Nicholas Glinsman | February 7th, 2022
There are no easy choices for the Fed, but here’s what we are hearing
Transitory is out, elevated is in. QE (quantitative easing) is out, QT (quantitative tightening) is in. Negative interest rates are out. We now know what medicine the Federal Reserve has in mind for the US economy. But we cannot be certain of the efficacy of the planned doses. Cooling a red-hot economy is no walk in the park.
The great American job-creation machine rolls on. It added 467,000 in January, even as Omicron was running at its peak. The unemployment rate, at 4 per cent, is down 2.4 percentage points in the past year; the number of unemployed persons down 3.7 million. Furthermore, as you can see from the chart below, long-term unemployment is collapsing – only 26% of those unemployed have been without a job for more than 27 weeks.
Little wonder that lay-offs are at a record low as employers grapple their workers to them with hoops of steel, while quit rates are at a record high as workers survey the 11 million unfilled job openings. In short, the labour market is strong enough to tolerate a tightening of monetary policy without creating a reserve army of the unemployed.
This is not, however, ambiguously good news for the Fed, as a tight labour market creates upward pressure on wages, which in turn raises costs and adds to similar pressure on prices. The reported 5.7 per cent jump in hourly wages this past year, a post-Covid high, was more than wiped out by the 7 per cent jump in the prices of stuff that workers’ families loaded into their supermarket trolleys.
As Fed chairman Jay Powell considers his options, he faces a board unlike any he has confronted, inflation with important differences from early bouts, an economy far different from that on which earlier boards operated, and a society that questions the competence of its governing institutions.
Start with the board. It will be very different from previous ones. President Biden’s three nominees have focused on racial and gender disparities, climate change and the regulation of bankers. The Fed, of course, was thinking about all these issues well before Joe Biden made his selections. Still, it is one thing to accept climate risk and inequality as appropriate for consideration, quite another to deem them central issues of concern. Which makes it difficult to predict which way the newbies will jump as policy to cool inflation develops.
This new group of policymakers faces a new sort of inflation, different in a big way from those it has dealt with in the past. The spurt in prices is partly rooted in supply-side constraints rather than the more familiar Keynes-style shortfall in demand. In addition to labour shortages, ports cannot handle the volume of goods headed to America, the construction industry cannot find enough materials to build the homes buyers are demanding, and microchips are in such short supply that vehicle production is constrained. Monetary policy is not equipped to cope with such problems, at least not directly.
Then, too, the vehicle in which we are travelling, call it economy Model 2022, is very different from the one that careened off the growth road in 2007-09, when it hit the ravine-sized pothole that was the overstretched housing market. The pandemic has left some of the firms that survived its consequences weakened sufficiently to make their ability to survive a Fed-induced slowdown uncertain. And consumers, with some 58 per cent anticipating a recession, are wary, now that various benefits have expired and they have whittled down their bloated savings. The sound of wallets being zipped up echoes around shops.
Perhaps most important, Americans are uneasy after two years of coping with the pandemic. Suicides are up, as is drug addiction; crime is rampant, with thugs looting stores, cops assassinated and miscreants going unprosecuted; illegal immigrants, some with criminal records, are being awarded airplane tickets to their cities of choice; carers never know when they wake up in the morning whether their kids’ schools have been shut by the teachers’ union, or they can go to work; if the latter, they wonder if public transportation is safe. It is not unreasonable to wonder whether such a society, with confidence in government economic policies at its lowest since 2014, will calmly tolerate an economic slowdown, especially if inflation continues to nibble at the value of workers’ pay cheques.
The Fed plans to calibrate its response to incoming data. Two problems:
In the end, the Fed will be forced to rely on its judgments. Unfortunately, those judgments have too often resulted in recessions. Perhaps this time round its policymakers will not emulate Napoleon, who, historian AJP Taylor wrote, “learnt from the mistakes of the past how to make new ones”.
