Our friend Adrian Day explores the likely outcomes for the Federal Reserve’s new “hawkish” policy.

June 15, 2022

Dear Fellow Investor,

When will he pivot? That is the question analysts are debating: how long before the Fed under Jerome Powell caves to deteriorating market and economic news and stops tightening?

I have little doubt that we will see the “Powell pivot” before inflation is firmly under control; and even less doubt that the Fed will be unable to bring inflation down without causing serious damage to asset prices and to the economy. I have scant respect for the Fed and its officials. But I have argued that this time around the Fed will be less concerned with declining asset prices and may stay the course a little longer than most are expecting. Two events this past week reinforce that view.

The strong labor report, showing more jobs created than expected is, in the “good news is bad news” equation, weighing on the stock market. The growth-heavy Nasdaq, fell by well over 2% on Friday, after the report. The strength in new jobs gives the Federal Reserve over to continue tightening. I have commented before that jobs are the most important indicator for this Fed; they will ignore the stock market and other assets declining (in fact they actually want to see declines in asset prices); they will ignore dollar strength or dollar weakness; manufacturing declines and many other signs of weakness. But a weak jobs market competes with high prices for Fed attention. (A cynic might note the discrepancy between the private ADP jobs report and the government Labor Department report, but we’ll leave that aside for now.)

In another significant development, President Biden and Fed chairman Jerome Powell met last week, with Biden reportedly telling Powell that bringing inflation down was his #1 job. Certainly, inflation is one of the main factors leading many analysts to predict a Democratic wipe-out in the mid-terms. Leaks and spin after the meeting emphasized not only that Biden told Powell bringing down inflation was his main task, but also that Biden respects the independence of the Fed, a not-so-subtle way of emphasizing that inflation is on Powell, not Biden. So given the strength of the labor market; given his marching orders from Biden and the short timeframe before mid-terms; and given the Fed’s deteriorating credibility with even former Fed officials, the Fed is likely to continue tightening despite damage in the stock market and broad economy.

The chief White House economic adviser, Brian Deese, in a press briefing, said the President was acknowledging “the pivotal role that the Fed plays institutionally and that monetary policy plays in the process of bringing prices down.” In other words, it’s his fault not ours. Expect more of this messaging, which can only add pressure to the Fed to stay the course. By putting the responsibility to lower inflation on the Fed, the White House is also implicitly laying the groundwork to blame the Fed if the economy moves into a recession. Meanwhile, even though charging the Fed with cutting inflation, Biden continues to implement by fiat executive orders that boost inflation; but that’s a different story.

I have commented many times that the path on which the Fed has embarked is hardly hawkish. If interest rates continue to increase over the next 12 months at the most aggressive pace discussed by Fed officials, rates will still, a year from now, be deeply negative in real terms (nominal rates less inflation), and lower in even nominal terms than in 2007.

In addition to raising interest rates, the Fed has also started to reduce the size of its balance sheet. To date a small 5% per month has been allowed to roll off––mature without reinvesting the proceeds. The task of actually selling bonds has yet to commence. If the balance sheet is reduced at the most aggressive pace discussed by Fed officials, the balance sheet will still be, a year from now, more than twice what it was two years ago. This is hardly hawkish. But the Fed continued with its loose policy for far too long and left reversing it too late; hardly anyone reputable disputes that (though of course many of those now saying the Fed left it too late were no-where to be seen a year ago). Many former Fed officials are criticizing Powell for starting to act too late, but I don’t remember any giving dissenting votes on policy or saying anything at the time. One member of the Fed’s rate-setting Open Market Committee, Christopher Waller, recently admitted, “If we knew what we know today, we would have acted sooner.” Even former Fed head and now Treasury Secretary Janet Yellen says she was wrong about inflation. While perhaps honest, these comments raise the question why the Fed had no clue what was coming.

The Fed will eventually surrender; the question is when. It was already making noises about backing away before this week, with suggestions it might pause tightening in September to see how the economy is responding to its policies. And there have been suggestions that if inflation comes down to 4% that might be sufficient to claim victory. But after this week, that probably changes: if you were Fed chairman and the President told you and the world that you are responsible for inflation and for getting it down, and that it’s your number one priority; and if commentators were daily suggesting that you don’t have the courage to stay the course, how would you react? You might stiffen the sinews, summon up the blood, and stick with the program a little longer than otherwise.

What makes this current situation so much more dangerous than previous episodes of tightening is the position from which we are starting: years of ultra-low interest rates; a balance sheet more than twice the size the last time the Fed attempted to reduce it; inflation at the highest in 40 years; and massive debt at the government, corporate and household levels.

