranted easing of financial conditions was a risk and it would make your life harder to bring inflation down… So, I was wondering, has that concern eased among members or is that still something you’re concerned about?”

After stating that conditions “didn’t really change much from the December meeting,” Powell added: “As we’ve discussed a couple of times here, there’s a difference in perspective by some market measures on how fast inflation will come down. We’re just going to have to see. I’m not going to try to persuade people to have a different forecast. But our forecast is that it will take some time and some patience – and that we’ll need to keep rates higher for longer. But we’ll see.”

Ten-year Treasury yields traded down to an almost five-month low of 3.33% during Powell’s press conference. It’s worth noting that the last time (prior to the current spike) inflation was at today’s level (up 6.5% y-o-y), Treasury yields were at double-digits. Ten-year Treasuries traded at an average yield of 10.57% during the eighties, 6.65% through the nineties, and 4.70% during the period 2000 through 2007.

Is the divergence between Fed rate forecasts and market rate expectations really about diverging views on the path of inflation? Why might Treasury yields remain so low today, considering recent inflation dynamics and the elevated risk of future inflationary shocks? And are today’s market yields sufficient to restrain what has been several years of historic Credit expansion?

Suffice it to say that these are critical and incredibly complex questions. My view is that markets are broken, and now hopelessly so. Prospects for – and actual – QE have fundamentally altered market perceptions and pricing for Treasuries, and this fundamental market distortion has led to artificially depressed term and risk premiums for fixed-income securities generally – which has fed through to inflated asset prices and speculative Bubbles (i.e. stocks, real estate, etc.) generally.

And, importantly, central bank-induced distortions have unleashed historic borrowing, both in the public and private sectors, along with unprecedented speculative leverage throughout global markets. This has ensured a massive accumulation of debt and financial leveraging that is unsustainable at more normalized (higher) market yields. Essentially, the Fed and global central bankers are these days trapped, a reality that is well-appreciated in the markets. Powell served soothing confirmation.

Listening to Powell and watching markets lurch to the upside, my thoughts returned to “The Maestro” Alan Greenspan. I had major issues with his monetary management, including what I believe was his penchant for obfuscation. For Powell, my feelings Wednesday vacillated between disappointment and a degree of sadness. I titled my November 4th CBB “Powell Building Credibility.” As central bankers go – and definitely compared his predecessors – Powell has been more the straight shooter. But does he believe what he was saying Wednesday, and if so, how does he explain major inconsistencies in his comments compared to just three months ago (November 1st)? I have lost confidence that the Chair is up to the challenge.

Greenspan was the original architect of “asymmetrical” monetary policy. He would raise rates gingerly, not to upset beloved markets. But he would then aggressively slash rates when markets found themselves in trouble. The free-markets advocate was in reality the master market operator. And what made Greenspan’s experimental policymaking so dangerous was that he was tinkering with the markets as the fledgling leveraged speculating community and Wall Street finance were rapidly becoming powerful players throughout the markets, Credit system and economy. He monkeyed with market incentives at the wrong time, with momentous and ongoing consequences.

And as the markets and Credit system became increasingly unstable, policymakers only doubled down with lower rates, bailouts and, later, QE. And let there be no doubt, without the 1994 bond market rescue and the 1995 Mexican bailout, there would not have been the terminal phase excess that culminated with the devastating 1997 Asian Tiger Bubble collapses and the 1998 Russia/LTCM implosion – and subsequent additional bailouts. The Fed and GSEs ensured excessively loose financial conditions through much of the nineties, accommodation that fueled the so-called “tech” Bubble. That bursting Bubble spurred perilous policy asymmetry – and the resulting much more systemic mortgage finance Bubble. And that bust sparked a previously unthinkable $1 TN of QE and years of zero rates.

Bernanke’s inflationist policies coerced savers out of their deposits and into equities and corporate bond ETFs, among other risky things – raising the risk of a disorderly reversal of speculative flows. And he took Greenspan’s asymmetrical approach to a dangerous new level with his 2013 declaration, “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”

Understandably, markets interpreted Bernanke’s comment as an overt confirmation of the Fed’s market backstop (“Fed put”) – no market downdrafts tolerated. In one of history’s spectacular speculative Bubbles, the S&P500 surged from 1,600 to almost 3,400, and the Nasdaq Composite 3,000 to 8,000 in six years, with the more speculative stocks and sectors greatly outperforming. The Bubble was bursting in March 2020, only to be resuscitated by $5 TN of Fed QE, along with unprecedented fiscal deficits. The S&P ended 2021 at 4,766 – though the S&P’s gain paled in comparison to manias in crypto, tech and growth stocks, “meme stocks,” SPACs and such.

