If the US Federal Reserve takes its policy cues at face value and focuses only on getting inflation back into its fund, already turbulent financial markets could get even uglier and investors just don’t seem ready for it.
While the decision was not so obvious to federal policymakers with dual price stability and full employment mandates, there is no doubt that the Fed and other Western central banks are under enormous public pressure to prioritize controlling the worst cost-of-living pressures in 40 years.
That may change if or when a recession eventually results – but it is likely that central banks will see hyper-tight labor markets buy them time to go to hell now as well as a good reason to do so.
Moreover, Federal Reserve Chairman Jerome Powell publicly acknowledged this week that “pain” may be inevitable as the central bank pushes inflation back down because it does not have the “precise tools” to engineer a smooth landing.
Kansas City Fed President Esther George made clear Thursday that tightening financial conditions was part of the plan rather than some unfortunate, unexpected outcome, with stocks falling “one way.”
Pointing to an inflation rate of more than four times the 2% target and now higher than that target for more than a year now, she told CNBC, “As I focus on the time when I focus on ‘enough is enough.'”
However, investors remain skeptical that the Fed will hold off on the first hint of economic or financial distress — futures contracts are now seeing a peak in the prevailing 1% target rate on the fed funds at just 3% by next March, given the cut The chart of the balance sheet is in my knowledge.
Assuming we get another half-point rate hike next month, this price structure points to a very moderate trajectory with an average rise of just a quarter-point at every subsequent policy meeting through March — and then a halt of just half a point above pre-pandemic. Peak in 2019.
Moreover, next year’s implied rate has fallen by almost half a point this month amid jitters in markets and recessionary openings.
This month’s survey of global fund managers by the Bank of America (BofA) showed a very bearish but also slightly confused and hesitant picture among investors.
While funds have already stockpiled their cash holdings to the highest levels since the dot.com shocks and September 11, 2001, Bank of America believes they have not reached a “complete capitulation” because they expect further interest rate hikes in the future.
But respondents also viewed hawkish central banks as the single biggest risk to financial stability. Even though Wall Street stock indexes are already about 20% off their peak, funds don’t expect the fabled Fed “situation” – or the pivot of policy to calm turbulent markets – without another 10% drop in surplus from here.
This doesn’t sound like an investment community that has already priced everything.
Shadows and Fog
So what if markets continue to underestimate the Fed’s willingness to take some pain while bringing inflation back to target?
Fed watchers reasonably discuss economics, politics, and even behavioral inputs that influence future policymaking and judge accordingly. There is probably no way to know now anyway because so much has to unfold and nothing is fixed.
But so-called quantitative analysis can also be useful for plotting a measure of what might be in the future, setting current policy settings against what we know from the past.
Earlier this year, Solomon Tadesse of Societe Generale outlined how a typically growth-sensitive Fed would have to manage a combined tightening of policy rates and a relatively modest $1.8 trillion balance sheet cut.
Modeling the so-called shadow rate on the fed funds that captures both effects — allowing comparisons to be made with historical periods of inflation that did not include bond buying or selling — the analysis concludes that if the Fed is keen to avoid a recession at all costs and allow some inflation at that time it could Peak Fed rates are less than half a point above the current 1%.
This was based on the assumption that the Fed’s shadow rate was actually -5% at its lowest due to the outsized effect of bond buying and remains negative even after two increases and before the so-called quantitative tightening kicks.
Tadese reassessed the model this week, instead crunching the numbers based on a different assumption — that the Fed is now prioritizing getting inflation back on target even at the expense of a hard landing. This approach would be akin to the approach taken by Paul Volcker’s Federal Reserve in the 1980s and would correspond to mounting political pressure to do so now.
The result makes reading the financial markets uncomfortable.
Tadesse believes the situation would require a brutal overall monetary tightening of 9.25 percentage points at a typical shade rate — consisting of a final rate of 4.5% and roughly halving of the Federal Reserve’s balance sheet of $3.9 trillion, based on the assumption that they are $100 billion each from the budget. The generality is equivalent to about 12 basis points of emphasis.
These are two extremes of course and the reality often ends up somewhere in between – which is where the markets are currently.
But the Fed may now have to make a choice or risk falling between the chairs, and that leaves markets at a crossroads.
“Such an intermediate path, sensible due to (shifting) political pressure or a mid-path reversal in policy priorities between price stability and full employment, is likely to fail to deliver on any of the mandates and may harm central bank credibility,” concluded the SG analyst.
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