Is the Fed making a drastic error?

Outlook: Today we get the University of Michigan consumer sentiment reading for January, likely a bummer. In addition to consumer spending, we get the PCE inflation number, always a bit lower than the CPI but still probably the highest in decades at about 5.8%. This will reinforce the outlook for Fed rate hikes, not that it needs any reinforcement. We also get the employment cost index, of fresh interest now that inflation is high, labor is in short supply and the logical conclusion is for a rise in labor costs. Eventually, this affects margins and possibly stock prices.

The cost index is quarterly. Last time it rose 1.3% q/q in Q3 from 0.7% the previous quarter, more than expected. The wages and salaries component rose 1.5% (from 0.9% in Q2) and the benefits component rose 0.9% (from 0.4%). See the chart from Trading Economics. The Q3 data is already a departure from the 10-year series and today could add even more. As predicted over the summer, labor’s newfound power is about to run headlong into the brick wall of stingy managers. In New York, the WSJ reports employers are now required to list the minimum and maximum salaries on job postings. Whoever heard of such a thing?!

The latest Reuters poll of economists on inflation is a doozy and has the power to fuel central banks re-thinking their forecasts and policies worldwide. “In the latest quarterly Reuters surveys of over 500 economists taken throughout January, economists raised their 2022 inflation forecasts for most of the 46 economies covered…. While price pressures are still expected to ease in 2023, the inflation outlook is much stickier than three months ago.”

This is persistent inflation, not the transitory kind, and it trims growth forecasts. After 5.8% growth in 2021, the world will get 4.3% growth in 2022, down from 4.5% predicted in October, in part because of higher interest rates and costs of living. Growth is seen slowing further to 3.6% and 3.2% the following two years.

Reuters quotes the Deutsche Bank chief economist: "The odds of an accident have risen and the likelihood of a soft landing in 2022 requires some favorable assumptions and a modicum of good luck." The growth outlook for over 60% of the 46 economies covered in the polls was either downgraded or left unchanged for 2022 and about 90% of respondents, 144 of 163, said there was a downside risk to their forecasts.

“This month's Reuters polls found 18 of 24 major central banks were expected to lift rates at least once this year, compared to 11 in the October poll.” The UK, US, and Canada–yes. Japan and the ECB, not this year, or not until near the end.

Is there a deduction to be made here on currencies? The Fed is the first big country central bank to sound the alarm. We had some squawks from Norway, Down Under, and Canada (with charming references to moral hazard), but the Fed stance now is the biggest, boldest and scariest. It should put the dollar at the front of the pack.

Upon consideration: We are converting to rapidly becoming consensus view of the Fed’s policy changes. It is a pivot and not a shift, and of historic proportions. We are coming to believe the dollar traders are right to buy and the stock market guys are right to sell because this Fed meeting was a game-changer. Evidently, we got snookered by the tame language and calm demeanor, which we now see as a tactical ploy. And we also see an additional factor that may be useful–that the Fed views the process as interactive and a great deal of the ambiguity and vagueness is an invitation to critics to offer feedback. This invitation aspect has been developing since Bernanke and may account for much of Powell’s demeanor.

First, everyone notes that Powell did not rule out multiple rate hikes. It was not only big bank nabobs calling for all those hikes but also a slew of Feds. Powell has to be ambiguous because the purpose of the press conference is to expand on what the meeting was about, not make up stuff the meeting didn’t address. But ambiguity is also a lure to get various fish to bite. And boy, did they bite!

The seemingly soft presentation was on purpose. It was shock and awe without seeming to be either. The Fed never wants to surprise. We cannot forget that the Fed spent a fortune on word-masters and public relations experts to come up with its own lexicon to promote “transparency” without making promises it may not be able to keep. This is because so many Fed-watchers are snotty, vicious nit-pickers poised to pounce on any stray word suggesting inconsistency. They have the mindset of a teenage video-gaming boy and without any appreciation that they are utterly unqualified to deliver the mail inside the Fed building, let alone make its decisions.

As the British say, they couldn’t lick Jay’s boots. We are so offended by their lack of civility that we may go overboard in the other direction to defend the Fed when some criticisms are worthy of consideration. But it’s unfair to criticize the Fed for things it doesn’t say in the spirit of “guidance” when the Fed is not the central bank of Turkey or Russia–it doesn’t dictate. A critical part of its job is to get approval from financial market players as well as the greater public–that’s the third mandate after controlling inflation and promoting employment–financial market stability.

Critics fail to see that it’s an interactive process, not a series of decisions made in a vacuum without consulting the affected parties. The Fed declares itself data-dependent, but it’s also participant and public opinion-dependent. Note that this approach was directed by former Fed chief Bernanke partly as a response to his predecessor’s deliberate obfuscation, the now much downgraded Greenspan, who famously said “If you understood me, I must have misspoken.”

In other words, restraint from specificity is deliberate. The Fed is seeking and heeding those snotty criticisms, fair or not. We imagine a group of Fed analysts making piles of commentaries, each ranked according to degree of agreement or approval of the latest Fed statements. You have to wonder what the categories must be! Inflation the new priority over employment is a no-brainer, but the timing of contracting the balance sheet is a tangled mess of conflicting interests. In the old days, that’s how members of Congress evaluated issues–one pile of snail-mail letters for agree and another for disagree. They literally weighed the piles of mail on the office scale.