So, what are we hearing about these potential judgements? Well, from as good a source as you can get, the Fed faces a conundrum (Chatham House rules apply though). Let me put it in bullet points:
In terms of QT, bear the following chart in mind from Bank of America:
None of the above Fed action list should come as a surprise. Central bankers are no longer patient when it comes to inflation. Federal Reserve Chair Jerome Powell made that clear at last week’s meeting when he basically confirmed a March interest-rate hike. European Central Bank President Christine Lagarde on Thursday refused to repeat previously-made comments that a rate hike this year was “very unlikely,” and instead indicated there was “general concern” among policymakers about inflation and that she’d be open to raising rates this year. Then, of course, there was the Bank of England, where policymakers seriously considered raising rates by 50 basis points in the latest meeting.
The market response has been swift, but not catastrophic… yet! The global pool of negative yielding debt plunged by 20% in one day, to the lowest amount since October 2018. Yields on Italian government bonds surged to the highest since May 2020 and German 5-year notes turned positive for the first time since 2018.
Over in the US, the move was more muted at first, but after a surprisingly strong January jobs report on Friday, 10-year Treasury yields surged to the highest since January 2020 and traders started pricing in a greater likelihood of six rate hikes by yearend. Investors finally started earning a positive real return on 30-year US bonds for the first time since June.
Even with all of these superlatives, markets have not yet really begun to comprehend what the synced up tightening of developed-market central banks will ultimately will mean. It is one thing for the Fed to return to a more normal rate. It’s another for the ECB to end its negative-rate policy — potentially as soon as later this year — for the first time since 2016. Add these two together, along with a highly uncertain economic trajectory and the biggest inflationary impulse in decades, and we’re in profoundly unknown territory.
US rate expectations
EU rate expectations
This dynamic is bound to create some big ripples, over and above a re-evaluation of investors’ holdings of Government bonds. Credit markets have remained relatively calm throughout much of this year’s equity turmoil, but started to show some cracks this week. Debt funds had their largest weekly outflow since March 2021, with $11.6 billion exiting bond funds in the week to Feb. 2, with high yield and investment grade debt seeing their ninth-largest weekly outflows since 2003, Bank of America Corp. and EPFR Global data show.
Furthermore, just look at credit default swaps for both investment grade and high yield – the professionals are beginning to hedge:
The overriding point to note is that we are going to exit this era of persistently negative real interest rates. This past 8 trading days, the markets crossed a Rubicon and we got a glimpse of what was once commonplace: a developed-market world where investors could actually earn money from bonds, even on an inflation-adjusted basis. However, it will come as a bigger shock as the realization sinks in. The safety net is gone. As stated earlier, central bankers seem more scared of runaway inflation than a market downturn.
This is a new era, one in which the market values of Facebook parent Meta Platforms Inc. and Amazon.com Inc. can swing by about $200 billion in one day. Nonetheless, it should not come as a surprise if there are even uglier days in the next couple of weeks and months, as investors reassess what a world of real yields means. It requires a revaluation of almost every asset against a backdrop of uncertain economic momentum.
Fed and ECB still behind the inflation curve – others weigh in
Some may consider me to have been too critical of the Fed and the ECB. Well, consider Mohamed El-Erian’s latest op-ed for the Financial Times. He worries that they are so far behind the curve, it is almost inevitable that they will both make further policy mistakes. Here are some highights therefrom:
“Already concerns about inflationary expectations becoming more embedded are building. There is a risk that price and wage setting shifts from seeking to compensate for the impact of past cost increases to also starting to include an element for future anticipated inflation. These considerations led the Bank of England to raise interest rates by 25 basis points, the first time it has opted for back-to-back increases since 2004. The fact that four of the five members of the Bank’s policymaking committee preferred an immediate 50 basis points rise suggests that a third consecutive increase at the next meeting is almost a done deal.
What I view as desirable and timely policy moves by the Bank of England stand in stark contrast to ECB and Fed inaction — a disparity that increases the BoE’s policy challenges. With its policy meeting last month, the Fed should at a minimum have signalled more seriousness in tackling inflation by immediately stopping its large-scale asset purchases. Even before Friday’s blowout December jobs report, failure to do so had contributed to a remarkable shift in market expectations that centre on five hikes for this year alone, with one prominent bank (Bank of America) forecasting seven. This, in my view, would constitute an excessive tightening of monetary policy given that the Fed is also expected to reduce its bloated balance sheet.
