Financial conditions management has become the primary tool of choice for the Federal Reserve, impacting market and consumer expectations even before any action on interest rate policy. Serial rate hikes this year have followed the guidance, with more to come, and the effect of them is still substantially yet to be felt in the real economy. Confidence and activity levels have already moved sharply lower with high levels of inflation the principal factor.
In his much-anticipated conference speech due Friday afternoon, Chairman Powell may have the satisfaction of seeing inflation in all likelihood having peaked and tentatively started a downward trajectory – he won’t say it of course, but this is something of the transitory argument coming through (although transitory version 2 following war-related surges in oil and food prices rather than transitory version 1 on Covid re-opening). Powell can also observe higher interest rates that have now been absorbed by markets, albeit painfully so far this year, and the withdrawal of quantitative easing underway. Activity levels are also meaningfully lower than six months ago and technically already in recession in the US and rapidly heading there everywhere else. Employment growth remains probably too strong for his liking, though much of the recent strength is accounted for by state employment, and wage gains appear contained and happily are going more to the lowest paid too.
So how hawkish on forward rate guidance does he need to be, and how hawkish would be constructive at this point? With inflation possibly subsiding, confidence levels may start to lift from historic lows, lower even than during Covid or the GFC. But they now face the alternative headwind of ever higher rates choking the economy and threatening, or confirming, recession with all the grim implications for employment, consumption, corporate earnings and – yes – crashing inflation expectations that come with that.
Plenty of rate hikes are currently guided and priced by markets and are yet to hit that weakening economic reality. It seems to us only sensible that his job is to lift that confidence somewhat and reassure markets that their rate expectations are correct, but that it will be likely a pause in further hikes will be both possible and prudent at some point. This would allow a chance to recalibrate where inflation has got to, what is driving it, how best to address it given the underlying condition of the economy. Crucially the longer legs the Fed gives to the economic cycle, ideally at a slower, less inflationary rate, the more opportunity they will have to reinitiate rate hikes later, if needed and which an ongoing, slower economic expansion could support.
The bond markets’ job is to protect capital from inflation and default; the job of equity markets is to assess future corporate profitability derived from the business cycle. The Fed must offer confidence to the former with enough rate hikes to bend inflation lower; and also, to the latter that the cycle will continue just strong enough and long enough for them to complete the job. If it takes longer, then that is a trade-off against crashing an economy, and the inflation expectations that we have all worked so hard to create for the past fifteen years….and there’s still a war in Ukraine.
With oil and gas supply in Europe the principal driver of inflation everywhere, and a war driving that for which no end is in sight, there is only so much the Fed should aspire to do anyway. It’s fighting talk to pretend you can hike away and risk a recession while those key facts remain.
The definitive resolution to this conundrum likely lies on the other side of war and peace, and until then, a continued rapid build-up in alternative energy sources. It’s more likely a game of attrition and keeping the economy moving forward becomes central to staying in the game. The renewable transition is alive and well, shale is as strategically vital as ever to Western interests on the journey to net zero, and a nuclear deal with Iranian oil may be in the offing. The Fed must balance the fears of inflation with the fears of higher interest rates and the fears of a crashing economy: we should be careful what we wish for.
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