The Federal Reserve faces a tough task navigating between inflation and recession. By Simon Boughey.
There must be times when Jerome Powell wishes that last year’s campaign by progressive Democrats to derail his reappointment as Federal Reserve chair in favour of someone less pale, less male, and preferably both had succeeded.
His task is to sail the US economy through very turbulent seas, charting a course, if possible, between the Scylla and Charybdis of inflation and recession.
Prices rose by 8.5% over the course of the year to the end of March, according to first-quarter CPI. This was the most aggressive increase in the annual inflation rate seen since 1981 and followed the 7.9% increase recorded in the previous month. Clearly, inflation can no longer be termed transitory.
The Federal Reserve is consequently now very much in rate-hiking mode. It duly hiked by 50bp at the May FOMC meeting and 50bp increases are also expected in June and July. This would raise the overnight rate to 1.75% by mid-summer, but the central bank is likely to go quite a lot further than this.
“In our survey of clients, stagflation has been identified as one of the main risks. I think the Fed believes in neutral rates in the short term. What this means is that they have to hike to 3.25%–3.5% relatively quickly,” said Bruno Braizinha, a director in US rates strategy at Bank of America.
Other analysts are a little more conservative. “Powell indicated we should expect 50bp increases at each of the next two FOMC meetings, and we think the committee will revert back to 25bp hikes thereafter. This would leave the Fed funds rate at around 2.625% at year-end,” said Phoebe White, fixed income strategist at JP Morgan.
Though opinions vary, it would not be a surprise to see the Fed funds rate at 3% or more by the end of the year. And if inflation is not showing signs of cooperating, then additional hikes could be forthcoming in 2023. Indeed, it is not beyond the bounds of possibility that the Fed funds rate could hit 4% by the middle of 2023.
It is true that the Biden administration has been hit with a perfect storm of rampant resurgent post-pandemic demand meeting supply chain shortages. These have been exacerbated by geopolitical factors beyond its control such as the war in the Ukraine and recurrent new lockdowns in China.
But it seems unarguable that the White House’s fiscal policy during the last year and half played a significant role in the kindling of the fire. The US$1.9trn American Recovery Plan involved massive spending on infrastructure, enhanced unemployment relief and the small matter of another round of household stimulus payments.
"More than any other governmental measure, inflation has been attributable to the direct payments to households. That is pretty immediately inflationary,” said Ebrahim Rahbari, global head of foreign exchange analysis at Citigroup.
The Fed played its part as well. It initiated a new round of quantitative easing, with US$120bn of asset purchases a month and eased rates to zero. Accordingly, the balance sheet ballooned from US$4.31trn when the programme began in March 2020 to US$8.96trn in mid-April 2022.
However, not only did the Fed recognise inflationary pressures too late, and when it did tended to downplay them, the expansionary measures are difficult to reverse quickly. Like an oil tanker, the Fed needs a long time to turn round. The conclusion of quantitative easing was accelerated, but it could not be halted immediately for fear of spooking the market. So, even after inflation was a recognised and ineluctable fact, the Fed was still pumping billions of cash into the market every month.
It is perhaps, then, no wonder that having pulled out all the stops to reflate the economy, the central bank is now forced to pull out all the stops to stop inflation in its tracks. Asset purchases ended in March, but, in addition to rate increases, the Fed is likely to announce quantitative tightening at the next FOMC meeting. The policy reversal will thus be complete.
From QE to QT
“We expect quantitative tightening to be announced in May and to start in June, with an initial US$20bn per month for Treasuries and US$10bn per month for mortgages. This will be quickly increased to US$60bn for Treasuries and US$35bn for mortgages,” said Steven Zeng, US rates strategist at Deutsche Bank. Deutsche expects the run-off to continue to December 2023, by which time the balance sheet at the Fed will have shrunk substantially to US$7.45trn.
This takes the buyer of first resort out of the market, so the Treasury will have to place an increasing proportion of issuance with the private market. It will also have to issue enough debt to pay for redemptions as the Fed concentrates on shrinking the balance sheet.