The Fed probably has some Byzantine evaluation process to get its feedback, or maybe a Rube Goldberg machine. Anyway, the point is that critics fail to grasp that their comments are not brushed off, but rather evaluated (for self-interest, among other criteria) and added to one pile or another for possible input into the next round of Fed statements. They are not ignored. That means, unfortunately, we can’t ignore them, either.

And we choose to buy the now accepted viewpoint that Powell was hardly wimpy, as some critics said. Some analysts are yelling the Fed is making a drastic error. As for wimpiness, not everyone saw it that way. Quite the opposite–he kept coming back to the strong economy, tight labor market and high inflation. We reached out to first-class Fed watcher Steve Beckner at Mace News, whose book on the Fed is long in the tooth by now but stands as the model for how to write a book about the Fed.

Beckner agrees with the “exceptionally hawkish” viewpoint, in part because of the repetition of growth/tight labor/inflation and stressing that the economy is so much stronger than 2015 when it began to raise rates that the differences will affect the pace of policy adjustments. As an answer to whether hikes could come at every meeting, this is certainly suggestive. He used the same “very different economy” answer to whether 50 points is possible instead of the standard 25. Bloomberg has already latched on the 50 bp idea with a front-page story. It may be right.

Beckner see more than three hikes. He also thinks contracting the balance sheet is going to be a big deal, and not far off, either. The market was not expecting “principles” as early as this, and notes that Powell kept saying that the reductions would be “substantial.” So, shrinking the balance sheet can come earlier than expected, too, unlike last time, when the Fed took three years to go from dove to hawk.

Finally, Beckner warns we call it tightening but let’s not forget “the FOMC has a long way to go to get to any semblance of neutrality.” And this is a pearl of wisdom. We do forget that rates should not be zero, let alone negative. That violates the entire history of savings/capital accumulation. Try explaining negative rates to your Uncle Bill or the guy who reads your meter (i.e., regular people and not crazy financial types), and they throw up their hands in despair because zero and negative rates literally do not make sense. Maybe those six-hike types are just longing for the Real Normal and projecting their wishful thinking onto the Fed. If so, the Fed is listening.

About gold: We admit to being a bit of a gold bug, but not for it’s supposed protection against inflation (not since seeing a centuries-long chart in The Economist years ago debunking it). We like it because it’s unique–nothing else comes close–and it’s beautiful.

Many in the FX market like and watch gold, but some of the commentary and forecasts are so biased, it’s hard to untangle the factors. First, gold is not money. It has only one of the characteristics of money–store of wealth. It’s not a unit of account or a medium of exchange–you may list it on your loan application as an asset but the bank probably won’t consider it because it’s not liquid, and you can’t buy a loaf of bread with it. Talk of restoring the gold standard is stupid when US money supply is millions of multiples of its gold stock. (We keep daring the gold standard folks to explain the machinery of restoring the gold standard and they keep throwing out our emails.)

Here it is: as of Sept 2021, the US had 8,133.53 metric tons of gold in reserves. As of Jan 26, 2022, a metric ton was worth $59.32 million per ton. Multiply. The total comes to $482.48 billion. Okay, what’s money supply? Tricky question, but let’s take M3. In Nov 2021, that was $21.437 trillion.

Now let’s divide M3 money supply by the gold available. If we put the decimal point in the right place, we have gold enough to cover 2.25% of money supply. Some standard. Nobody should buy gold because the gold standard might get restored.

Demand for gold got a little chewed up by crypto, but demand is stable to rising for jewelry and industrial/tech applications. Where gold falls short is return–it doesn’t have any inherent return, and in fact has costs to store and insure. In a yield-seeking world, gold is a loser. But in a world at war, including civil war, severe political turmoil generating refugees, and some other dire outcomes, gold is king. (Diamonds are easier to carry but harder to get your hands on.) Think of the jewelry sewn into the dresses of the Tsar’s daughters.

So, you’d think impending war in Ukraine would lift the price of gold–but it didn’t, not in the face of the Fed all but promising rate hikes. And that’s when the rate hikes are not even expected to result in a positive real return in the bond market. Gold is supposed to be a hedge against crises, if not against inflation, but this outcome suggests we don’t have a crisis. It’s a severe blow to gold and suggests that (1) the probability of war in Ukraine (or civil war in the US) is low and (2) the potential buyers of gold would rather wait for assets with any yield, even a still-negative yield on the inflation-adjusted basis. The one asset that can deliver a real return is equities. And gold's failure to rise means investors and traders believe in the stock market recovery.

In fact, gold is pretty expensive now. Periodically the financial press trots out the gold/inflation story. See the chart from the WSJ in Aug 2021 (by the always-worthy Mark Hulbert). He points out “Even though the price of gold is 50 times as high as in 1971, stocks have performed even better. The S&P 500 has produced an annualized return of 11.2% since August 1971, assuming dividends were reinvested along the way. That compares with 8.2% annualized for gold.

“Furthermore, the only reason gold came even this close to matching stocks over the past 50 years was its huge return during the first decade following Nixon’s announcement. Take away that decade, and gold has lagged behind even intermediate-term Treasury notes. Over the past 40 years, gold has risen at a 3.6% annualized rate, compared with 12.2% for the S&P 500 and 8.2% for the Treasurys.”

Bottom line–for gold to falter and fall this year is a foregone conclusion (in the absence of a crisis) and don’t blame the Fed–it’s gold’s mojo, given the broad market’s preference for higher returns, however beautiful gold may be.

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This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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