In a leak to The Wall Street Journal earlier this month, the Federal Reserve no doubt believed they were adding clarity to the market situation. But in true Fed tradition, all they did was add confusion that will trouble markets for months to come, if not longer.
Let’s untangle the Fed’s latest web of miscommunication…
The leak appeared on May 31, under the byline of Nick Timiraos. He’s a good reporter, and he’s also the Fed’s designated leakmeister. This is the no-drama Fed. They want markets to know in advance what they’re doing so there are no shocks.
The Fed usually imposes a two-week blackout period on public comments by Fed officials regarding interest rate policy. So a May 31 leak was right on time. The substance of the leak was that the Fed would not raise interest rates at the June 14 FOMC meeting.
That was the extent of the clarity.
Everything Else Is Confusion
Markets were divided on what the Fed might do. There are strong arguments in favor of another rate hike. Last Tuesday, the May inflation data was released. Inflation is currently 4% year-over-year. That’s a big improvement from the 9.1% inflation rate recorded in June 2022, but it’s still a far cry from the Fed’s goal of 2.0% inflation.
The Fed’s mission is not accomplished. It will still take more monetary tightening to get the job done, but I’m sure the Fed was pleased to see that inflation fell from 4.9% in April to 4% in May.
There were equally strong arguments for hitting the pause button in June. Signs of recession are everywhere including inverted Treasury yield curves, declining real wages and a rising unemployment rate.
The ongoing banking crisis that began with Silicon Valley Bank on March 10 is not over. The danger is that the Fed would go too far, raise rates beyond the so-called terminal rate (where inflation comes down on its own without further rate hikes) and actually cause the recession it wants to prevent.
Until the Fed’s leak, I was leaning toward the view that the Fed would hike rates one more time. The Fed’s target rate right now is 5.25%. Another 0.25% rate hike would have pushed it up to 5.50%. Given the economic weakness, a 5.50% target rate would almost certainly be at or above the terminal rate.
Neither Pause nor Pivot
The Fed has given fair warning that a recession might result from its policy of monetary tightening, so a 5.50% terminal rate that happened to coincide with a recession should not have been unexpected. That combination of high rates and a recession would push inflation down to 2%, perhaps lower.
Then the Fed could rest for an extended period of time and let the economy adjust to a new world of positive real rates (where the nominal Fed rate is higher than inflation). That debate is over. The Fed paused in June. Inflation and the economy will take their course from there.
There were clearly voices inside the Fed who felt that the battle against inflation had not been won and further rate hikes were needed. To appease that group, the Fed’s leak made it clear that the Fed would skip the June rate hike but this was not the same as a “pause.”
Nor was it close to the “pivot” (to lower rates) that Wall Street has been predicting (incorrectly) for over a year.
You’re All Wrong
The Fed’s view was that they would not raise rates in June, but they were leaving open the possibility that they might raise rates at their July 26 meeting or even their meeting on Sept. 20.
Here’s a direct quote from the Timiraos article that summed up the situation: “Federal Reserve officials signaled they are increasingly likely to hold interest rates steady at their June meeting before preparing to raise them again later this summer.” (Emphasis added.) Got it?
In effect, the Fed was saying everyone was wrong. The group that expected the Fed to raise at least one more time in June was wrong. And the group that expected the Fed to pause in June and then pivot was also wrong. The Fed would skip June but prepare to raise rates again in July or September.
So there was no hike, no pause and no pivot. What we got is a “skip.”
Here’s the problem: The analysis behind the skip policy assumes either that the economy remains strong, inflation remains high and further rate hikes are needed or that the economy weakens, inflation comes down and the skip can turn into a pause.
The Plague of the Phillips Curve
This binary scenario assumes that a weak economy (and higher unemployment) means lower inflation and that a strong economy (and tight labor markets) means persistent high inflation. This analysis is based on the Phillips Curve, which equates low unemployment with high inflation and vice versa.
The flaw is that the Phillips Curve is a joke. You can draw a Phillips Curve with raw data but there is no correlation between unemployment and inflation. In the 1930s, we had high unemployment and low inflation (actually deflation).
In the early 1960s, we had low unemployment and low inflation. Beginning in the late 1960s we had low unemployment and higher inflation. In the late 1970s, we had high unemployment and high inflation. In the 2010s we were back to low unemployment and low inflation.
Anyone see a correlation there? There is no correlation. Unemployment and inflation are the result of complex dynamics and take their own courses, but they are not inversely related.
The Fed’s belief in the false Phillips Curve means they have missed the most dangerous outcome of all – high unemployment (due to recession) and high inflation (due to fiscal policy, expectations and asset bubbles).
This is known by the ugly name “stagflation.” If that case materializes, the Fed will face the worst possible outcome. They will need to raise rates to fight inflation even as the economy sinks into a severe recession.
The Ghost of Paul Volcker
If that scenario sounds familiar, it should. This is a repeat of the infamous Volcker Blunder of 1980. At that time, Paul Volcker had been raising rates to fight inflation since August 1979. A surprise recession emerged in early 1980. That recession had nothing to do with monetary policy but was the result of a stupid credit-related regulatory policy from the Carter White House.
Still, Volcker blinked and cut rates sharply to deal with the recession. Contrary to the Phillips Curve nonsense, unemployment rose but inflation roared back with a vengeance. It was at that point in late 1980 and 1981 that Volcker had to raise rates to 20% in order to snuff out inflation that had risen to 15%. The 1981–82 recession that followed was the worst since the Great Depression up until that time.
We could be watching a replay. The recession signs include not only those noted above but a fall in the ISM Services Employment Index from 50.8 to 49.2 and a fall in the ISM Manufacturing New Orders Index to 42.6 (anything under 50.0 shows contraction).
At the same time, inflation is stubborn. We’ll have to see if May’s decrease holds.
Markets and the Fed will be watching for new data to see which way the winds are blowing. Again, we’ll have to see what happens.
The ghost of Paul Volcker will be watching too.
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