Clear As Mud: The Fed’s Policy Announcement and the Coming Economic Landslide

Well I was honestly a little disappointed with the Fed’s decision this past week week and with Chair Powell’s press conference announcing the decision.  Along with pretty much every other economist I follow, I was expecting a .5 percent increase in the federal funds rate and an announcement that winding down the balance sheet had already begun and would continue.  This was my middle-of-the-road expectation (see my earlier column: What The FED Will Do and What It Will Mean).

Instead, Chair Powell announced a half point rate hike but explained that the wind down would only start in June and be smaller than pretty much everyone had expected.  Also, when asked during the Q&A whether the Fed would raise rates more in the future – for example by .75 points – he said “no” they currently didn’t have any such plans.  Of course, the policy committee can change its mind and he said they’d watch the data, but still this was a mixed, watered-down message.

To be clear, I think the Fed should have been doing .25 to .5 percent rate hikes since last summer. And I still think that they are behind the ball and will have to raise rates higher in the coming meetings because the +.5 they just did will be insufficient to slow inflation.

I’ll save my comments about the Fed’s balance sheet unwinding for another time, but the wishy-washy announcement about a mild unwinding was a strong sign of Fed caution.  Everyone watching felt like Chair Powell was hedging his bets and playing it too safe.

Two things then happened. First, the stock market rallied.  The basic interpretation of the rally is that the Fed didn’t go to the opposite extreme, raising rates more than a half point and committing to stronger balance sheet reductions.  So it was a sort of we-dodged-a-bullet rally.  Second, the stock market tanked the following two days and continued its decline today (Monday).

I don’t read much into the stock market. But my interpretation of the subsequent drop in markets is that everyone is realizing the easy money period is over yet inflation and the recession are still here, so rates are sure to rise by much more. It reminds one of the old Margaret Thatcher quip that “when you are in the middle of the road you get hit from both directions”. 

And that’s where the Fed seems to be today.  Inflation is still rising, interest rates are still higher, and the economy is slipping towards a recession.  The Fed looks weak.

My View

The Fed knows that their monetary framework works by raising interest rates to slow consumption and investment. This lowers demand for goods and services. Lower demand then lowers prices which is less inflation.   But less demand also means less jobs and hence higher unemployment. That’s how their framework functions. It’s not a secret.

Chair Powell however shied away from admitting this every time he was asked about the impact of the Fed’s rate hikes for the average American family.  He was asked how quickly families would see this rate hike helping them with inflation. He dodged that too.

The truth is, according to the Fed’s own models, the interest rate hike should be higher than it was in order to lower inflation. But higher would mean much more unemployment and a real recession.  He said repeatedly that the Fed wants to avoid that and instead aims for a soft landing.

My suspicion is that the Fed is worried about “supply side shocks” causing a recession no matter what the Fed does.  Those would be the higher oil prices, supply chain disruptions and other things due to Russia invading Ukraine, China’s Covid problems, etc.  Because the economy is running too fast and burning too hot, they know that some supply shocks might just slow the economy from hot to warm (soft landing).  But if there are supply shocks and big Fed rate hikes, that would take us from hot to cold (recession).

I think they are planning to let inflation run its course and the economy slow over the coming, say, 2 years. I also think this is dangerous.

My prediction is that, while possible, it’s very unlikely that this will happen.  Anything can happen in the meantime.  Additionally, those supply shortages will again lead to some price spikes in selected markets like commodities, for example. 

Real wages are falling like a rock for the first time in a long time because people’s actual wages are rising about 5% a year but prices are rising 8% (and maybe more soon) so we are losing 3% a year.  No wonder businesses want to hire. Real wage costs keep falling! 

Eventually that will mean less consumer buying power and will lead to a slowdown in demand.  But that’s a horrible and cruel way to slow the economy. It means we are letting the poorest among us suffer the most to get the economy to adjust back to normal after our policy makers intentionally pushed it to abnormal levels. It’s just mean, in my opinion.

Anyway, their bet is that inflation will fade slowly and the economy will slow and they can raise rates some. Even Powell, however, admitted that this sort of a soft landing was extremely difficult to pull off.

I think what will happen is this: Bond, stock and foreign exchange markets will react negatively. Government financing costs will rise as interest rates rise and this will cause political fighting.  Consumers will continue to suffer higher prices and worker will see falling real wages.

And then the supply shocks, war and all the other problems around the world today will still cause a recession anyway.  The result will be that by year’s end we’ll have a recession, higher interest rates and still have inflation. That is stagflation and it is about as painful a scenario as possible.

The sad thing is that it was totally preventable. The Fed should have slowed money growth last year and raised interest rates slowly last year.  We would have had mild inflation and no recession.  Every month they put off actually correcting course, the worse the correction will eventually be and they will lose all credibility. They have no idea how to deal with that.

The whole thing will turn on a dime. One minute we will seem okay. The next minute we’ll be into a recession before we notice what happened. 

Exactly when that happens, I don’t know. I was expecting it this summer, but it may be happening now.