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Introduction
Federal Reserve Board Chairman, Jerome Powell, announced the latest interest rate raise and an intention to use tapering to tighten the Federal Reserve’s balance sheet. While the 75 basis points raise was expected by most observers, Mr. Powell’s comments suggest a strong commitment to hawkishness in order to solve inflation. This is important because it dashes hopes for a return to dovish policies and suggests that a substantial recession is on the way.
I believe that Jay Powell’s words are genuine, and fit a recent pattern in which the chairman cited the work of the late Federal Reserve Chairman Paul Volcker as inspiration. Volcker’s record of raising interest rates to skyscraper levels during the 1970s to battle frightening rates of inflation is widely seen as a template of courage for today’s Fed to follow.
Jay Powell has indicated his admiration for Paul Volcker before Congress in March 2022:
“…Jay Powell was asked if the US Federal Reserve was prepared to ‘do what it takes” to get inflation back under control — and if necessary, follow in the footsteps of his venerated predecessor, Paul Volcker, who regained price stability ‘at all costs.’”
“Calling the late Volcker ‘the greatest economic public servant of the era,’ Powell responded: ‘I hope history will record that the answer to your question is yes.’”
Wednesday’s meeting, decisions and ensuing statements by the Chairman support the idea that the Federal Reserve is indeed wed to its path.
“‘The Federal Reserve is raising rates “purposefully” to reach levels to bring down inflation, Federal Reserve Chair Jerome Powell said in the press conference after the central bank raised its key rate by 75 basis points …it’s taking ‘forceful and rapid steps to moderate demand,’ he added.”
Powell also commented on expecting trimming of GDP growth, and tight and ‘out of balance’ labor markets.
A few takeaways from Jay Powell’s comments:
- Raising rates is a piece of a multi-step strategy to: Raise interest rates significantly and consistently, suppress demand among businesses and consumers, and “rebalance” labor markets.
- The goal of the strategy is to achieve a systematic reduction of inflation as soon as possible.
- Demand destruction is a key component of the strategy, and if this leads to substantive increases in unemployment, the Federal Reserve will accept those towards achievement of broader aims.
If people doubted the resolve of the Federal Reserve or believed that 75 basis points were “baked in” to the markets, Jay Powell disabused them of that notion. He also confirmed that the Fed would soon begin quantitative tightening or tapering of fixed instruments.
The era of easy Central Bank money adding to reliably profligate administration spending is over. Mr. Powell may not be remembered as an imitator of Paul Volcker, but he has cast aside the dovish label and virtually stomped on its remains.
A Glance at the Macro Picture
The US economy is a strange beast these days. There was COVID, which created an objectively absurd reality in which all normal life shut down. Economic activity was severely restricted by government measures and widespread fear; it limped along until people and companies adjusted to remote work. Travel faded, mass physical isolation became the mandated norm, unemployment soared and central governments injected rescue packages into the lives of millions.
COVID passed in declining waves until something like normalcy returned. However, massive government outlays created a temporary welfare state in which attention to deficits and debt were shunted aside. A crisis had to be averted — one that might lead to mass social unrest beside economic devastation. If a new version of economic normalcy has emerged from the pandemic, it’s one packed with inflation and its attendant dangers.
Inflation vs. Deflation
For years now, people have proposed that deflationary forces were afoot and changing economies. The primary driver of deflation was efficiency facilitated by revolutionary technology. Driven along multiple axes of product development, this software-focused technology enabled a networked computing reality associated with concepts like virtualization and cloud. Conducting business is now faster, easier and potentially more profitable.
The COVID and post-COVID eras pushed talk of deflationary forces into the background. Only a few continued to speak about deflation in the face of a macro inflationary reality. There’s no denying the reality and threat of that reality, but it does not erase the validity of the deflationary argument.
I believe that deflation remains a fundamental factor in the modern economy. Once inflation is reduced or “conquered,” perceptive observers will understand that. Until inflation’s damage fades, the deflation conversation will be deferred.
Geopolitics Ask to Be Heard
In the background there’s the Russian invasion of Ukraine, and a hard war that seems to have no end in sight. The conflict already has directly impacted the energy situation and specifically European nations that have been dependent on Russian energy.
Beyond that, a cloud of uncertainty now hangs over international commerce and security. Unlike the closure of a Nordstream pipeline, the dreaded prospect of a world war is unsettling to markets and investors. The possibility, however slim, of global conflagration adds a wild card to investing. If the impact can’t be easily measure, it still exists.
Markets’ Reaction
The markets’ initial reaction to the Federal Reserve meeting was immediately negative. The averages plunged Wednesday, all three major indices were down about 1.7%. In the overall scheme of this pronounced Bear, this could be seen as just another bad day. Most days, investors find a reason to sell, and this was another reason for a new day.
The disturbing aspect of the Wednesday sell-off was that Jay Powell’s 75 basis points were said to be baked in, a phrase that fits into the lexicon of cliches that attempts to capture the collective investing mood. The raise and Powell’s press conference managed to give another jolt to investors’ confidence, as the specter of recession grows nearer with each turn of the tightening screws.
Pessimism is now ingrained. Some optimistic triggers need be released to change the mood of fear and resignation. It’s not really volatility but a slow grind down based on a widespread belief that inflation will yield to damaging recession.
What Will Restore Investors’ Confidence?
The most logical conclusion to market behavior after the Fed policy meeting is that investor confidence is quite damaged. It has gotten there in stages, the last of which includes the understanding that this Federal Reserve is a hawk on an ascending flight pattern.
If anything is baked into today’s markets, it’s pessimism that provokes negative reaction to the realization of anticipated policy statements. Nothing about Jay Powell’s Wednesday should have surprised investors, but the “big money” keeps leaving the markets.
We live in a world of multiple heavy shocks — a devastating pandemic, then central bank and government intervention to close down economies to preserve health and societal survival. This led to sequential moves to revive those economies as COVID variants appeared one after the other.
As COVID was retreating and normal life resurfacing, the Russian invasion of Ukraine brought more shock and trauma. The war that began Feb. 24, 2022, poses a huge threat to international security and economic life. It impacts energy and food supplies, forcing entire nations such as German to reassess and shift economic and political strategies.
Add to these macro and geopolitical events the inflation they helped bring. The easy central bank policies that pumped liquidity into the system were going to end sometime. The Federal Reserve’s awareness of government propensity to out-of-control spending was one more driver for the dove-to-hawk change. At least for central banks, the era of free money was over.
For investors, the grave uncertainties that began in February/March of 2020 just won’t go away. About fear and greed and the markets – the fear is real and has morphed into prolonged, deep anxiety.
I think these factors are necessary for the restoration of investor confidence (institutional or retail):
- Federal Reserve policy must work and inflation decline consistently. The numbers need to drop significantly and consistently.
- The labor market imbalances need be corrected without provoking high unemployment. Anything that points to a lasting and deep recession will deter investment.
- A recession, if in fact inevitable, should be fairly mild and of a reasonable length.
There’s more, but I think those are a good start. Jay Powell’s statements imply that he believes inflation can be beaten without a deep and disastrous recession ensuing. Whether or not people believe his optimism is another question. Yes, the restoration of confidence is attainable. It is also sitting at verifiable low levels at present.
I can’t say whether the Federal Reserve’s effort to attain something that looks like a hard-soft or soft-hard landing will succeed. I do think it will take time and that many confusing indicators will appear along the way. For long-term investors, panic is not the prescription. Caution is.
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