The Tightening Part 1 - And then he stacked it

Oh dear, sometimes less is more.

Wednesday 26 January 2022 was the day the market story changed.

It happened during question time, after Fed Chair Jerome Powell delivered his official statement on monetary policy.

In a nutshell, he said that high inflation is a risk to the expansion and because there is a much higher level of economic and labour market growth as well as price inflation than there was in 2015, rates are likely to go up ‘sooner and faster’ than in 2015. Period.

His overall intent is to move from accommodative policy to substantially less accommodative policy, to one that’s not accommodative at all.

So, after 8 minutes of niceties, he waited for question time with the Press before gunning the engines of the U.S.S. Fed and ploughed unapologetically into a bunch of pedestrians quietly strolling on the equities promenade.

Why?

The Fed is not independent. It might be owned by banks and private investors, but the White House hires and fires the leadership team and President Biden told America that inflation is public enemy number one, and not to worry because Jay Powell would fix it.

Your guess is as good as mine as to how higher and faster he will go with the Federal Funds Rate and how much (if any) will be enough to reign in inflation.

What we do know is that volatility is back and markets will be choppy at least until the next meeting in March, as the Fed and White House refocus the narrative on food, fuel, shelter and wages.

Below is what happened, and there’s a bit to get through so here we go.

The first 7.5 minutes was going OK - it was calm sailing.

Wednesday started off with a balanced narrative about the Fed’s ‘adaptive’ monetary policy. It was reminiscent of the artful navigation he displayed at his last meeting in December.

Powell described a ‘very strong’ economy.

He stated that remarkable progress had been made in the labour market with 365,000 average monthly job creations over the past 3 months.

He also stated that unemployment was a low 3.9% in December and that labour demand was ‘historically strong’ and that wages had been rising at their fastest pace, although wage inflation remained subdued.

Powell said inflation was well above the Fed’s long term goal of 2% and that price increases had spread to a broader range of goods and services.

He then said he was worried about real wage growth but that he expected inflation to decline over the course of the year.

His key point: the Fed wants to promote a long expansion, and that requires price stability. In support of that, the Fed will use its tools to support that goal and ensure higher inflation does not become entrenched. Period.

He then confirmed the Fed’s view that lifting the Federal Funds Rate as appropriate was unchanged, and reaffirmed he and his colleagues would end asset purchases in March (i.e., no more growth to the balance sheet).

He said the economy no longer needs high accommodation and that’s why the Fed would be phasing out asset purchases and after that it would then be appropriate to raise rates (nothing new there either).

Importantly, he stressed that moves in the Federal Funds Rate will be the Fed’s primary transmission mechanism to reign in inflation.

He also said the Fed will remain nimble and alive to persistent inflation risk, and it would be prepared to respond (with humility) as appropriate to achieve its dual mandate.

He then finished with the Fed’s new high level principles re: the balance sheet:

Fed Funds Rate is the primary means of adjusting monetary policy (meaning interest rates will be his blunt instrument of choice).
Balance sheet purchases will be reduced before interest rate lift off (i.e., after March).
Asset reductions would be over time and in a stable and predictable manner in the form of a run-off.
Over time the Fed will hold securities as needed, and in the longer run it will primarily hold treasury securities (what that means is it will run off mortgage backed securities at a high pace/amount).
Decision to reduce (shrink) the balance sheet be guided by maximum employment and price stability goals and therefore will readjust based on data as it comes in (this means he can reverse gears if the Fed gets it wrong, again).
No timing, pace or details of shrinking the balance sheet (yawn).

OK, so not too bad, and he mostly confirmed last meeting’s narrative.

Whether you or I agree with his views on the strength of the economy and whether inflation is demand or supply side, is largely irrelevant. What is important is that most of what he said to tat point had been factored into the bond market, and to an extent (begrudgingly) the equities market - and equities were up during those first 7.5 minutes.

Then came question time.

And not to be outdone by the policy statement he had just read out, he well and truly stacked it, reversed, and stacked it again without apology.

Over the next 45 minutes, Powell basically went full throttle on how he and his colleagues were prepared to go to protect the expansion, and that 2022 was so totally different to 2015. Really?

He literally ploughed down the Press, unapologetically, on a quest to flatten that unwelcome, no better still, evil inflation curve.

Seeing that, the equities market responded by selling off high beta/growth stocks.

Here’s some of the guidance and manoeuvrings by Powell which rekt the ‘growthy’ promenade:

