Federal Reserve Chairman Jerome Powell is doing what he said he would be doing. It’s a cliché that a central bank’s job is to take away the punch bowl. Powell said he was going to remove it, and he did. And the market is not happy, well mostly because we got addicted to easy money. Inflation is too high and interest rates need to go up to tame it down. If inflation stays elevated we are in big trouble. Powell wants inflation back to around 2%.
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There’s this weird rollercoaster dance between Powell and the market. If the market thinks he’s turning dovish or there’s a hint of a pivot in his policy, Powell the hawk shows up. And if the market thinks he’s going too hard, a dovish Powell shows up. At yesterday’s press conference we saw both Powell (Dove-Hawk).
Dove Powell
“With the lags between policy and economic activity, there’s a lot of uncertainty, so that we note that in determining the pace of future increases will take into account the cumulative tightening of monetary policy, as well as the lags with which monetary policy affects economic activity and inflation… that’s why I’ve said at the last two press conferences that at some point it will become appropriate to slow the pace of increases. So that time is coming, and it may come as soon as the next meeting or the one after that.”
Hawk Powell
“We may ultimately move to higher levels than we thought at the time of the September meeting. The incoming data since our last meeting suggests the ultimate level of interest rates will be higher than previously expected. The risks are asymmetric. If the Fed does too much, it can cut. If it doesn’t tighten enough, then you’re in real trouble… It is very premature to be thinking about pausing… We think we have a ways to go.”
The market went up for about 30 minutes and then down following his comments. The market initially viewed the statement as dovish. But a hawkish press conference caused almost a full reversal. Powell explained in his press conference that he really is staying the anti-inflation course, after a Fed statement had seemed to hint to the contrary.
At the end of the day, the best indicator for where interest rates are heading is where inflation expectations are going. And this will determine the price of assets. Expected inflation is something that we can build into our financial assets. If you expected inflation is 7%, you set a bond coupon rate at 10% (or whatever) to cover inflation. Where you get in trouble is when inflation exceeds expectation, like inflation comes in at 9% instead of 7%, then the bond is repriced downward (higher yield) to make up for the higher inflation. Now imagine you have to do that for all financial assets.
At this point, the question of where expected inflation fall, between the 2% and 9%, is what’s driving markets. Some think inflation will fall to 2%. Others think high inflation will persist. That’s why markets are so volatile. It’s hard to price assets because expected inflation is all over the place.
Inflation
There’s been a lot of talk about what drives inflation. You have the supply-side factors like war, supply chain issues, labor shortage, Covid etc… And the demand side of inflation, where consumer behavior fuels inflation (excess buying/stocking up because of higher price expectations, too much money chasing not enough goods, compensation contract with inflation clause).
The San Francisco Federal Reserve bank does a good determining how much do supply and demand drive inflation. According to their data, demand factors are responsible for about one-third of inflation and that supply factors are responsible for more than half of the current elevated level of 12-month PCE inflation (Fed’s preferred measurement for inflation has it capture changes in consumer behavior and has a broader scope than the CPI). This implies that if we didn’t have supply chain issues inflation would be around 2%-3%. Exactly around the Fed’s target rate. The problem is supply chain issues persist and are no quick fix. And rate hikes doesn’t do much to fix supply chain issues. Higher rates doesn’t make cargo ships go faster. It doesn’t get deck workers to unload faster. It doesn’t produce complex microchips at faster rate. But higher rates does slow down hot demand and we are seeing that with a slow down in housing prices.
The way Powell explained it, it’s better if they over do it with the rate increase, because they can cut to bring back growth. If they don’t do enough, and inflation gets out of control, that’s a bigger problem. Price stability is a good thing for the global economy over a long period of time.
I’m of the opinion that most of the heavy lifting has been done. Monetary policy works with long and variable lags. It will take some time but inflation will drift downward. That means that it will take time for higher interest rates to affect the real economy and check inflation, and it might make sense to slow or stop rate hikes before inflation is anywhere near a comfortable level.
