Fed help isn’t coming | Financial Times
This article is an on-site version of our Unhedged newsletter. Sign Up here to receive the newsletter directly to your inbox every weekday
Good morning. It’s Katie again, who in turn replaces Rob as he sips piña coladas in his favorite Birkenstocks.
Last week I said that readers could say hello at email@example.com. I honestly didn’t expect you to do it. It made a really nice change from the crypto headbangers firing off capital only emails telling me to have fun to stay poor. You have been generous with your thoughts on ways to wind down Rob in his absence, with several of you urging me to praise the many benefits of ESG. Please keep in touch with me and/or with Ethan at firstname.lastname@example.org. Rob’s email is still open if you want to send him ESG press releases.
RIP Fed hopium
Understandably, a market heavily conditioned on central bank support can struggle to move forward. Seriously though, it’s time to put the “Fed pivot” idea to bed. It is over. Rounded. Jay Powell is not here to save your portfolio from disaster, even if you live and breathe strong technology stocks and a weak dollar. (Hello, SoftBank.)
To sum it up, some investors thought they saw a surge in the Federal Reserve in the middle of last month — half a hint that the central bank might cut inflation-fighting rate hikes. Fed speakers reacted quickly and came out one after another to tell the markets that they were wrong and that hopes/expectations for rate cuts as early as the start of next year were premature.
But the final, devastating blow came on Friday, with a monstrous report on nonfarm payrolls.
“Hands up, how many of you had 528K off, as your US payrolls guess?” Michael Every, strategist at Rabobank this week asked in a note. The answer: “No one, because the Bloomberg survey low was 50K and the high was 325K.” Yes, yes, Covid disruptions. Also, revisions. Still, “in short, the illusion of a Fed-dovish pivot has been dispelled”. He proposes adding the Fed’s pivot, in addition to the long-lost promise of “passing” inflation, to the dustbin of recent market history.
Get bets up another 75 basis points in September and some pretty extraordinary moves in the debt markets. Stocks have been fairly calm, but a 21bp rise in two-year yields is a big deal.
Is there anything that could change this supertanker? Goldman Sachs’ Jan Hatzius thinks Fed rate hikes could shrink from 75 basis points per meeting to a relatively modest half-point-a-pop if we see a slowdown in inflation. From his last note:
The most immediate reason for anticipating disinflation is the nearly 20 percent drop in gasoline retail prices since mid-June, which should continue. By itself, this drop should take at least 1 pp of the overall CPI level over the next 2-3 months.
Perhaps more importantly, improving supplier lead times and other supply chain measures are increasingly leading to slower PPI inflation and will soon show up in core commodity CPI as well. However, we remain concerned about lodging and other service prices. . . All in all, we expect a major slowdown in the outsized prints of the past two months, but it will likely take until early next year for sequential inflation to slow enough to convince the Fed to stop walking.
All this pulls me neatly to a new paper by Ricardo Reis at the London School of Economics, entitled “The Burst of High Inflation in 2021-22: How and Why Did We Get Here?” Read it.
The short answer to what went wrong is that policymakers had”some bad luck and some mistakes”. The slightly longer answer is fourfold:
Wrong diagnosis. “The sequence of supply shocks was all interpreted as temporary storage shocks as opposed to sustained changes in potential output. As a result, deliberately allowing inflation to overshoot its mark was considered optimal and desirable.”
Deadly assumptions. “The second cause was the firm belief that inflation expectations would remain anchored, as they had been for two decades. This belief led to reliance on surveys. . . to support this strong prior. Missing the drift of their anchor, central banks underestimate the persistence that inflation deviations from the target would have.”
Self believe. “Either through bad luck or by relying too much on past credibility, some of it has been lost, sparking an upward spiral of inflation as production surpassed potential.”
Fighting the last battle. “The Influence of Estimates of a Falling and Low” [neutral rate of interest] in the review of monetary policy frameworks. These led to a determination to fight low inflation, a greater tolerance for inflation above target, as well as a focus on stimulating the economy through aggregate demand. When inflation started to rise, it helped prevent it from being fought as vigorously as it otherwise would have been.”
It is early to write the history books about this episode and draw conclusions about how policy should evolve, as the paper acknowledges. But Reis also suggests that policymakers need to get back to basics, shout louder about inflation risks and act “forcefully” when they show up, even if it means activity slowing.
James Guppy, an investment analyst with the UK Pension Protection Fund, contacted us to say that a ‘walk until it hurts’ approach ‘is a bit like using dynamite to get a fish meal. It will work, but the collateral damage will be very real.” Mandate adjustments may be needed, he suggested, perhaps by breaking inflation down into the chunks that monetary policy can and cannot affect. Can central bankers really do something about energy prices?
But who is allowed to implement those mandate changes, and for what purpose? The UK, with the ‘race’ of Conservative party leaders now creeping torturously towards its incredibly predictable conclusion, could be the test case here as leading candidate Liz Truss has spoken in loose terms about the need to step up the role of the Bank of England to change.
“I want to change the Bank of England’s mandate to ensure it matches some of the most effective central banks in the world in controlling inflation in the future,” she said. Cryptic stuff.
Any suggestions? What would a serious discussion of a new BoE mandate mean for sterling and other asset prices in the UK? Send us your guesses.
Catching Katie’s Eye
A good read
A very curious story from Bloomberg: They left Goldman’s Star Trading team, then the bank sounded the alarm