For example, in November this year, US$110bn of Treasury debt matures; this will have to be funded. In February 2023, the redemption amount is US$130bn.
Moreover, if recession does begin to take hold, then Treasury receipts will diminish, increasing the deficit. The market is in a rising rate environment anyway, so the burden of the debt on the Treasury is increasing as well.
The ability of the private label market to absorb greater issuance in the absence of the Fed is already becoming a talking point among investors, say analysts.
“The pressure to be fiscally responsible will increase. This may help getting inflation under control but it will come at the expense of slower growth,” said Rahbari.
The problem is that by expending all this effort to get away from the yawning mouth of inflation, the US economy will sail straight into whirlpools of recession, in a repeat of the early 1980s. Indeed, the economy is looking quite a lot like the one that Paul Volcker inherited when he assumed the reins of office as Fed chair in 1979.
According to the Wu-Xia shadow rate, calculated by researchers at the Atlanta Fed, all this hiking, the end of QE and commencement of QT is equivalent to 13 synthetic rate rises. It is hard to see how that cannot have a deflationary impact.
Indeed, the chickens might be coming home to roost already. At the end of April, it was announced that first-quarter GDP had shrunk by 1.4%, representing what a clearly chagrined CNN described as “an absolute body blow to Democrats already reeling”.
President Biden addressed the recessionary concerns with characteristic cogency and clarity of thought, saying: "Well, I'm not concerned about recession. I mean, you're always concerned about recession, but the GDP, you know, fell to 1.4%."
But this is the dilemma in which Powell finds himself: to kill off inflation he was tardy to acknowledge, he needs to move fast and aggressively; but too fast and too aggressively could kill the economy.
Soft or hard landing?
Analysts are split on the right course of action. “The market is priced for the Fed to go to 3% at least. This is an overshoot. I’m not sure it makes sense for the Fed to overshoot to that magnitude. It isn’t clear to me that by crushing the US consumer you’re going to control inflation,” said Braizinha.
But others think that crushing demand is exactly the point. To slow the economy, you have to slow demand, and to slow demand, you have to raise the cost of borrowing. Bill Dudley, former head of the New York Fed, says that the Fed has to continue to raise rates until the market “cooperates”.
This cooperation could well take the form of a recession, with an accompanying collapse in equity values. “There will be no soft landing. This is what the Fed is trying to achieve, but given all the elevated risks around tightening monetary policy in this environment, achieving a soft landing will be very difficult,” said Zeng.
Once again, JP Morgan takes a more upbeat line. “A recession in the next 18 months or so is not in our forecast. In general, we think the economy is better positioned to handle higher policy rates, given high savings balances and a healthy corporate sector, and given that central banks globally are tightening policy, in contrast to the 2015–2018 cycle. So, we think a soft landing is possible,” said White.
For the first time in many years, sharp divisions of view and perspectives are discernible among analysts on Wall Street.
The Fed wants to land on the nirvana of neutral rates. But if inflation is more entrenched than it hopes, it will have to go beyond neutral. And then the whirlpools loom closer. Complicating the issue is doubt over where neutral actually resides. The Fed has not changed its view on neutral for most of the last decade, despite inflationary pressures, and still calculates neutral to be around 2.5%.
The yield curve has already begun to indicate recession might be on the cards. At the close on April 29, two-year notes were at 2.70%, while 10-year notes were yielding only 19bp wider. Five-year versus 10-year yields inverted briefly at the end of March. For the last half century, an inverted yield curve has accurately predicted a recession within 18 months.
Deutsche Bank forecasts two-year rates of 3.35% and10-year rates of 3.30% rates by year-end – the curve thus inverted by 5bp. It believes the 30-year long bond will yield 3.30%, meaning the 2s/30s curve will be inverted as well.
JP Morgan suggests the two-year will be at 2.90%, 10s at 2.85% and the long bond at 2.80%. So it predicts less of a sell-off but, crucially, also an inverted curve.
It looks as if time is running out for Chairman Powell. That narrow strait between Scylla and Charybdis is shrinking and the waters are getting choppier. Expert, and lucky, seamanship is required.
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