A strong belief that the economy is stronger than in 2015 and that this will have implications for the pace of decisions (think, faster and harder).
Both sides of the mandate (employment/prices) are calling for the Fed to move steadily away from highly accommodative conditions. His personal view is that the economy is now at maximum employment, so now is the time to raise the range.
Quite a bit of room to raise interest rates and tighten financial conditions without threatening the strong labour market. He has a strong sense that the Fed can move up rates without undermining the labour market.
Reiterated the Fed will use its tools to ensure inflation does not become entrenched.
No confirmation on speed or impact of balance sheet issues, with more details at next meeting. Said that now there is a bigger balance sheet with shorter duration and economy is stronger and inflation is higher, therefore will move sooner and faster than they did last time (i.e., Chair Yellen’s run-off and interest rate lift off in 2015). Highly hawkish.
Reluctant to give any rules of thumb. Says balance sheet correlation to market effect in uncertain although very clear on how the Fed funds rate effects markets. It will become the Fed’s anti-inflation instrument of choice.
Confirmed the taper will end in March, and then they’re onto rate hikes.
Clarified that the March meeting is when they will make the decision, but he thinks the Fed will probably raise rates at the March meeting.
Balance sheet process will be orderly and predictable.
He has not yet had important discussions on balance sheet as yet with rest of Governors.
Inflation risk is that it will prolong and go higher - not the base case, but there are risks and he wants to be in a position to respond if that is the case as it would be a risk to the expansion.
He sees risk from Omicron and that further problems with supply chains (which are still not that much better) and Chinese zero COVID policy could cause lockdowns and European geo-political risks.
Overall, thinks inflation is slightly worse and raised his views on inflation (i.e., even less transitory than he had initially thought).
Current thinking is that the Fed is moving from an accommodative policy to a substantially less accommodative policy to one that’s not accommodative at all. King hit 1.
The key as he sees it is to get inflation back down to 2%.
Would not take 0.5% hike off the table because this time it’s different to 2015 (everything is higher in terms of inflation, growth and labour creation) and he can go higher and faster. King hit 2 - and I think this is what really stacked it for the equities market.
Thinks there’s not been much progress in supply chains. Denied the policy change was too late (but time will tell once history is written - maybe in 15 years or so).
On yield curve flattening and inverting - basically said the Fed was watching it as one of many factors and didn’t see it as an issue given it’s only one of many things (i.e., didn’t really care).
Summaries and reiterated that 2022 is a year to finish asset purchases, lift-off rates, run-off the balance sheet and have a couple more meetings about shrinking the balance sheet, before putting a plan into effect, but will remain nimble.

Summary: hawkish with a firm target on inflation’s rump. Consumer price inflation is the devil, because Joe Biden says it is. Out comes the Fed Funds Rate as the blunt instrument of choice. Conversely, asset price deflation is not in Powell’s wheelhouse, just as much as asset price inflation was also not in his wheelhouse, for the past 5 years. Yup, here we go again, not my job!

Technical justification for rate lift off: the Fed wants to promote a long expansion, and that requires price stability. In support of that, the Fed is committed to using its tools to support that goal and ensure higher inflation does not become entrenched.

Real reason: Biden’s party favours those who are most sensitive to and affected by inflation, and Powell wants to remain in power so he had better do what Joe wants - plus it’s a little convenient for him that the Fed’s not really independent.

Most repeated: the path of the economy is uncertain but the Fed is committed to using its tools to ensure inflation does not become entrenched.

Most telling: this year has major differences to 2015 (2022 will be stronger, bigger and more solid) and that will have implications for the pace of decisions (i.e., sooner and faster).

In a nutshell, the right lessons have not been learned, and others have been learned all too well.

What the market didn’t like was the overboard hawkish guidance provided during the press Q&A. Sometimes less is more. But this time it appeared he wanted to flex his muscles and show the markets what he could do if they did not play ball.

And just like Powell’s view that asset inflation was not in his wheelhouse, he left the market thinking he does not care about deflating asset prices either, because price stability and full employment are sacrosanct, at all costs.

In a nutshell:

Powell sees high inflation as a major risk to the expansion and there’s now a much higher level of economic growth, labour market strength and price inflation than there was in 2015, so rates are likely to go up ‘sooner and faster’. He’s saying that this time it’s different.
Following the taper ending in March, rates will lift off. The balance sheet will then be run-off and shrunk at a later date with mortgage backed securities falling of first in an orderly and predictable manner; and with the overall intent to move from accommodative policy to substantially less accommodative policy to one that’s not accommodative at all.
There is no firm pace, steps or eventual levels for the full normalisation and retraction of accommodation - so nothing’s really off the table (and that’s what has spooked markets).

But, beware the lessons not learned from the 1928 Fed and the Volcker Fed.

They tried to normalise the excesses of the past too quickly, and while interest rates today are nowhere near where they were on those occasions, there’s way more debt that needs to be serviced - so slow and gradual is better if you have the luxury.

Also, there’s a natural ceiling to short term interest rates before they become higher than long term interest rates and the yield curve inverts (implying recession).

Instead, it appears the lesson that Powell has learned only too well is to not go against the White House. He resisted Trump until he could no longer do that and ended up slashing rates to zero. Now he’s giving very little resistance to the Biden Administration, and he’s going to lift interest rates. There’s a pattern.

As always, most of the Fed effect on markets is via its guidance, not necessarily its eventual actions.

We should also remember that the Fed’s throttle has a big red ‘reverse’ embossed into the steel and it’s now become the government’s policy transfer mechanism like I wrote last week, and it’s also had plenty of form for jamming the ship into reverse with little to no warning.

On top of that there’s a school of thought that says with inflation slowing in December amidst an ageing population, the great resignation, the withdrawal of fiscal impulse, voluntary lockdowns and disinflationary technology - deflation is still more likely than inflation once we start to emerge from this period of dare I say it - stagflation (i.e., rising inflation and declining growth).

But whatever your particular view, it’s best to see what happens over the next couple of months with the Taper, Ukraine, Evergrande, Omicron, Soft Bank and real wage growth in the lead up to the next FOMC meeting on March 15-16.

Things could get even murkier if the threat of an inverting yield curve and/or debt serviceability conspire to limit Powell’s available tools - but if they don’t, it seems he might stand on the forward throttle, so don’t try to be a hero - or find another promenade where there are no ships in site!

And tomorrow, we get to hear from the Reserve Bank of Australia (Part 2).

Part 3 will round out this three part series after we hear from the Bank of England and the European Central Bank (ECB).

Mike

Michael GanonJanuary 30, 2022#economy, #finance, #interestrates, #business, #trade, #transformation, #strategy, #ceos, #cfos, #c-suite, #currency, #construction, #mining, #renewables, #technology, #leadership, #india, #china, #australia, #perth, #education, #research, #uk, #growth, #retail, #businessowners, #future, #brexit, #nextlevelcorporate, #mikeganon, # community, #tradewar, #America