The median projection for the appropriate level of the federal funds rate is 1.9 percent at the end of this year, a full percentage point higher than projected in December. Over the following two years, the median projection is 2.8 percent, somewhat higher than the median estimate of its longer-run value. Of course, these projections do not represent a Committee decision or plan, and no one knows with any certainty where the economy will be a year or more from now.
That announcement by Fed Chair Jerome Powell came and went and, despite a little flurry of activity, the market pretty much went about its business, once again proving the age old Federal Reserve adage: “No news is no news…”
It’s the Fed’s business not to say anything — especially when they’re in front of a microphone saying something.
I’ve said it before right here on the Streetlight site: “My firm belief is that anyone who rises to the level of sitting on the board of the Federal Reserve must have an advanced degree in rhetoric. (Or just a natural ability to talk a lot without actually saying anything.)”
In essence the main job of their messaging is to “remain calm” — kinda like Kevin Bacon…
And while it’s true that panicking rarely helps anything, playing down or even ignoring the severity of the situation is just as bad.
Here’s what the Chairman wanted viewers to come away with…
The “Tools” to Fight Inflation
While part of their job description is technically to maintain price stability (i.e. control inflation) a more important aspect of that work is to maintain “anchored expectations.” They have to get the world to believe that they can, in fact, keep inflation running at 2%.
Because if that belief becomes “unanchored,” and the masses start thinking inflation is headed substantially higher for the long term, investment patterns will change dramatically — especially where government debt is concerned.
To that end, Powell emphasized that the Fed has all the “tools” it needs to handle the current situation.
In fact, he was so bent on driving this point home that, during his speech and Q&A, he said some version of “we have the tools” 18 times.
If you were playing the FOMC drinking game and that was one of your “shot words” — you’d be hammered for two days.
Powell didn’t talk much about what those tools were. That would be diving into trivial details. Everyone knows what the Fed’s tools are. And how effective they are in fine tuning prices and employment.
All their “tools” are monetary tools. Open market operations like repurchase agreements (Repos), the discount rate and, of course ,the Fed Funds rate. In case you’re not familiar, the Fed Funds rate is the rate — set by the Fed — that banks charge each other for overnight loans to ensure their reserve requirements are met.
Which really doesn’t matter any more because according to the Fed itself:
Effective March 24, 2020, the Board amended Regulation D to set all reserve requirement ratios for transaction accounts to 0 percent, eliminating all reserve requirements.
In other words, banks can now charge a higher rate on money there’s actually no need for them to lend. (What could go wrong?)
Still, the Funds rate is the base rate for pretty much all other rates in the market. And a quarter-point hike by the Fed should push everything else up with it (except savings rates, which is another discussion altogether). Higher interest rates (risk free returns) attract capital (increase savings) and thus cool the economy from a demand perspective.
In theory, that’s how it’s supposed to work.
But those tools can’t really fix the problem because this round of inflation is more than strictly a monetary phenomenon. Fed Vice Chair Lael Brainard said as much testifying before Congress this past January (my emphasis):
“We have a set of tools. They’re very effective, and we will use them to bring inflation back down,” Brainard said. “Sector to sector, there are microeconomic issues—market structure, supply chain disruptions—at work. That’s not where our tools are effective.”
So assuming that China stops shutting down its country over every new COVID spike and the supply chain eventually fixes itself, the Fed may be able to stabilize prices.
The Other Factor Driving the Inflationary Problem
That would be the labor market and wages. According to Powell’s statement:
Labor demand is very strong, and while labor force participation has increased somewhat, labor supply remains subdued. As a result, employers are having difficulties filling job openings, and wages are rising at their fastest pace in many years. FOMC participants expect the labor market to remain strong, with the median projection for the unemployment rate declining to 3.5 percent by the end of this year…
One reporter asked outright if we were in the early stages of a wage-price spiral.
Powell zigged and zagged in his reply (my emphasis):
…the (wage) increases, not the levels but the increases are running at levels that are well above what would be consistent with 2 percent inflation, our goal over time. And that may be — we don’t know how persistent that phenomenon will be. It’s very hard to say.
In the very next breath said…
And that’s really, I think, the sense of your question about a wage price spiral, is that something that’s going to start happening and become entrenched in the system. We don’t see that.
This is not where, as Vice Chair Brainard said, “our tools are effective.”
It would likely take a recession to dampen the effects of an overheated labor market. So the best he can say right now is that they don’t see rising wages becoming entrenched in the market.
Speaking of Recessions…
In contrast to his clear emphasis on “tools,” the word recession only was only mentioned four times in the entire hour — and only one of those times by Powell. It’s clearly a topic he didn’t want to get into. Instead he chose to focus on how robust (i.e. recession-proofed) the economy currently is.
He opened by noting:
Economic activity expanded at a robust 5-1/2 percent pace last year, reflecting progress on vaccinations and the reopening of the economy, fiscal and monetary policy support, and the healthy financial positions of households and businesses.
He then peppered his comments with reassurances that recession was a long long long shot…
The American economy is very strong and well positioned to handle tighter monetary policy.
We feel like the economy can handle tighter monetary policy.
And at one point saying the economy could actually “flourish” in the face of rising interest rates.
…all signs are that this is a strong economy and, indeed, one that will be able to flourish, not to say withstand but certainly flourish, as well, in the face of less accommodative monetary policy.
The bounce back in 2021 was encouraging, but you also have to remember that it came after the economy cratered nearly 3.5% the year before thanks to the pandemic lockdowns. This isn’t a normal pick up in economic activity.
A major portion of GDP participation is now gone.
According to the SBA, before the pandemic small businesses contributed 44% to GDP. Today hundreds of thousands of small businesses have closed permanently thanks to the lockdowns
GDP growth has averaged 2.3% annually over the last 25 years. In my opinion it’s still too early to determine how robust the economy really is.
The Best They Can Do is Look Like They’re Doing Something
Powell has come out and said they would be planning to raise at every meeting going forward. That would park the funds rate somewhere roughly around the Fed’s median projection for 2022 (see the table below).
Overall the market had been anticipating a move in that range. But what’s significant was the fact that the Fed actually said it out loud. Score a small win for the hawks.
I believe the reality is there’s little the Fed can do to fix this situation as it is. Inflation is not just a monetary phenomenon today and they’re likely going to find their tools are pretty useless in dealing with it.
A recession would dampen demand as well as wage increases, but absent a correction to the supply side of the equation, inflation could remain a serious threat. And inflation plus recession equals a real mess.
How the Fed moves to raise rates now will likely have a much greater impact at least where the markets are concerned.
The best thing they can do right now is tap the brakes and keep the markets calm. Like when you’re learning to drive a car…
When you have 500 feet to slow down, you learn to stop your car gently. But when a car pulls out in front of you, you have to just slam on the brakes — and that’s when things get shaken up.
If the Fed is able to continue to address inflation in a slow, methodical method, I believe the markets will be able to reasonably handle the rate hikes. (That’s not to say the economy will fare as well.)
But should a car pull into traffic, it could be a whole different story.
What might oncoming traffic look like?
The FOMC published its Summary of Economic Projections (SEP) I’ve included below. You can see their current GDP projections for 2022 are significantly lower than they were at the end of last year. Inflation projections are considerably higher.
Those will be the key data to watch in the coming months.
Make the trend your friend,
Editor, Streetlight Confidential