The Fed’s Triple Whammy
Today’s red-hot inflation numbers only reinforce the notion that the Fed will aggressively raise rates at next week’s FOMC meeting, and also at July’s meeting. We don’t have to guess at that. The Fed has already told us that’s their intention, even before today’s report.
It may even “shock and awe” investors with a 75-basis-point hike this month or next month. Markets are predicting 50-basis-point hikes.
The “taper” is also over. A so-called taper is the process of slowing the rate at which the money supply is expanding.
When the Fed buys Treasury securities from banks, it pays for the securities with money printed from thin air. That’s called quantitative easing, or QE. The Fed has been doing that since early 2020 when the pandemic began.
The Fed gets out of QE in stages by reducing the amount of securities it buys each month; that’s the so-called taper. It’s still printing money, but the amount printed is reduced until it hits zero.
It may seem odd to call money printing tightening, but everything in markets happens at the margins. If the Fed is printing less, it is tightening even though it’s still printing. The amount of QE hit zero about three months ago, so QE is officially over, the taper is done and the Fed is preparing to reduce its balance sheet.
The balance sheet is actually down a bit since March when it was $8.96 trillion. As of this week, it’s $8.92 trillion.
But the Fed is preparing to reduce the money supply by a lot more than that. This is the opposite of QE and is called quantitative tightening, or QT. The Fed hasn’t said exactly how much it will reduce its balance sheet, but a recent New York Fed report projected a reduction to just under $6 trillion by 2025.
And the Fed itself estimates that “reducing the size of the balance sheet by about $2.5 trillion over the next few years, as opposed to maintaining the size at its peak level, would be roughly equivalent to raising the policy rate a little more than 50 basis points on a sustained basis.”
But it admits that the estimate “is associated with considerable uncertainty.” That means it really has no idea.
A Triple Whammy
So we have three forms of tightening at once: the end of QE, rate hikes and the beginning of QT. This is a triple whammy that will slam the U.S. economy and send stock markets down sharply in the days ahead, quite possibly even more sharply than recently.
None of this is what the Fed wants, but that’s what it’s going to get.
When the Fed started QT in late 2017, it urged market participants to ignore it. It said the QT plan was on autopilot, the Fed was not going to use it as an instrument of policy and that it would “run on background” just like a computer program that’s open but not in use at the moment.
It’s fine for the Fed to say that, but markets had another view. Analysts estimate that QT is the equivalent of two–four rate hikes per year over and above the explicit rate hikes. Not surprisingly, we had the Christmas Eve Massacre in December 2018, and Powell was forced to begin easing policy again.
The key takeaway is that tightening policy in a weak economy is almost certainly a recipe for a recession.
When the recession does arrive, the Fed won’t have enough “dry powder” to fight it. The Fed needs rates to be at least 3%, and preferably higher, when recession begins. That gives it plenty of room to cut rates.
But recession will hit long before the Fed can get rates that high, so cutting rates won’t be much help.
The Fed Is Far Behind the Curve on Inflation
Obviously, the Fed’s recent actions are all in response to raging inflation. But it’s too late. The Fed is far behind the curve as today’s inflation report shows. The inflation is here and it’s about to get worse. Even worse, the Fed doesn’t understand why.
It is used to models that focus on “demand pull” inflation where consumers are buying in anticipation of even higher inflation to come. But the data shows that consumers actually don’t expect much inflation after this initial wave.
Medium-term expectations are still anchored. The best research shows that expectations are overrated anyway. What affects behavior is what’s happening right now, not the expected future.
The inflation we’re seeing is called “cost push” inflation.
This comes from the supply side, not the demand side. It consists of higher oil prices due to Biden policies of shutting down domestic oil production. It also comes from global supply chain disruption, and now the war in Ukraine.
Since the Fed has misdiagnosed the disease, it is applying the wrong medicine. Tight money won’t solve a supply shock. Higher prices will continue. But tight money will hurt consumers, increase savings and raise mortgage interest rates, which hurts housing.
The Fed is tightening into weakness.
The Fed’s Nothing if Not Consistent
The Fed’s track record of using the wrong models, using flawed models and doing the wrong thing at the wrong time remains intact. The Fed has begun a chain of tightening that will sink stock markets and slow the economy. But it largely created this mess and it’s now trapped.
It really has no clue about the real world. I’m a big critic of the Fed models because they’re obsolete and they don’t accord with reality. When the Fed realizes its mistake of tightening into economic weakness, it will have to turn on a dime and shift to an easing policy.
What would cause the Fed to back off? A market meltdown. If the stock market sold off 5%, which would be over 1,700 points on the Dow, that would not be enough to throw it off. But if it went down 15%, or over 5,000 points from current levels, that’s a different story. Ben Bernanke actually told me that once.
Easing will come first through forward guidance and pauses in the rate hike tempo, then possibly actual rate cuts back to zero and finally reversing its balance sheet reductions by expanding the balance sheet through more QE if needed.
But by then, the damage will have been done. We can see the damage coming and plan accordingly.
for The Daily Reckoning