For its part, the ECB should have provided stronger guidance on interest rate rises this year at its policy meeting last week. The markets are already pricing in such increases. The ECB also reiterated its adherence to a “step-by-step” approach to raising rates only after stopping net bond purchases, a move that further reduces its degrees of freedom.
All this increases the possibility of a second central bank policy mistake in as many years. The more the Fed in particular delays, the greater the risk of a summer bunching of monetary policy tightening that unduly suffocates the much needed strong, inclusive and sustainable economic recovery. An even bigger risk is that such policy tightening would come after inflationary expectations have been de-anchored, resulting in a twin blow — higher prices and lower income. That hits particularly hard the most vulnerable segments of the population. The damage would be amplified if pronounced market volatility spills back into the broader economy. The consequences of these policy mistakes extend well beyond Europe and the US. They are particularly threatening to developing countries lacking policy flexibility and financial resilience.
It took way too long for the Fed and ECB to correct their misreading of price increases. The additional difficulties this poses are now being compounded by unnecessary delays in altering what remains an inexplicably uber stimulative monetary policy stance. Rather than ensure a soft landing for the economy, the world’s two major central banks are likely to be forced into excessive “catch-up” policy tightenings. Stubbornly slow and partial now, the policy pivot that is sure to occur in the next few months risks considerable damage to livelihoods.”
Federal Reserve Nominations Update
Last week, the Senate Banking Committee held a nomination hearing on Sarah Bloom-Raskin, President Biden’s nominee for Fed Vice Chair of Supervision; as well as nominees for the remaining two Board seats – Lisa Cook and Philip Jefferson (all pictured above). Committee Chair Brown has said he intends to hold a vote on these nominees as well as the renomination of Chair Powell and Lael Brainard as Vice Chair on 15 February.
As previously noted, Raskin is clearly the most controversial of the various Fed nominees. Oil and gas industry stakeholders, as well as Republicans, have criticized her views on climate policy. While she has been praised by trade associations representing small banks (i.e., ICBA, ABA), we’ve been watching carefully as to whether her criticism of S.2155, the law passed years ago that provides regional banks more flexibility on capital requirements, would be controversial. She is unlikely to get any Republican votes in the Banking Committee, nor in the full Senate. The risk to her nomination has thus been whether all 50 Democrats will support her. Having watched for whether Joe Manchin would express concern about Raskin’s climate views, this week he made notably positive comments in reference to all the nominees (signaling likely support for her), while Senators Tester (D-MT) and Warner (D-VA), who might have also expressed concern about her climate views (in Tester’s case) or her views on S. 2155, instead expressed support for her. Given this, the risk to her nomination has materially declined and she will most likely be confirmed. However, the absence of Senator Lujan (D-NM) from the Senate until at least early March due to health issues will likely delay a full Senate vote on her nomination until then.
Republicans have also expressed concern about Cook’s views on the intersection between diversity and monetary policy, but this sentiment has not proliferated, particularly among Democrats, as one might expect, though she too will likely need to rely on almost only Democratic votes and her confirmation will also likely be delayed until Lujan’s return.
To date, it has been the objective of the White House and Senate leaders to have Powell (who many progressives oppose) confirmed in the same time-frame as the other nominees about whom progressives are enthused, which could delay his, and Lael Brainard’s, confirmation until at least early March. His term as Chair expired last week, but there is a Greenspan-era precedent for the Fed not having a confirmed Chair for a period of time, so there is little suspense about the outcome of the vote to confirm him.
If markets begin to express concern about the delay in Powell’s confirmation, pressure could build on Senator Schumer to split Powell’s confirmation from the others and hold a vote earlier. If there is no external pressure on Schumer to do so, then he will wait to hold a Powell confirmation vote in the same March timeframe that is likely necessary for Raskin and Cook (given their reliance on Lujan’s support).
An interesting historical anecdote