Investors are lying about the Federal Reserve. They are right to do so.
At first glance, and with a great deal of relativity, the updated summary of last week’s economic projections and President Jerome Powell’s comments mark a radical turnaround. Officials noted that rates could increase in 2023, earlier than previously telegraphed. And during his press conference, Powell acknowledged for the first time that inflation may turn out to be hotter and more persistent than the Fed has projected, not a small change for one person who has pushed the idea of transitory inflation, says Tom Porcelli. . Chief US Economist at RBC Capital Markets.
But when you step back, the Fed is still as dovish as ever. When the consumer price index stands at 5%, it is not aggressive to say that there is a possibility that the acceleration in prices will be faster and last longer than expected. It already is and already has.
Powell, like former Fed chiefs, told investors to take the so-called dot plot of officials’ economic projections with a big grain of salt. But to the extent that the points are useful for reading the internal debate, they still show that only three members changed their opinion on the rate hike in 2022, which is not enough to raise the forecast median of 0.125%. How aggressive can all of this be if, in total, the most skeptical members are thinking of increasing rates by 0.5% in 2023? Furthermore, the 2023 message from the dots goes against the Fed’s own updated economic forecasts. It still sees inflation just above 2% in 2022 and 2023, despite the new tolerance for above-target inflation. , and predicts a significant slowdown in growth after this year.
Stocks and bonds were initially sold on Wednesday after the Fed’s policy meeting, but recovered quickly. The
The index, packed with expensive growth stocks, closed just below an all-time high on Thursday and endured the brunt of Friday’s sell-off after St. Louis Fed Chairman James Bullard said he expects the first increase in late 2022 (Bullard is a voting member next year). Still, Friday’s dips are not a tantrum and the 10-year Treasury yield was lower on Friday than it was before the Fed news. More interesting still is how the overnight indexed swap has traded at 5 years / 5 years.
The 5-year / 5-year OIS captures investor expectations for the highest fed funds rate in the business cycle, says Joe LaVorgna, Natixis chief Americas economist. When long rates were selling earlier this year, the gauge rose to around 2.40%, he says, suggesting that traders assumed the next tightening cycle would broadly resemble the previous one. After the Fed meeting on Wednesday, the indicator returned 1.94%. As of press time on Friday, it was at 1.71%, the lowest performance since early February.
“We don’t believe you,” the futures market is effectively telling the Fed, “and it’s saying it loud and clear with a megaphone,” LaVorgna says.
Recent history has sided with the market, not legislators, he says. It points to the long-term equilibrium funds rate, which the Fed had to keep revising down amid a decline in the 5y / 5y OIS. Once thought to be around 4%, the long-term interest rate estimated by the Fed is now between 2% and 3%. The upper end of that range still seems too high if the 5-year / 5-year OIS is any guide.
It makes sense. The sensitivity of financial markets to monetary policy has never been higher. The Fed’s balance sheet has doubled since the end of the 2008 financial crisis, now 40% of gross domestic product. By buying massive amounts of bonds, the Fed has lowered rates and used asset prices, especially stocks, as a primary tool for monetary policy. That’s through the wealth effect, or the tendency of consumers (who account for two-thirds of gross domestic product) to spend more as their assets grow. Any correction in stock prices would negatively affect economic growth and therefore limit the Fed’s ability to adjust, logically.
Less discussed: The prospect of higher fiscal spending would in itself make it a difficult task to phase out bond purchases. The Fed has become such a dominant force in the bond market and would presumably need to keep buying additional debt as the Treasury incurs it. (The Biden administration has proposed a budget of $ 6 trillion for 2022).
That’s one part of the argument that the Fed won’t be able to adjust significantly. Another is the debt side of the economy. If the Fed was unable to raise rates above 2.5% during the last tightening cycle and had to cut rates in several meetings before the pandemic prompted its emergency actions early last year, why might it increase now? Since then, households, businesses, and the US federal government have taken on more debt.
“When an economy has a debt-to-GDP ratio of 100% or more and growth is driven by debt, it is very difficult to raise rates,” LaVorgna says. “The Fed is in a box and I don’t think I can get out of it.”
The result? Easy money is likely to flow well beyond 2023. For now, that would translate into continued stock market gains, especially in rate-sensitive areas like technology. What that means for the US economy is another question, and what it means for markets in the long run is another.
For LaVorgna, it probably all leads to what he calls secular stagnation. A euphemism, perhaps, for stagflation.
Investors worried about inflation remain just as worried. The Fed tiptoed to acknowledge that current policy doesn’t square with reality, but it didn’t really move the needle, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I’m someone who thinks the Fed has been going 200 miles per hour in a 50 mph speed zone. I saw Powell slow down to 175 “.
Boockvar remains long areas that hold up best during periods of rising inflation, including energy and agriculture stocks, precious metals, and Asian and European stocks. “Inflation is now a Main Street story,” he says. “I’m gritting my teeth and holding my ground.”
It also appears that the Fed will. You may not have a choice.
Write to Lisa Beilfuss at [email protected]