The Fed’s Fight
‘Look what he’s done. Look what Joe Frazier has done!’
The other day was a big day for the Fed. The cameras rolled. The reporters leaned in. Inquiring minds wanted to know:
‘Which way will it go? What are you fellows going to do?’
In the old Soviet Union, no one was sure of anything until it was officially denied. And last week, we got our official denial. From Ben Bernanke, probably the least conscious central banker in US history, came this:
‘…history teaches us…inflation will not become self-perpetuating, with price increases leading to wage increases leading to price increases, if people are confident that the Fed will take the necessary measures to bring inflation down over time.
‘The Fed’s greater policy independence, its willingness to take responsibility for inflation and its record of keeping inflation low for nearly four decades after the Great Inflation, make today’s Fed much more credible on inflation than its counterpart in the ’60s and ’70s. The Fed’s credibility will help ensure that the Great Inflation will not be repeated, and Mr. Powell and his colleagues will put a high priority on keeping that credibility intact.’
Yep. It’s official. The Fed is going to win this fight, says the old humbug.
Out of shape
Is it? While we’re trying to keep an open mind, a Fed victory seems less and less likely. Yes, Fed governors are out of rehab and back in the gym. They promise to stay off the drugs and booze. ‘Early to bed and early to rise,’ says Chairman Powell.
The papers reported not only that the Fed raised rates by 75 basis points…but that it intends another big increase next month. The Wall Street Journal:
‘The supersized rate rise put in place by the Federal Reserve Wednesday may not be the last one, Federal Reserve Chairman Jerome Powell said Wednesday.
‘Speaking about the Fed’s rate rise, Mr. Powell said, “Clearly, today’s 75-basis-point increase is an unusually large one and I do not expect moves of this size to be common. From the perspective of today, either a 50-basis-point or a 75-basis-point increase seems most likely at our next meeting.”’
Not since 1994 — 28 years ago — has the Fed acted with such resolve. But the Fed is facing the fight of its life. And it is old, ‘out of shape’ and unprepared.
Economists describe the US’s central bank as ‘way behind the curve’. They’re talking about the inflation/Fed Funds curve. A ‘normal’ or ‘neutral’ interest rate for the Fed is about 2%. As inflation rises, so should the Fed’s key rate. But that’s 2% in real terms. That’s 2% ABOVE the inflation rate. So, at today’s CPI, the current Fed Funds rate should be more than 10%…not today’s 1.5%.
That would mean a rate increase of not 75 basis points…but 900 points. And that would be the biggest shock to the markets ever seen in the US. Even if Fed governors were the grittiest, dirtiest, toughest fighters in the ring, they still wouldn’t dare throw a punch like that.
Which is why you hear commentators say the Fed has ‘lost control’ of inflation. It can’t do what it needs to do.
In 2018, the Fed was raising rates, trying to catch up with soaring stock market prices. That was the time for a 1% increase…followed by another 1% increase…and another one. That would have gotten the Fed where it needed to be — ahead of the curve.
But as the hot summer came to an end, and investors drove home from their vacation houses, they looked in their rearview mirrors and saw the Fed gaining on them. Fearing a bear market, they began to offload their overpriced stocks in September. By the end of the year, the S&P was down 17%.
This caused Janet Yellen, then the Fed jefe, to make what will probably be regarded as one of the worst mistakes in central banking history. Instead of continuing the fight to get back to a normal position, she took a dive. The Fed ‘paused’ its rate increases…and then collapsed the Fed Funds rate down to zero, where it remained until this year.
And while the Fed lay as lifeless as a comatose heavyweight, consumer prices rose…to the point where they are now going up approximately nine-times faster than the Fed’s key rate. Even with rate increases of 0.75% a quarter, it will take four years to catch up. And that is only if the CPI stays still. Which is very unlikely.
Just look at the Producer Price Index. It is rising at more than 10% per year. Those are the costs that will work their way into finished, consumer prices later.
Mortgage rates are rising too. They’ve approximately doubled this year. On a US$350,000 house, for example, the monthly payment has gone up from about US$1,500 to US$2,100. Still very low. But the pool of people who can afford to spend US$2,100 a month is vastly smaller than the pool of those who can afford to spend US$1,500. So sales go down. And so do prices.
The jig is up
You’ll recall from Monday, too, that wage increases have in no ways kept up with these price increases. The average family struggles to keep up with the basics — food, fuel, and shelter — leaving it with less and less money to spend on other things.
Over in the corporate world, the situation is not much different. Businesses — including many ‘zombie’ companies that lose money rather than make it — stayed alive by refinancing their debt at lower and lower interest rates. That jig is up too. While the average junk bond yield (what bad corporations pay to refinance their debt) is still below the inflation rate, it’s now twice what it was last December.
That’s why we’re seeing such a bloodbath in the zombie sector. Last week, we looked at MicroStrategy…a money-losing company that pinned its hopes on Bitcoin [BTC]. But when the cryptos went down…down went MicroStrategy, losing 90% of its peak value.
Stocks are falling. Bonds are falling. Houses are falling. Inflation is rising. And a recession has probably already begun.
Nobody knows how this fight will end. But if the Fed can get up off the mat and land a knockout punch, it will be one for the history books…as if Howard Cosell had decked Joe Frazier with a baseball bat.
For The Daily Reckoning Australia