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Last week, the Federal Reserve delivered a 75-basis point rate hike, but Fed Chair Jerome Powell failed to deliver the more doveish rhetoric that many expected.
The messaging did not indicate much softening in the stance on the future trajectory of rate hikes, despite an apparent “soft pivot” the week before.
In his podcast, Peter broke down Powell’s messaging and pointed out a number of very scary admissions that came out of the Fed meeting.
Peter said the Fed did do a soft pivot but was able to back off when the bond market stabilized.
“I believe the Fed was forced into making that pivot because it stood on the precipice of a bond market crash, which was in the process of happening. And I think the only way the Fed was able to stop that slow-motion crash from playing out accelerating was by throwing a bone to the markets and indicating through the Wall Street Journal that there was going to be some type of statement that was going to go along with the rate hike that would indicate that maybe there was going to be a pause in the pace, a slowdown in the pace, that the Fed was going to take a step back and reflect and assess, and maybe acknowledge the progress that had been made without indicating complete victory, but at least acknowledging that victory was at least in sight and that the Fed could take a more cautious approach going forward. … Something to that effect was expected.”
However, the Fed didn’t deliver anything close to that.
Initially, the markets thought the Fed was going more doveish. The statement released by the FOMC left some wiggle room for a slowdown in hiking or even a pause with language about monetary policy “lags” and “cumulative” effects.
“In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
By acknowledging the lag between rate hikes and inflation, the Fed gave itself the leeway to pause.
Initially, the stock market rallied. But during his prepared marks, Fed Chairman Jerome Powell spooked the markets, saying that price stability is essential and the historical record strongly cautions against prematurely loosening policy. Powell emphasized that the central bank was committed to “staying the course” until the job is done.
As he moved through the Q&A, Powell dropped a number of what Peter called “unexpected bombshells” that the markets were not expecting.
First, he reiterated the Fed’s commitment to positive real interest rates. Right now, the Fed interest rate sits at 4%, but CPI remains over 8%. Powell implied that we will get to positive real rates as CPI falls. But what if CPI doesn’t fall? That would mean interest rates have to go much higher than the markets anticipate.
“I think the fact that Powell had to acknowledge that ultimately we have to have a positive real interest rate — that is very scary for the markets.”
Powell also admitted they don’t know what the actual underlying inflation rate is.
“Now, that is a very scary admission by the Fed. Because if the Fed is committed to fighting inflation, but it doesn’t even know how big the monster that it has to slay is, then how does it know how many rate hikes are going to be necessary? How does he know how high rates have to be in order for there to be a positive real rate of interest if he doesn’t even understand what the underlying rate of inflation is? And if he doesn’t understand it now, why will he understand it at some point in the future? The Fed has no clue. All it’s looking at is the same headline number as everybody else. And based on that, the Fed is still way behind the inflation curve and has a long way to go. And that, again, should scare anybody who is counting on the Fed to ease up on its current trajectory of tightening.”
When asked if inflation has become entrenched, Powell didn’t say no. In fact, Powell said the Fed has no way of knowing when inflation becomes entrenched.
“That’s another scary admission by the Fed. Because if it doesn’t know, it’s just kind of flying blind, and it has to err on the side of caution to make sure inflation doesn’t become entrenched.”
Of course, as Peter pointed out, inflation is entrenched. It’s not a matter of psychology. It is a matter of monetary policy.
“The Fed has created so much inflation for so long — it didn’t even start with COVID. It didn’t even really start with QE. The Fed was creating inflation even before it upped the ante to quantitative easing and then upped it again in the aftermath of COVID.”
Powell also admitted that inflation was a lot higher and has lasted a lot longer than anybody at the Fed had expected.
‘This is tantamount to saying, ‘We got this wrong. We made a mistake. And now we need to correct that mistake by staying tighter for longer or going higher than markets expect.’”
Powell said the real risk was in doing too little tightening, not doing too much. He said he would prefer to overtighten. Powell said if the central bank tightens too much, it has the tools to support economic activity if necessary. In other words, it can always go back to monetary stimulus.
“Again, those are very scary comments, especially if you were expecting the Fed to adopt a softer tone.”
But it also reveals the fatal flaw in the Fed’s thinking.
“Powell is wrong to think that if they just tighten too much, meaning they tighten so much that the economy really weakens into a severe recession, that the Fed has the tools to prop it back up and stimulate it to support economic activity. It doesn’t. Because if the fight against inflation drives the economy into recession, if the Fed then uses those very tools to support the economy, well then, inflation is going to take off and get much worse. You see, if the Fed is really committed to fighting inflation, then those tools are no longer at its disposal. The fact that Powell is so quick to admit that he’s going to use those tools if the inflation fight does too much damage to the economy really reveals that the Fed is not as committed to fighting inflation as it maintains, or as the markets believe. Because, as I’ve said many times, the Fed’s commitment to fighting inflation stops if it brings about a severe recession or a financial crisis.”
The Fed is willing to tolerate a “hard landing” and a mild, short recession. But if it gets worse than that, it will use its tools. Peter said he thinks it will use those tools long before inflation gets near 2%.
“But even in the extremely unlikely situation where the Fed got inflation back down to 2% because of its tightening and then, with inflation at 2%, the Fed then used those tools to stimulate the economy, anything it had achieved in reducing inflation will be lost and the inflation rate will spike back up again. So, even if inflation does go to 2%, the Fed still can’t use those tools.”
Peter said when the economy really starts to fall apart, the Fed will make a hard pivot. He also said despite Powell’s rhetoric, he believes the Fed did recently do a soft pivot to rescue the bond market.
“It’s just that Powell didn’t follow through in the Q&A. I think that pivot was, in fact, written into the prepared remarks, but Powell went off script and went back to his newfound hawkishness.”
The rally in the bond market after the soft pivot made that possible.
“But now that Powell has returned to his hawkish rhetoric, the market crash that the Fed interrupted is going to resume. And I think when faced with those circumstances again, especially if it’s the bond market and not just the stock market, I think Powell is going to have to come back and clarify his remarks. And by clarify, I mean do a complete 180.”
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