Pro Perspectives 5/16/22
May 16, 2022
We entered the year with record high net worth for both consumers and corporate America.
And near record low debt service.
And with inflation running at forty-year highs.
We knew, coming into the year, that the Fed had finally acknowledged the inflation problem, and was ready to take action — albeit in very conservative baby steps.
Even after seeing it's first 8%+ inflation number, the Fed still was projecting a shallow rate hiking cycle, to end around 3% on the Fed Funds rate. That's about historically neutral (not accommodative, not restrictive to economic activity).
As we've discussed, if we look back at the inflation fight of the early '80s, beating inflation required the Fed taking the Fed Funds rate above the rate of inflation. The Fed Chair at the time, Paul Volcker, beat double-digit inflation with short-term interest rates that approached 20% — and in doing so, he took the economy into recession.
But he also, in stabilizing prices, set the stage for a long and very good period of development for the U.S. economy.
The current Fed still has given us no indication that they have the appetite to take such a path with rates.
That said, what they have done is promised to "bring demand down."
And the sacrificial lamb, as the Fed has explicitly framed it, is the job market.
So, yes, we have a Fed that suddenly trying to manipulate to the goal of less jobs.
At the moment, there are two open jobs for every one job seeker. Not only has Fed Chair, Jay Powell, told us that they intend to bring the ratio of job openings/job seekers to one-to-one, but Ben Bernanke (the Fed Chair that presided over the Great Financial Crisis), echoed that game plan this morning (bring the job seekers ratio to one-to-one).
The question is: How do they do it?
Raise rates, aggressively? Higher rates equals tighter credit. Tighter credit equals less business spending and investment. And less business spending and investment tends to equate to less hiring.
But, again, the Fed is not projecting an aggressive, inflation chasing rate hiking campaign.
With $6 trillion of new money floating around (thanks to all of the post-pandemic fiscal spending largesse), the level of demand is being reflected in an inflation rate of over 8%. Yet the Fed's projected interest path, ending around 3%, gets them no where near the inflation rate.
As it stands, executing on the Fed's projected rate path would still fuel demand (and therefore inflation).
So how to they intend to get their desired effect?
It may be that they intend (hope to) talk it into existence.
What the Fed and other central banks learned through the global financial crisis fight, was that once they crossed the line and backstopped nearly everything, the markets would respect their threats/promises.
This became a new tool, added to the central bank toolbox. They called it "forward guidance."
Throughout the financial crisis, the Fed used forward guidance to manipulate behaviors of consumers and businesses by telling us that rates would remain low for "an extended time."
The European Central Bank adopted it in 2012, by promising to defend the solvency of the collapsing European sovereign bond market, by saying they would be a buyer of unlimited sovereign debt (they would be the buyer of last resort). Just by saying it, interest rates of the weak countries of Europe fell sharply, and the risk of major defaults subsided — without the ECB having to buy a single bond. The threat, alone, worked. And that was something that Mario Draghi (the ECB President, at the time) bragged about.
So, perhaps the Fed's threat to "bring down demand" is just "forward guidance," intended to influence behaviors (weaker demand). Just talk.
If so, it's working – so far.
Stocks are behaving as if the Fed will take some recession-inducing action. The (roughly) a 20% haircut in the stock market lowers the net worth of consumers, from record levels, which will soften demand. That (stock market decline) alone, is good enough to put a dent in job creation, as companies start reining-in risk (from "uncertainty").
Meanwhile, market interest rates (determined by the market) are at just 2.88% (having done an about face after trading as high as 3.2%).
A ten-year yield at 2.88 (at today's close) is not pricing in an aggressive, inflation chasing, rate hiking cycle. If the bond market is indeed "smarter" than the stock market, perhaps the bond market knows the Fed is just playing the "forward guidance" game — talking, with no intention on big policy action.
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