March 10, 2023
Years back there was a famous tightrope walking family known as The Flying Wallendas. Led by patriarch Karl Wallenda they performed breathtaking feats of daring.
I don’t need to tell you, traversing a highwire 40, 50 or even 100-plus feet in the air is a dangerous business. One misstep can lead to disaster. The Wallenda family knows that all too well. In 1962 a 7-person pyramid, a stunt they had been doing for years, collapsed killing two members of the troupe and paralyzing one.
Not all tightrope adventures are necessarily life threatening. But there’s always an element of danger.
Like the one that Jerome Powell and the rest of the Fed are undertaking right now. They walk a tightrope every time they address the market. And just like with the Wallendas, one misstep by them, and bad things could happen.
Powell’s balancing act currently involves inflation and the markets.
He was back on the wire again this week…
Humphrey Who??
This week was the Fed’s semiannual Humphrey-Hawkins testimony in front of Congress.
The Humphrey-Hawkins Act, also known as the Full Employment and Balanced Growth Act, was named for its authors Senator Hubert Humphrey and Rep. Augustus Hawkins. It aimed to set specific goals the nation was supposed to strive toward, namely: full employment, growth in production, price stability, and balance of trade and budget.
In theory, according to the act, attaining these goals was supposed to be left to the private sector. That’s all well and good, except that the act “Requires the President to set numerical goals for the economy of the next fiscal year in the Economic Report of the President and to suggest policies that will achieve these goals.”
If it seems a bit audacious that the federal government should set growth goals for the economy given that it doesn’t (or shouldn’t) actively participate in the economy, well it is… but that’s the government.
In any case, this is where the Fed’s full employment and 2% inflation mandates come from. And twice a year, every year, the chairman of the Fed is required to deliver the committee’s Monetary Policy Report to both houses of Congress.
Anytime the chairman of the Fed talks, people are all ears. That’s because of the undeniable impact the Fed has on financial markets. They control all the money…
This week he was doing a lot of talking.
His statements to both houses were virtually identical (with one minor modification) and picked verbatim from much of what he’s been saying for the past six months.
The big challenge for Powell this time, however, was a feat that no Wallenda ever attempted — stepping out onto the highwire with the elephant in the room…
Powell’s problem arose just after February’s FOMC report. In his comments, Powell had turned almost dovish. He stated that inflationary forces were beginning to cool. And that the committee was ready to start slowing — and possibly even pausing — their rate hikes.
The ensuing economic numbers pretty much crushed his carefully laid out narrative. Even the Fed’s favorite inflation estimate, the PCE index, pretty much stomped all over their hopes and dreams that inflation may have been coming under control.
Now he had to shift gears from “we’re seeing positive signs” to “well… we’ll see.”
So on Tuesday, Jay Powell stepped out onto the wire in front of the Senate Banking committee and started inching across.
The data from January on employment, consumer spending, manufacturing production, and inflation have partly reversed the softening trends that we had seen in the data just a month ago.
He also noted:
…inflationary pressures are running higher than expected at the time of our previous Federal Open Market Committee (FOMC) meeting.
Not denying the obvious is always a good start for one of these speeches. But then he got to the part that shook the market (my emphasis)…
We will continue to make our decisions meeting by meeting, taking into account the totality of incoming data and their implications for the outlook for economic activity and inflation. … If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.
Just when everyone thought it was safe to go back in the water, “increasing the pace of rate hikes” wasn’t the news the market wanted to hear. The S&P 500 dumped 62 points.
S&P 500 March 7 (5 min)
Then on Wednesday, in front of the House Financial Services Committee he made a weak attempt to soften the impact of Tuesday’s comments by making one change to his prepared remarks…
“If — and I stress that no decision has been made on this — but if the totality of the data were to indicate that faster tightening is warranted, we’d be prepared to increase the pace of rate hikes.”
The market wasn’t very encouraged…
S&P 500 March 7-8 (5 min)
Right now, the market doesn’t want to hear about more rate hikes. The fuel that has driven most of the bull market since 2009 (hell, since 2000 if you want to be technical) has been cheap money. And if the Fed’s not going to play along well… the market is no longer interested.
Re-Dotting the Dot Plot
The “dot plot” is part of the FOMC’s quarterly Summary of Economic Projections (SEP). It offers each member’s “assessment of appropriate monetary policy” — in other words where all the governors think rates need to be given the current economic situation. I’ve included their latest one below.
FOMC SEP December Dot Plot
In December, 15 of the 19 members believed an appropriate rate for 2023 was somewhere between 5.125% and 5.375%. With the Fed’s current target range at 4.50%-4.75%, that’s just over 60 basis points — barely more than half a percent raise in rates — to meet that target for 2023. (Notice how projections start coming down in 2024 and 2025.)
