Oh dear, what can the matter be?
It’s the morning after the night before. On Wednesday evening the US Federal Reserve concluded its two-day FOMC meeting and raised their key Fed funds rate by 75 basis points. This was as expected, but only thanks to a last-minute leak to the Wall Street Journal. Prior to that, the consensus expectation was that the US central bank would raise rates by 50 basis points and signal that it would repeat this move following its July meeting. While Fed Chairman Jerome Powell insisted that future 75 basis point rate hikes would not be common, the markets aren’t convinced. Now the expectation is that the Fed will hike by another 75 basis points next month.
If there’s one thing this tells us, it’s that the members of the Federal Open Market Committee (FOMC) are admitting that they got things wrong. Having to rush out a three-quarter point rise (the first since 1994) and leak it to the media in the hope that it wouldn’t cause equity and bond markets to crash, is a desperate measure. The Fed has been wrong-footed in spectacular style, and they in turn are responsible for misleading investors. Of course, it’s fair to say that the central bank lost its credibility years ago. Perhaps we shouldn’t scapegoat Chairman Powell given the Fed’s long history of egregious policy errors. But he’s the current incumbent so he must carry the can for mistakes made under his tenure. The most obvious was his reluctance to accept that inflation was anything other than transitory. Most commentators have been saying for over a year that inflation was rising at a dangerous rate. But they were ignored as the hundreds of central bank Ph.D. economists insisted that their models were correct and that investors were wrong to trust the evidence under their noses.
Learn from your mistakes
To my mind, Powell’s other major policy error is repeating the mistake he made a few years back in raising rates while simultaneously reducing the Federal Reserve’s balance sheet. The problem back then was that it was impossible to untangle the two actions thereby confirming which of them was working and in what way in normalising market conditions. Ultimately investors decided that this double-barrelled approach was both unwieldy and dangerous. Their response was to bail out of equities in a move which saw the S&P 500 lose 20% in the three months between September 2018 and the end of that year. Just think about that. That’s the same loss that we’re seeing today in half the time. Eventually Jerome Powell woke up. In January 2019 he signalled that monetary tightening was over, and by the summer the Fed was back to cutting rates again. Given this prior history, it’s rather surprising that Powell’s Fed would want to repeat the process. But here it is again: raising rates while simultaneously ready to start cutting its balance sheet. What could possibly go wrong?
Well, one answer is that the Fed’s new-found aggressive hawkishness could end up crashing the markets. It could be that despite the sell-off since the beginning of this year, the declines have only just started. Alternatively, one could argue that the market has made its move. By thinking back to 2018, investors have anticipated the Fed’s repeat of its policy mistake rather than reacted after the event. That could mean we’re closer to the bottom than the bears believe. The trouble is that inflation wasn’t an issue back then. All the Fed was trying to do was ‘normalise’ the situation given the zero/negative rate policy and quantitative easing that followed the Great Financial Crisis. Back then, Powell was able to ‘reverse ferret’ in response to the signals the markets were giving him. Now the Fed must continue to hike for as long as inflation heads higher. But if investors see any signs that price rises have peaked, that may be a sign that the worst is over.
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