By Michael Every of Rabobank
Seeing Things (John) Bullishly
The Fed minutes overnight were clear cut: as our Fed Whisperer Philip Marey puts it, “The minutes and Powell’s recent interviews support our view that the Fed is going to hike the economy into recession.” (here for more... incidentally, this has also been our view since the start of 2022).
The long and the short of it is that the Fed are going to hike 50bps at the next two meetings in June and July, taking rates to 2.00%, and will then reassess if they need to keep going or not. If you are an optimist, you will believe they stop there, “because markets”, and then start cutting and do QE. In which case, go long every bond you can find, some say; and go long every commodity you can find, say others.
The Fed said it expected the imbalance between aggregate demand and supply to diminish over time due to rate hikes, an easing of supply bottlenecks, a further rise in labor participation, and the waning effects of pandemic-related fiscal policy. Some Fed voters also observed recent monthly data might suggest that overall price pressures may no longer be worsening. Their forecast for core Personal Consumption Expenditure (PCE) deflator additionally drops back sharply in 2023 and 2024, which sends a similar message.
Then again, which central bank doesn’t use a hockey-stick forecast for growth and an inverse one for inflation? They are then wrong whenever anything slightly out of the ordinary happens, either accidentally (due to flawed methodology), or deliberately (called “setting market expectations”).
Yet not everyone in the Fed was on board the 2% train. Far from it. The minutes show other meeting participants emphasized that price pressures remained elevated, that it was too early to be confident that inflation had peaked, and that they are still clearly minded to keep going into restrictive policy territory. They agreed risks to inflation were skewed to the upside due to supply bottlenecks and rising energy and commodity prices, both of which were exacerbated by the Russian invasion of Ukraine and COVID-related lockdowns in China. They mentioned nominal wage growth, high household savings, and the possibility that longer-term inflation expectations could become unanchored because of persistently high inflation.
On balance, as Philip notes: “All participants reaffirmed their strong commitment and determination to take the measures necessary to restore price stability… In light of the continuing inflation risks, members judged that it would be appropriate for the post-meeting statement to note that the Committee is highly attentive to the upside risks to inflation.”
It’s really up to you if you think 2% is the ceiling or not. And yet it’s not up to you in any way – it’s up to supply chains, energy prices, commodity prices, Covid lockdowns, nominal wage growth --which could encourage more borrowing at negative real rates-- and inflation expectations.
What is also worth a mention is the 2% level itself. There is an old historical phrase about the ‘natural’ rate of interest that some in the industry know, and which I have used many times before, dating back to the 19th century and Walter Bagehot, the founder of The Economist and spiritual father of parts of central banking, who infamously said: “John Bull can stand many things, but he cannot stand 2%.”
By this he meant that the investing public can put up with a lot, but once base rates drop lower than 2%, they won’t put up with it: why invest when returns are so low? And, for businesses, the signal sent when rates are so low is that expected returns are low too – so why bother making anything?
That is an indirect link to the long-standing monetary and economic theory that low/negative interest rates do not stimulate productive investment and GDP growth – they just pull forward future consumption and encourage asset bubbles. Everyone in economics from Marx to Mises was aware of this – our modern central bankers and almost everyone in markets fixated on them today are the exception.
You know – the same people who have ignored the simplified Taylor rule of base rates = nominal GDP growth since the Global Financial Crisis of 2008-09. The same people who also ignore "Bagehot's Dictum", that in times of financial crisis central banks should lend freely to solvent depository institutions, yet only against sound collateral and at interest rates high enough to dissuade those borrowers that are not genuinely in need. Nowadays, the dictum is to lend to anyone who can fog a mirror against pictures of monkeys wearing sunglasses at zero rates to push up asset prices so ‘we all get rich’ – or so they can retire and give $250,000 after-dinner speeches to the rich.
Is the Fed now willing to see asset bubbles burst as it gets more Volckerish or Bagehotian? As one internet wag put it this week, it’s remarkable how much tougher the Fed is on markets since they were told they weren’t allowed to trade stocks anymore.
So far it has to be said that it looks like they have crypto in their sights. Indeed, Brainard just said, “Private monies could threaten consumer protection and financial stability,” and speaks to Congress today about digital assets. What would Bagehot have said about creating your own money at home?
Are the Fed also looking at China(?) via higher rates and a stronger dollar policy? If so, they are not the only ones. The US SEC says “significant issues remain” over reaching a deal with China over auditing its US-listed firms, while the Chinese regulator says both sides are committed to doing so: which side to believe? The US review of $300bn in tariffs on Chinese goods that is required as the duties reach a four-year(!) anniversary will take months, says the US Trade Representative’s Peisch - which will be right before the US midterm elections. Peisch also says the Indo-Pacific Economic Framework (IPEF) launched Monday offers “incentives and opportunities” rather than market access in the form of lower tariffs; which, as I argue here, likely means de facto non-tariff barriers against China. And Secretary of State Blinken gives a speech on US China policy later in the day. Little new is expected, but little in terms of olive branches either.
That is as Premier Li Keqiang flags his economy is worse off in some ways than in 2020, and 100,000 civil servants dialed in to a state conference-call yesterday about the latest measures to try to get things moving: yet how many dialed in from homes they cannot leave? The Wall Street Journal flags a policy stand-off between Li and Xi over the latter’s zero-Covid policy. If true, that’s likely zero-sum, politically. As is President Zelenskiy, pushing for yet more Western measures against Russia, saying, “China is now taking the position that it’s normal to occupy the territory of other countries.” No CNY loans for you, Kyiv.
Circling back, the Fed minutes also flagged concerns over financial stability. Several meeting participants noted that monetary policy tightening could interact with vulnerabilities related to the liquidity of markets for Treasury securities and to the private sector’s intermediation capacity – which is as serious as it gets when you are talking about the foundation asset of the global economy. A couple of participants also pointed to increased risks linked to commodities, which had led to higher prices and volatility across a wide range of energy, agricultural, and metal products. In particular, they observed that the trading and risk management practices of some key participants in commodities markets were not fully visible to regulatory authorities. Expect a lot more (geopolitical) regulation of both markets ahead(?)
Does the above concern point to expectations for 2% or more than 2% Fed Funds? If the aim is to deal with commodities, the answer is more than 2%. On the Treasury front, it remains to be seen – but are we observing a lack of bidders so far? Hardly!
To conclude, it’s certainly possible to look at these Fed minutes bullishly. However, it is also necessary to look at them John Bullishly.
