Let's be clear about one thing: markets aren't in turmoil because the Fed might hike 75 basis points this week. They're in turmoil because inflation is really bad, and no one has yet stepped up to declare--like Mario Draghi of Europe did when their debt crisis was reaching a climax--that the central bank will do "whatever it takes" to fix the problem.
Of course the Fed wants to "balance" the inflation fight against the risks of sending the economy into recession. Unfortunately, inflation is proving just as damaging to Americans. Consumer sentiment just plunged to a record low in the University of Michigan's 75-year series history. It's worse now, in other words, than at any point in any prior recession since 1952. Is this what success is supposed to look like?
It's not. It's a clear failure. And worse, there's no relief in sight. Even if Russia ends the war on Ukraine and its energy supplies return to the global market, the world is under-supplied in oil right now. Global demand is higher than supply, even including Russian barrels. The unexpectedly sharp rebound in demand has tightened markets of all types to the point of breaking, and it was global stimulus that juiced us to this point, before pandemic-hit supply chains were ready to handle it.
Now, no one can keep up with demand because we literally don't have enough workers, and the resulting wage pressures are spreading inflation throughout every aspect of the economy. The global stimulus created a curious problem: too many jobs all at once. There just aren't enough available workers to fill all the jobs employers need filled right now. The market is quickly trying to find a clearing point through (a) resetting pay higher, and (b) destroying "phantom" job openings like those in stimulus-juiced industries (crypto, anyone?) that were more or less a mirage.
The Fed at best can get out of the way and not counteract this process right now. By pivoting to rate hikes and balance sheet shrinkage, it is at least slowing the amount of stimulus it's adding to the economy--stimulus that would worsen these problems. The fact that so much of the economy's "nominal" growth is being eaten up by inflation right now is plain evidence that policy overshot. The U.S. should be growing around 4-5% a year nominally, or 2-3% in real terms after inflation. Instead, we exploded to almost 10% nominal growth last year, and each quarter we have less "real" growth leftover to show for it, because it's all going into inflation.
And--the Fed is still running expansionary policy! Don't be fooled by the rate hikes and "quantitative tightening." If the "neutral" level of interest rates is at least 2.5% right now (and it's probably higher, because inflation is so high), then any rate below that level is stimulative. They could hike 75 basis points this week and that only puts them in the 1.5% to 1.75% range--still way below neutral, let alone "tight" monetary policy.
And yes, the balance sheet reduction also counts towards that goal, but it's not clear by how much. One recent paper suggests $2 trillion in reduction over 3 years is only equal to about 30 basis points of rate hikes; 90 basis points if markets are extremely risk averse. Put differently, QT raises the odds of a financial markets "accident" and is necessary to avoid leaving too much inflationary dry powder in the economy, but doesn't equal much in terms of tightening policy.
This is why interest rates are once again spiking higher, especially since the super-high CPI report last Friday. The 10-year Treasury yield nearly hit 3.3% this morning; that means the 30-year fixed mortgage rate will probably cross above 6% by this afternoon. The market isn't just trying to figure out the odds of a 75-basis-point rate hike this week, but calculating just how much more the Fed needs to do against how much it is willing to do right now, and how much worse inflation will be for how many more months as a result.
Would markets freak out if Fed Chair Powell came to the podium on Wednesday and said, bluntly, the Fed will do "whatever it takes" to bring inflation back down quickly to their 2% target? After all, markets are already freaking out! The Dow just had its worst losing streak in almost a century. The dollar is soaring, which is never good. The S&P reentered a bear market with the renewed selling pressure this morning.
What's worse, for us to linger here for months with continued macro uncertainty, feeling like we're in a recession anyhow? Or to have the Fed move more quickly to truly tighten policy, and give markets some much-needed clarity on the preeminence of their inflation-fighting goal? Congress may have given them a "dual mandate" on price stability and full employment, but it forgot the lesson from Scripture; "man cannot serve two masters." And no one else but the Fed can truly fix the inflation problem, as we have had to keep learning over the years.
See you at 1 p.m!
Kelly