Summary
We need to acknowledge that the fight against inflation started from and is still primarily waged by the US Federal Reserve. Other central banks seem to already be lowering their colours. The calculus seems to be changing. As the probability of a recession rises, central bankers are beginning to fear sticky inflation less. The global economy could further decelerate, as the data from China are suggesting possibly more supply chain pressures down the road.
Make no mistake. Hawkishness is still the prevalent feeling. No one can fight the Fed, not even other central banks. It represents the world’s deepest markets, the biggest banks, the largest economy and the word’s ubiquitous global reserve currency. The Fed leads and others must follow, however reluctantly.
The question in everyone’s mind is: Is the Fed making a policy mistake now? And if yes, is there still time to reverse it, before something breaks that can’t be mended?
2023 will feature a different environment than 2022
Economic stagnation and possibly recessions and demand shocks in developed economies
A pressured bond market
A dollar that is already strong and rates that are near peak
A different Fed
We wouldn’t fight the Fed when it lowers rates. It’s easy to unleash animal spirits. But when it tightens, especially in an environment of economic malaise, we would dare to guess that its potency is more diminished. The Pivot didn’t happen last week, as some investors expected, but chances are that it will in the near future, possibly after January. The Bond markets can only take so much pressure. The economy is contracting, to the detriment of governments, and consumers are getting more reticent. A slightly different Fed, might think differently.
----------------------------------
In fighting inflation with sharp interest rate rises and quantitative tightening, the Fed is making many assumptions, mostly borrowed from the 1970’s playbook. The most important is that persistent supply inflation will cause consumers to ask for higher wages. This will create a self-perpetuating vicious cycle of wage hikes leading to higher demand and higher prices. This was certainly the experience of the 70’s. However, the 2020s are not the 1970s. Even if some parallels can be drawn between the pandemic, the war in Ukraine and the supply shocks of the time.
Unlike the 70’s this period doesn’t come after the ground-up restructuring of the world economy. It comes after 20 years of virtually stagnant real wages, fourteen of which saw massive consumer deleveraging and ‘secular stagnation’.
It does not come with a new monetary system (1971) but an old one, with more established rules and practices.
The world is much more globalised, so local responses to inflation are less potent.
Additionally, the data does not yet suggest that long-term inflation expectations are un-anchored or that there’s a wage growth spiral in the US, the Fed believes this may happen. Experience has suggested that economic models are not that great at predicting human behaviour.
Mervyn King and John Kay’s Radical Uncertainty (2020) decries the belief that human behaviour can be boiled down to models and “How To” manuals.
Instead of looking at outward data, we need to delve deeper to understand how the central bank’s thinking may have shifted in the past few months.
But first, we need to acknowledge that the fight against inflation started from and is still primarily waged by the US Federal Reserve. Other central banks seem to already be lowering their colours. The European Central Bank has suggested that it will not long persist with hikes. And the Bank of England terminal rate projection was also lower than what the markets previously believed. The Bank of Canada was also more dovish than expected, hiking twice instead of thrice. The Chinese central bank has effectively been on its own loosening cycle for some time.
One-by-one, the calculus for the central banks seems to be changing. As the probability of a recession rises, central bankers are beginning to fear sticky inflation less.
The global economy could further decelerate, as the data from China are suggesting possibly more supply chain pressures down the road.
Make no mistake. Hawkishness is still the prevalent feeling. No one can fight the Fed, not even other central banks. It represents the world’s deepest markets, the biggest banks, the largest economy and the word’s ubiquitous global reserve currency. The Fed leads and others must follow, however reluctantly. Attempts to pursue a different strategy can result in countries adding currency inflation to supply-side inflation and upward wage pressures. But overall, the hawkishness is really originated from the other side of the Atlantic.
But if the ex-Fed consensus is more dovish, then we must try to understand what drives American Hawkishness.
First, let’s check the data
US growth is slightly more robust than European (and UK). Currently, the US is expected to grow by 0.5% in 2023, whereas the UK is expected to contract by nearly as much and the EU to remain stagnant.
Wage growth is higher in the US and has permeated the services sector.
This means that the US can afford more hawkishness. But is it justified?