Powell Wednesday needed to push back firmly against speculative markets, against the legacies of Greenspan and Bernanke. After printing $5 TN, he should have demonstrated a modicum of policy symmetry by at least leaning against the “echo Bubble.” It was astonishing to see Powell instead throw fuel on a major short squeeze and dangerous market instability.

The Goldman Sachs Most Short Index surged 5% on Powell’s comments – and was then up another 8% intraday in Thursday’s chaotic trading session. The Goldman Short Index was up 30.5% y-t-d as of Thursday’s close (ended week up 27.4%). Don’t underestimate the ramifications of the great January 2023 cross-market short squeeze.

Powell’s assertion notwithstanding, financial conditions have loosened dramatically since the Fed’s December 14th meeting. Squeezes loosen conditions, while unleashing self-reinforcing speculative excess and leveraging. Corporate Credit spreads have significantly narrowed. After trading to 1.65 percentage points in October, corporate investment-grade spreads to Treasuries (from Bloomberg) were down to 1.30 on December 14th – and traded Thursday at a nine-month low of 1.15. High-yield spreads also narrowed to almost nine-month lows post-Powell.

Bank CDS prices are near the top of my list of financial conditions indicators. JPMorgan CDS closed December 14th at about 74 bps – down from October’s high of 130 bps. JPMorgan CDS ended this week at 60 bps, the low since February 2022 (before the Fed began raising rates). Also closing at lows back to last February were Goldman Sachs (78bps), Bank of America (63), Citigroup (72), and Morgan Stanley (66). The KBW Bank index sports a year-to-date gain of 13.6%, with the Broker/Dealers (XBD) up 10.5%. Why would the recent loosening of conditions not prolong the historic lending boom?

I have been pushing back against the Wall Street narrative that the bond market was pricing recession risk and for a resulting Fed pivot. I find Powell’s assertion that bond pricing reflects Wall Street’s constructive view of inflation even less convincing. There was certainly nothing this week that has me shying away from my view that the Treasury market is discounting the probability of an accident. These markets are an accident in the making.

The spectacular equities short squeeze is indicative of mounting trouble for the leveraged speculating community. In particular, long/short strategies have been hammered to begin the year by losses on short portfolios overwhelming gains on longs. And with the abrupt reversal in stocks, Treasuries, corporate Credit, British gilts, European and global equities and bonds, and emerging market currencies and bonds, it’s hard to believe last year’s big macro and quant hedge fund winners are not off to a bad start for 2023. Meanwhile, many of the funds that performed poorly last year were surely caught under exposed for January’s big rally – compounding their performance agony.

Markets are a mess. Squeeze dynamics have been causing mayhem. Meanwhile, waning Fed hawkishness and dollar weakness have supported precious metals and some commodity prices. And then Friday’s blowout payroll gains spurred a dollar reversal, with the yen, Australian dollar, New Zealand dollar and South African rand all down about 2% (euro down 1.1%). The Bloomberg Commodities Index sank 2.1%. Treasury yields reversed sharply higher Friday, with two-year yields surging 19 bps.

The backdrop is set for an especially challenging year for the leveraged speculating community. And as the marginal source of global market liquidity, a rattled zigging and zagging speculator community suggests market volatility, instability and uncertainty. And the longer the squeeze and market rallies are sustained, the more vulnerable markets are to a destabilizing downside reversal. In the meantime, the combination of unsettled fundamentals and capricious trading dynamics ensures extremely challenging performance dynamics. Furthermore, there’s China uncertainty, Bank of Japan uncertainty, Ukraine war uncertainties, and geopolitical uncertainties – not to mention financial and economic vulnerabilities.

I worry about Market Structure, and these concerns (including leveraged speculation, derivatives, and the ETF complex) will only grow if FOMO takes over, everyone gets bulled up and markets go into Bubble melt-up mode. At the end of the day, the existing structure – dominated by derivatives and “delta hedging,” risk obfuscation, leveraged speculation and trend-following flows – is not sustainable. From this perspective, the Fed being forced into rate cuts later this year seems more than plausible.

Original Post 4 February 2023

TSP Smart & Vanguard Smart Investor serves serious and reluctant investors