The First of Many Federal Reserve Flinches
You might think that a whopping 0.5% interest rate hike from the Federal Reserve would trigger carnage in an overleveraged economy. One that was already shrinking at an annualised pace of 1.4% before the rate hike…
Despite this, as the Financial Times put it, the ‘Fed reaches for its “hatchet” to attack galloping inflation’ and ‘prepares to supercharge its tightening policy’.
Central bankers with supercharged hatchets don’t seem conducive to rising asset prices either.
But markets surged on news of the Fed’s 0.5% hike. Dramatically so, too, with the Dow Jones Index surging to its best day in two years. That doesn’t sound like much, but extreme volatility during the pandemic obfuscates the comparison.
How can a supercharged hatchet of a rate hike be good news for asset markets or a shrinking economy?
As always, it comes down to what the market expected versus what actually happened. But the market did expect the 0.5% hike, so what’s behind the sudden stock market spike?
Well, what investors didn’t expect was for the Fed’s chair to take 0.75% rate hikes off the table for the future.
Now, central bankers’ promises and assurances about their future behaviour are not exactly credible in the first place, as Australian borrowers have found out the hard way.
Promises to keep Aussie rates at zero until 2024 didn’t exactly play out at the RBA. Someone peeked behind the curtain and discovered a lot of inflation hiding there.
Now Aussie mortgage borrowers are quaking in their boots, and even the property advertising-dependent media is reporting on the carnage to come for property prices.
The RBA governor who made the promise? He’s merely ‘embarrassed’. Whoopsie daisy, oh well, she’ll be right mate, our condolences to you (not you, variable rate borrowers, only to Phil).
Anyway, at the margin, news that the Fed wasn’t ‘actively considering’ a 0.75% hike was good news for the market. It lopped off some uncertainty about the pace of future rate hikes and so prices rallied.
Here’s what I really want to dig into, though: Wednesday’s narrative and market action is the first in a series of flinches from central bankers. Just as they have had to about-face on loose monetary policy once inflation proved not-so-transitory, they’re going to have an about-face on tight monetary policy too.
This will trigger a series of similar rallies and spikes to what we saw on Wednesday. And, before we know it, central bankers will be back to their old ways of pumping up markets and government finances with freshly created money.
At least, that’s what I’m expecting. Before I explain why, consider just how deep a hole they’re already in…
Despite claiming that ‘neutral’ monetary policy would be at interest rates of about 2.5%, the Fed has made clear it’s not going to move that way fast. This means that even if rate hikes do occur, central banks would still stimulate the economy for many months to come.
If you ask me, this is madness. Inflation is at 8.5%, neutral policy is 2.5%, and official interest rates are less than 1%. The Fed’s still pouring gasoline onto the monetary bonfire; it merely announced a slight reduction in how much.
This is what I meant when we covered the idea of ‘behind the curve’ in such great detail in past editions. Central bankers would be stuck fuelling the flames for fear of chasing rates higher too fast.
A credible rate hike, which would slow inflation, would be to levels higher than 2.5%. That’s according to the Fed’s calculation of the ‘neutral’ rate, anyway. As far as I’m concerned, you’d probably need rates higher than 8% because you need positive real interest rates to fight inflation.
But you only need to go to 2.5% to realise what’s wrong with this scenario. The economy simply can’t handle the rate hikes needed to bring down inflation. In fact, the US economy was already contracting before rates were hiked…
That is why central banks are shuffling their feet while the value of money burns.
A quick explanation of what’s supposed to happen will prove helpful. Central banks are supposed to control the business cycle and inflation by way of hiking and cutting interest rates. Those rates affect borrowing costs, making it easy for central banks to make us richer or poorer by way of their interest rate lever.
But this lever presumes that inflation can be brought down by way of reducing economic activity — by making us spend less. What if there’s so much debt and asset prices are so pumped up that the choice isn’t between making us richer and poorer, but between triggering a financial crisis or fuelling inflation?
At some level of debt, this is inherently the case. Even the tiniest of rate hikes kicks off a debt crisis instead of just an economic slowdown. We may well be at that point.
So, what central bankers are trying to do in this cycle is not to slow down the economy in a conventional way. That’d require genuinely tight monetary policy — positive real rates above 8% according to me, or 2.5% according to the Fed. That’s miles out of reach.
No, this time, the central banks want to trigger a gentle debt crisis. Because that threshold will come long before they can slow the economy with positive interest rates affecting consumption and borrowing.
While monetary policy remains insanely loose by my measure and very loose by the Fed’s, small rate hikes may still be enough to trigger a debt crisis somewhere.
In other words, we’re not talking about reducing demand by making mortgages more expensive and reducing consumer spending. We’re talking about defaults and falling asset prices — 2008, not 1990.
But here’s the twist. You might think central bankers fear inflation above all else, or perhaps you’re a bit cynical and believe they fear unemployment more. But the truth is that they fear financial instability much more than either.
Indeed, the original role of the central bank was to prevent a banking crisis, not conduct monetary policy.
The reason is that a financial crisis triggers a rapid deflationary shock, no matter how high your inflation is running at the time.
Central bankers are walking a tightrope between funding inflation and triggering such a crisis on purpose by raising rates. It’s no wonder they’ve erred on the side of inflation.
What’s surprising about all this is that it’s surprising at all. It is, after all, what has happened in every monetary policy cycle since the ‘80s. Central bankers hiked interest rates until something in the financial system snapped, and a crisis began.
This happened at a lower peak in interest rates each time because the overall amount of debt kept growing, so it only required lower and lower rates to kick off the crisis each time.
Indeed, just as the Fed is always behind the curve when inflation sparks, it’s always behind the curve in triggering the next debt crisis. It often continues to hike rates in the face of the next crisis beginning. That’s what makes the US GDP disappointment so interesting. It’s so familiar.
So my prediction is for history to rhyme and the Fed’s tradition of triggering financial crises to be upheld. Its rate hikes will trigger a debt crisis somewhere. And that’ll force central bankers to rapidly return to QE and ridiculously low rates.
An article in the Australian Financial Review says that Macquarie’s global head of strategy, Viktor Shvets, agrees with this idea:
‘Rates are going up, then straight back down…
‘Central banks will be forced into a dramatic “back pedal” and will be considering cutting rates within 12 months just as markets expect policy rates to peak.’
I’m not even sure we’ll get that far.
Do you really think central banks will hike interest rates when a recession may’ve already begun, when stocks, bonds, and house prices are crashing, when commodity prices and supply chain chaos is behind the inflation, and when government debt-to-GDP is at wartime levels, not to mention being in a proxy-wartime?
If they do, it won’t be effigies of Jerome Powell they’ll be burning…
Until next time,
Editor, The Daily Reckoning Australia Weekend