Reducing the size of the balance sheet, and withdrawing liquidity from the economy, is potentially more dangerous if only because the Fed has no experience in handling that. Withdrawing liquidity from an economy (and markets) that have thrived on excess liquidity can only have a damaging impact on not only asset prices but on the economy. Already J.P. Morgan CEO Jamie Dimon says “a hurricane is coming”, while Elon Musk is about to lay off staff. More: Something will break; there are many companies out there alive only because of excess liquidity, companies with no profits but with plenty of debt. How many Lehmans will the Fed be prepared to see this time before reversing course? Or will the administration simply bail out everyone and everything that get into trouble, thereby aggravating the inflation they say they want to tame?

The Fed doesn’t seem to know, or won’t admit, the reasons for inflation, namely the excessive money creation of recent years. Instead we hear about Putin, and supply-chain issues and Shanghai lockdowns. Extraneous factors––such as the sanctions on Russian oil and gas––can cause those prices to go up (though goodness knows that there are other reasons causing higher oil and gas prices). But they do not cause all prices to go up at the same time. So a drought or a strike or a product recall or any number of circumstances can cause this or that price to go up; but that is not inflation. Given the same amount of money in an economy, a higher price on one good will see a lower price on another. Only when prices in aggregate go up do we call it inflation (and, as I have explained, that is not actually inflation, but the symptom of inflation); inflation, as Milton Friedman said, “is always and everywhere a monetary phenomenon”.

Paul Krugman, the high priest of establishment economists, wrote as recently as June 2021 that inflation was not a risk. That was within one month of the low. More recently he has said that “the current bout of inflation” came on suddenly because of dislocations from the pandemic. He wrote last year that to think inflation was coming back “you had to believe either that the Fed’s model of how inflation works is all wrong or that the Fed would lack the political courage to cool off the economy.” Yes and yes, Paul, for once you are correct; you hit the nail on the head.

The Fed’s whole methodology is faulty. First, this Fed prides itself on being “data dependent”; it will look at the data and be flexible based on the data. But data show what has already happened. Being “data dependent” means always being backwards looking. Thus the Fed winds up reacting and being too late. Second, there is a fundamental problem with the models that the Fed (and most modern economists) are using. Fed models are static; they believe you can tweak one input and get a desired change in the outcome. But when there are changes, to interest rates, to liquidity, households and businesses react and change their behaviour. So you don’t get the desired outcome. We have seen just in the last couple of weeks many companies, from Tesla to Starbucks, discuss impending labor cuts.

If your models made predictions –– on inflation, on GDP, and other economic conditions –– that year after year proved incorrect, and frequently wildly inaccurate –– as have the Fed’s –– would you not perhaps revisit your models (or even start to wonder if the whole business was invalid)? After all, the Fed is the body that sets short-term rates and injects and withdraws liquidity from the economy, so they actually have some influence on the outcome. They have over 400 PhDs in economics working for them.

If even they get it wrong, then it’s time to not tweak the model but revisit the fundamentals. Of course “even” is the wrong word in the previous sentence. These PhDs and their models have no experience of the real economy. They do not understand how business managers make decisions –– on hiring and firing, on expansions and retrenchments –– in response to changes in the economy. They do not understand because they have never been in the position of having to make those decisions.

Economists’ expectations for inflation have consistently been lower than the reality, every quarter since January 2021. The outlook is for stagflation: continued inflation, even if it settles below current levels; and a recession or stagnant economy. The consumer, particularly the lower income without large investments in the stock market, is tapped out; the savings rate is now back down to the levels of 2008, while credit card debt saw its largest one-month jump in history. In a stagflation, as we discussed last Bulletin, gold, gold stocks and oil, followed by smaller market equities, are likely to be the top performers (though oil stocks are short-term overbought while there is no rush yet for smaller market equities).

The Fed has also been ignorant or disingenuous about its policies. We should remember Fed Head Ben Bernanke’s comments in 2011 that the Fed was not monetizing the debt, because that “would involve a permanent increase in the money supply to pay the government's bills through money creation. What we're doing here is a temporary measure which will be reversed, so that at the end of this process, the money supply will be normalized, the Fed's balance sheet will be normalized and there will be no permanent increase, either in money outstanding or in the Fed's balance sheet.” This is so preposterous that it raises the question whether he actually believed what he was saying.

I am reminded of the wonderful words of Mark Twain, “sometimes I wonder if the world is being run by smart people who are putting us on or by imbeciles who really mean it.”