The market has been clinging to these projections like a 10-year old’s hopes for a new bike at Christmas.
The problem is, those interest rate projections are largely dependent on the committee’s inflation expectations. Also from the December SEP…
Last month, as I mentioned, the PCE Price Index did a number on the Fed’s expectations. The main index printed 5.4% while core PCE was 4.7%. PCE month-over-month printed up 0.6% which annualizes to a little over 7%!
Those numbers are nowhere close to what the FOMC was looking for in December.
The other bad news is they’ll be revising those projections at this month’s FOMC meeting.
The Fed is Walking a Tightrope (Without a Net)
Over the past few months, Powell has been trying to toe the “hawkish” line saying things like:
My colleagues and I understand the hardship that high inflation is causing, and we are strongly committed to bringing inflation back down to our 2 percent goal…
Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all…
We continue to anticipate that ongoing increases in the target range for the federal funds rate will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time…
Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions…
While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses…
Let me be clear… Powell has NO CHOICE but to take this stance. Like I’ve explained before, the Fed’s entire credibility depends upon them getting inflation under control. (They tarnished their image a couple years back insisting inflation was “transitory” for the better part of a year.) If the Fed’s credibility is damaged, they can’t control consumer expectations about the economy. And controlling the perceptions about markets and the economy is — at the very bottom line — pretty much their entire job.
Of course they will need to show some results beyond all the talk. Which brings us to the dangers they — Powell and the whole 19-man highwire pyramid of the Fed — are facing up on that tightrope.
For one, economic conditions are starting to make things pretty windy up there.
The short end of the yield curve is getting punished thanks to inflation’s unwillingness to move while the long end is spinning its wheels in uncertainty. The 10-2 yield curve is as negative as it has been since 1981 — a bad sign where impending recessions go.
Employment is likely worse than economic reports are telling you. Powell’s concern with excess job openings is legit. Don’t fill them and the economy eventually slows and suffers.
But the problem is, the labor market isn’t “tight” in the traditional sense. More likely it’s permanently skewed.
The 2.4 million excess retirements that came about thanks to Covid have very likely weakened the labor market overall and frankly I don’t think they have a clue how to “seasonally adjust” for that…
The labor gap isn’t going away.
And then there’s that pesky inflation problem.
Stepping Out Onto the Tightrope
Powell and his Fed brethren’s goal is to get inflation back to their 2% annual target range — without pushing the economy into a recession. (Engineering the mythical “soft landing.”) Do that, and they’ve made another thrilling walk across their financial tightrope.
One danger on their path across the highwire is if inflation stays elevated. If the Fed hikes rates high enough, inflation will eventually come down. But that would be because they’ve finally caused the recession they’re so desperately trying to avoid. The question at the moment is how high rates have to go and how quickly inflation might respond.
Substantially higher rates combined with sticky inflation and a contracting economy will lead to a devastating period of stagflation — an outcome they won’t even talk about.
The other danger is what if inflation does start to respond to their efforts?
You can be sure Powell knows that asset markets are fueled by cheap money. If the rate of inflation does start coming back toward their 2% target and they start to lower rates to appease the markets, they’ll only start to inflate the next asset bubble.
Powell also knows that too much cheap money eventually loses its power. That means when the next crisis comes around, and it certainly will, they’ll be pretty much helpless lowering rates from 2.5% to zero. (That was what created the need for “quantitative easing” back in 2008. The zero interest rate policy they established after the 2000 tech wreck left them no room to maneuver once the ensuing housing bubble blew up. All that was left to do was figure out a way to print money.)
Back in last October’s Streetlight Confidential issue, I shared my thoughts on the subject.
My take is the Fed will follow through on their current plans pushing rates to 4-4.5% by the end of 2022 or early 2023. Then I’d expect a pause for one or two meetings giving inflation three to six months to see whether there’s any meaningful slow down in rising price levels.
But even then, I don’t think they’ll be done. Based on historical levels that so many traders today have forgotten about, I’d be looking for a 6% target before this is all over.
Barring a massive spike in inflation, I still think that 6% target is likely.
Controlling inflation is priority number one for the Fed. As long as they have that to stand on they can justify raising rates. But as soon as inflation starts to respond, the market will be all over them to start lowering rates again.
It’s going to be a tricky balancing act.
By the time you receive this, February’s non-farm payroll numbers will have been released. The consensus as I write this is for 205K jobs to be added to the economy.
Next Tuesday the BLS will be releasing the current CPI numbers.
Then on Wednesday we’ll be getting word on the Producer Price Index AND retail sales.
And then the following week, on March 21-22, the FOMC will convene behind closed doors to decide the fate of the financial world.
Let’s hope it’s not too windy up on that tightrope…
Make the trend your friend,
Bob Byrne
Editor, Streetlight Confidential