When you’re fighting inflation, it’s a problem if people feel richer
What a great country, right? Six days before a crucial midterm election, the head of the central bank was talking down the stock market.
On Wednesday, stocks on Wall Street rallied in reaction to an encouraging phrase in a Federal Reserve statement, but Jerome Powell, the Fed chair, extinguished the rally half an hour later by making clear that the Fed was nowhere near done raising interest rates. So much for the idea that the Fed takes orders from the political party in power.
Then again, politically independent does not imply economically infallible. There’s a strong case to be made that Powell and company are overdoing the rate increases to fight an inflation surge that’s already receding, and that they will inadvertently cause an economic downturn that’s much deeper than it needs to be. On Friday, Representative Maxine Waters, the California Democrat who leads the House Financial Services Committee, sent Powell a letter saying she was “deeply troubled” by the Fed’s “rapid series of supersized interest rate hikes.”
The elections of 2022 might someday be compared with those of 1992, when a Fed led by Alan Greenspan cranked up rates and President George H.W. Bush lost re-election. “I reappointed him, and he disappointed me,” Bush told the interviewer David Frost in 1998.
What happened on Wednesday is that the Federal Open Market Committee raised its target for the federal funds rate, the short-term rate it controls, by another three-quarters of a percentage point. The top of the target range is now 4 percent, up from 0.25 percent as recently as March, an extremely rapid increase.
The rate-setting committee’s statement at 2 p.m. Eastern time tantalized investors because it said the committee would take into account “the lags with which monetary policy affects economic activity and inflation.” The Dow Jones industrial average rose more than 400 points because the statement seemed to say that the Fed might wait to see how the economy responded before going ahead with more increases. The hearts of Democratic campaign strategists must have leaped.
But at a news conference half an hour later, a stern Powell said, “Incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.” The Dow industrials ended the day down more than 500 points.
Why is Powell still sounding so hawkish on inflation? There’s an economic explanation and a market-psychology explanation. The economic explanation is simple: Fed officials fear that if they don’t deal with high inflation soon, it will become chronic because people will come to expect it. The Consumer Price Index rose 8.2 percent in the 12 months through September. And so far, the overall economy hasn’t been badly harmed by higher rates. On Friday the Bureau of Labor Statistics reported that nonfarm payrolls increased by 261,000 in October.
On the other hand, there’s lots of evidence that both inflation and job growth have reached inflection points and will soon be heading down as the economy tips into recession. It’s a bad sign for the economy when short-term interest rates are higher than long-term interest rates. The high short-term rates reflect efforts by the Fed to cool off the economy by making it harder to borrow, while the low long-term rates reflect market expectations for low inflation and slow growth. In July, yields on two-year Treasury notes broke above yields on 10-year notes, and the differential has steadily grown. The last time this happened was the eve of the deep recession of 2007 to 2009.
Or look at housing, which is highly sensitive to Fed policy because most people take out mortgage loans to buy homes. This chart reproduces one created by Jim Reid, the global head of fundamental credit strategy at Deutsche Bank. The sharp decline in affordability is bad for buyers and sellers of homes, but also bad for the economy as a whole because the construction and furnishing of homes is a big contributor to economic growth.
I could go on with the bearish signs for the economy, including the Credit Managers’ Index of the National Association of Credit Management, which fell in October to its lowest since the pandemic month of June 2020. But I don’t think economic indicators entirely explain the Fed’s decision-making.
Psychology is also in play. Powell has to wear a frowny face because if he shows any sign that the Federal Reserve is about to ease up, the stock market will take off, as we saw briefly on Wednesday. A strong stock market would make people feel richer, which would encourage them to spend more. It might also persuade some people that they don’t need to go back to work because the market will do their earning for them. Spending more and working less is exactly what the Fed does not want to see.
“Powell had zero incentive to talk dovish” on inflation, Tom Porcelli, the chief U.S. economist for RBC Capital Markets, wrote in a client note on Wednesday. He added: “The moment Powell acknowledges anything close to a dovish take on the backdrop is the moment financial conditions meaningfully ease, thus unwinding the hikes they put in place. He can’t do that at this juncture. Powell will be the last one to acknowledge this.”
“The Fed’s policy is: ‘Get out and start looking for a job. Get off your rear end. Stop thinking the stock market is going to bail you out,’” David Rosenberg, the founder of Rosenberg Research in Toronto, said in an interview.
If Rosenberg is right, don’t expect the Fed to pause until the stock market weakens even more. He points out that when the former Fed chair Paul Volcker, whom Powell admires, finally relented on rate hikes in the early 1980s, stocks were only half as expensive as they are now in relation to corporate earnings.
Trouble is, the “controlled burn” that the Fed is trying to conduct could turn into a raging wildfire, says Mark Spitznagel, the founder and chief investment officer of Universa Investments in Miami. He made that point in a recent essay for Barron’s.
While members of the Federal Open Market Committee don’t see unemployment getting any higher than 4.4 percent in the next two years, according to September’s Summary of Economic Projections, “you can tell a pretty convincing story that the unemployment rate has to go up to 5.5 or 6 percent” for the Fed to achieve its goals on inflation, Joel Prakken, the chief U.S. economist for S&P Global Market Intelligence, said in an interview.
“I think it would be at risk of moving back over 6 percent,” Rosenberg told me.
People at the Fed are undoubtedly aware that unemployment could get much higher than the 4.4 percent in the committee’s median projection. But they can’t signal that the Fed would be prepared to lighten up if unemployment got much worse, because if they do, people will prematurely celebrate the end of the Fed’s tightening and all the bank’s painful work to date will be undone. In the meantime, then, expect more Kabuki theater from Powell and company.
Number of the Week
The estimated change in the U.S. Consumer Price Index over the 12 months through October, according to the median forecast of economists surveyed by FactSet. Inflation peaked at a 40-year high of 9.1 percent in June but has been slow to retreat since then. The Bureau of Labor Statistics is scheduled to report the official October data on Thursday.