Joseph Wang: Are Markets Misreading the Fed?
Are the markets misreading the US Federal Reserve’s intention to curb inflation? And what are the risks of misreading the Fed?
Millions of words are written about the US central bank every year.
Every statement and action can shift trillions of dollars around the world.
But rarely do you get an ‘inside’ look.
Joseph Wang traded for the Fed for five years. Now he’s a private trader and commentator.
Right now, he says the markets are misreading the Fed, and the consequences could be getting stuck on the wrong side of the trade…
Watch below as Callum Newman chats with Joseph about the Fed, the strong US dollar, Bitcoin [BTC], and gold:
Joseph Wang: Fed Guy
Joseph spent five years as a senior trader for the Fed on the open markets desk.
The experience was crucial in acquiring an insider’s knowledge of the financial system’s plumbing.
As Joseph explains, the desk is ‘one of the few places in the world where one can definitively learn how the system works’.
Armed with this experience, Joseph spoke with Callum about the US central bank’s plans to combat inflation…and whether the market was misjudging the Fed’s intentions.
Are markets misreading the Fed?
During the interview, Joseph told Cal that:
‘By all indications, the US Federal Reserve is going to continue to tighten. Yet markets don’t seem to be very good at pricing regime changes and it seems to me we are in one right now.’
He reiterated his argument in a recent post:
‘The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation.
‘Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power — credit, wages, and wealth — all appear to easily support elevated inflation.
‘These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate.
‘The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked.’
Can interest rate hikes fight supply-driven inflation?
A common rejoinder Joseph hears centres on the supply-side causes of inflation.
If inflation is mostly exogenous to factors relating to demand, interest rate hikes are too blunt an instrument…with wide collateral damage.
Raising rates won’t increase the supply of oil, or grains, or houses…so why do it?
Joseph pointed to comments from Fed Governor Christopher Waller, who affirmed that the central bank’s mandate is stable prices, simpliciter, not stable prices contingent upon it not being a supply shock.
In Waller’s own words earlier this year:
‘We can argue about whether supply or demand is a greater factor, but the details have no bearing on the fact that we are not meeting the FOMC’s price stability mandate. What I care about is getting inflation down so that we avoid a lasting escalation in the public’s expectations of future inflation. Once inflation expectations become unanchored in this way, it is very difficult and economically painful to lower them.’
Are markets misconstruing the Fed as too dovish?
As Joseph told Cal in the interview, for the Fed, the weighting of inflation’s causes — demand or supply — doesn’t much matter in its pursuit to curb it.
Joseph noted that the whole commodities complex collapsed as the Fed aggressively hiked rates.
Oil, grain, and iron ore are all down from their 2022 highs.
‘That tells me’, said Joseph, ‘that raising rates does work, in part because so much of the commodity complex is financialised’.
Because the paper commodities market is so much bigger than the physical market — and the paper market is sensitive to interest rates — you can tank the paper market by hiking rates, Joseph argues.
So what does this all mean?
The Fed wants to meet its price stability mandate and tamp down inflation…whether inflation is driven mostly by supply shocks or not.
The markets have to calibrate their expectations of Fed policy accordingly.
As Joseph concluded in a recent post (emphasis added):
‘The market’s implied path of policy appears to misunderstand the Fed’s priorities. Over the past few weeks the market has more aggressively priced in rate cuts in early 2023 following a string of weak economic data.
‘The Fed’s current priority is inflation, and then full employment. This means declining economic activity is a desired outcome of monetary policy and not a reason for a dovish pivot.
‘Nominal spending fueled by wages, wealth, and credit continues to grow at an exceptional rate, suggesting that monetary policy may still be too accommodative.
‘The market’s move to price in rate cuts is effectively easing financial conditions when the effects of tightening are just materializing. The Fed will have to strongly push against market pricing to retighten monetary policy.’
For more of Joseph’s thoughts — including his thoughts on recent price action of gold and bitcoin — listen to the interview embedded above.