Certainly US core Personal Consumption Expenditure, an index stripping out energy effects as much as possible, certainly gives room for concern.
However, barely positive growth is not the hallmark of an overheating economy. And while wage growth is strong in the US, a liberal labour market, there isn’t much evidence of a wage growth spiral.
Meanwhile, pressures in the global bond market continue to build up and the probability of an accident.
Policy errors do happen, and the consequences can be severe. In 1929, US Treasury Secretary Andrew Mellon allowed banks to fail, believing that the ‘invisible hand of the market’ will remedy stock volatility. The world sank into depression and the road towards the second world war was paved. In 2008, Alastair Darling, the UK Chancellor of the Exchequer scuttled Barclays’ deal to buy Lehman. “We will not import your cancer,” he said to Hank Paulson. The Global Financial Crisis was underway…
Jay Powell could end up being hailed as the “New Paul Volker” who broke inflation’s back or decried as the “New Marriner Eccles”, the US central banker that almost collapsed the economy recovering from the Great Depression by mistakenly hiking rates in 1937.
The question in everyone’s mind is: Is the Fed making a policy mistake now? And if yes, is there still time to reverse it, before something breaks that can’t be mended?
Trying to analyse the Fed in data terms may be confusing. There’s no “book” and precedent is scarce. Instead, it makes sense to analyse people.
We need to remember this chart.
While the Fed had it’s previous composition, rate expectations for December 2022 moved slowly from 0.25% to barely 1%. Then after January 2022 the Fed almost immediately became more hawkish.
Time for our own assumptions.
One thing we can say about Jay Powell is that he lacks the economic gravitas of (now a Nobel Laureate) Ben Bernanke, Alan Greenspan, or even of Janet Yellen. He seems to run the Fed through consensus. This is not necessarily a bad thing. But it does lend room for other actors to have a larger voice.
The Federal Open Markets Committee (FOMC) is composed of eight voting members. One is Jay Powell. Four were appointed by the Democrats, they are mostly dovish and are led by Lael Brainard. Two were appointed by the previous administration, they are Republicans and they have been more hawkish. John Williams, the powerful ex-officio Vice Chairman speaking for the New York Banks has kept silent. Some saw that bond volatility has been very good for them. BofA reported a 27% surge in Fixed Income Trading revenue in Q3. Goldman's saw a 41% rise. JP Morgan saw an 8% jump. Citi was more reluctant, asking for higher margins, and saw its trading activity reduced. Overall, however, bond market stresses have not irked the big US banks.
Then there are the four regional Fed Presidents, who rotate every year. This year, three out of four were the perma-hawks, who have argued for higher rates and stoppage of QE long before the pandemic: James Bullard (St. Louis), Esther George (Kansas) and Loretta Mester (Cleveland).
The 2022 FOMC voting composition is arguably one of the most hawkish in recent history. But in 2023, the rotating part will change. Charles Evans (Chicago) and Patrick Harker (Philadelphia) are very experienced pragmatists, currently neither hawks nor doves. Neil Kashkari (Minnesota) may be currently counted among the Hawks, but he has a history as a super-dove. Lorie Logan (Dallas) is also more neutral.
The fact that FOMC minutes don’t show much dissent is beside the point. The Central Bank, like many other institutions, has long learned the value of presenting a united face to the world. If the Hawks win, all must appear hawkish. If the Doves win, then the tune must change for the Hawks too.
2023 will feature a different environment than 2022
Economic stagnation and possibly recessions and demand shocks in developed economies
A pressured bond market
A dollar that is already strong and rates that are near peak
A different Fed
The social impact of ‘difficult decisions’ is amplified by the openness of communication. This is not 1985, when people were sending their house keys to Paul Volcker because they couldn’t pay their mortgages. This is 2022, when a few influential tweets may cause rebellion.
We wouldn’t fight the Fed when it lowers rates. It’s easy to unleash animal spirits. But when it tightens, especially in an environment of economic malaise, we would dare to guess that its potency is more diminished. The Pivot didn’t happen last week, as some investors expected, but chances are that it will in the near future, possibly after January. The Bond markets can only take so much pressure. The economy is contracting, to the detriment of governments, and consumers are getting more reticent. A slightly different Fed, might think differently.