In the last week of March 2022, the Federal Reserve revealed a regime change in their policy. The Fed moved from balancing jobs and inflation and being patient to a new policy of aggressively raising rates in order to fight inflation, regardless of its impact on the economy.
On March 16, 2022 the Fed raised rates for the first time in several years 25bps. The move was well broadcast and expected by markets for many months. Many critics of the Fed have complained the Fed has waited too long to raise rates. In 2020 the Fed lowered rates and engaged in massive quantitative easing (“QE”) in order to pull the economy out of the recession that resulted from the COVID shutdown.
On Monday March 20, 2022, Chair Powell appeared at the NABE (National Association for Business Economics) conference; his comments revealed a clear change in priorities at the Fed, and some insight to policy going forward. (1) In his statement he shares that “Supply chains are healing, but we are now seeing new COVID related supply disruption from China. The healing will come in time as the world settles into a new normal, but the timing and scope of that relief are highly uncertain. In the meantime, the Fed will be focused on trying to reduce price pressures.
As the magnitude and persistence of inflation became more clear at the end of 2021, the FOMC pivoted to less accommodative monetary policy. I believe these policy actions, and those to come, will help bring inflation down to 2% over the next 3 years.“
“Events of the last 4 weeks remind us that in tumultuous times what seems the most likely scenario can change quite quickly.”
“We have the necessary tools and will use them to restore price stability.”
During a Q&A session following this speech Powell shared more insights.
“Wage increases need to be sustainable, meaning within the 2% inflation framework.” He added, “In order to have a strong labor market, you need price stability and that’s why we are currently focused on inflation.”
When asked what would prevent the Fed from raising rates 50bp in May, 2022, Powell shrugged and said “Nothing.” While the crowd laughed at his bluntness, his manner and seriousness were telling.
Such a change in how aggressive Fed policy is going forward is dramatic.
Powell explained, “Many things other than monetary policy can work to reduce inflation. I would point to a slowing in growth from the reopening of the economy, I would point to waning fiscal policy, I would point to the possibility of supply chain improvements, for example in the vehicle sector. There is some evidence of improvement on supply chains. So, all of those things can help. It’s not necessary for the Fed to do 100% of the work.”
Powell added, “But, we are not conducting policy now with the expectation that we will see significant near term progress; we are going to be looking for actual progress at this point.”
“I don’t see the likelihood that the chance of recession in the next year is elevated, I say that because the economy is very, very strong; I would point to growth and to the strength of the labor market. I think its an economy that can handle less accommodative monetary policy.”
“This is a labor market that’s out of balance… we have an excess of demand over supply. We have 5 million openings in excess of employment at this time. Wages are at 40-year highs. The labor market is great for workers, but we need it to be ‘sustainably tight’. It has to be tight with 2% inflation over time. Things would be more sustainable if demand were brought back in line with supply.”
This is an ominous warning to workers that the Fed change in policy will seek to eliminate some of those 5 million excess openings, but as central bank officials always say… ‘Monetary policy is a blunt instrument.’ The damage to the economy could manifest in ways that are more widespread and not entirely clear.
Powell was asked if better productivity can help “Productivity is not forecastable with confidence. It just happens when it wants to happen. We all wish for more productivity, and its great to see more productivity, but forecasters tend to believe that productivity will migrate back to the long-term trend of 1.5% over time. You can make the case that with the labor shortage there will be a lot of investment into improving productivity… reinvestment into automation to replace human labor, or to compliment human labor. I do think that will be especially true of service industries that are public facing.”
When asked if the Fed would consider raising the Long Term inflation target from 2% to 3% to allow inflation to run hotter and allow a soft landing. Powell stated bluntly and emphatically, “No, that’s not something we are looking at. I think… no.”
Powell was asked, If the economy enters recession and inflation remains stubbornly high, are you willing to maintain tight policy and prolong a downturn to achieve price stability? Powell responded, “We are very committed to restoring price stability and that is the thing that allows us to pursue a strong labor market in the face of a strong downturn. The world we have been in for 25 years has been one where you can go really hard to support the economy when it weakened, because you knew inflation expectations were anchored… Because you knew inflation would stay under control. For the first time in a very long time we have high inflation, and we know that we need to restore that.”
This sounds very much like the Fed under Chairman Paul Volker in the early 1980’s.
During the week other Fed officials revealed they were on the same page with Chair Powell and the Fed was committed to battle inflation. (4)
“If we need to do 50, that is what we’ll do,” San Francisco Fed President Mary Daly told Bloomberg. “We’re prepared to do whatever it takes to ensure that we get price stability, which clearly no one thinks we have right now.”
Cleveland Fed President Loretta Mester, who favors raising rates to 2.5% this year, said earlier Wednesday that the Fed will “need to do some 50 basis-point moves” to get there. “I don’t want to presuppose every meeting from here to July, but I do think we need to be more aggressive earlier rather than later.”
James Bullard of the St. Louis Fed and longtime hawk argued, “We have to think bigger maybe than we have in the past… The committee will have to make sure we maintain credibility on our inflation target.”
Patrick Harker of the Philadelphia Fed added his voice, saying “I am very open to going faster” depending on the data. “Given the level of uncertainty that we are facing in this economy, I wouldn’t take 50 basis points off the table for the next meeting. I am not committing to that right now.” (5)
However, raising interest rates aggressively could have negative consequences for the economy as a whole…
Former Fed official Bill Dudley stated in an interview “the soft landing chances are “very remote”. The Fed has made a US recession inevitable.” (3)
Dudley foresaw the present situation in June 2021 when he wrote:
“This means monetary policy will remain loose until overheating begins – and cooling things off will require the Fed to increase interest rates much faster and further than it would if it started raising rates sooner. […] The delay in lifting off, for example, is likely to push the unemployment rate considerably below the level consistent with stable inflation, increasing the odds that the Fed will need to tighten sufficiently to push the unemployment rate back up by more than 0.5 percentage point. Over the past 75 years, every time the unemployment rate has moved up this much, a full-blown recession has occurred.”
This, he explains, is exactly what’s happened.
Dudley explains, “To create sufficient economic slack to restrain inflation, the Fed will have to tighten enough to push the unemployment rate higher.”
On Bloomberg Friday March 25, 2022 Jim Bianco (Bianco Research CEO) shared a stunning insight. “In the United States we are probably looking at dramatically higher prices from here. We were seeing slowing in the economy even before the war started and that’s only going to exacerbate it.” (2)
“Growth is not the priority of the Fed anymore… it is inflation, and they are going to hike, and hike, and hike until the inflation rate comes down. And if they are going to risk a recession, they are going to risk a recession. Chair Powell has already said there is 1.8 jobs for every unemployed person. 40% of Americans have $1000 in savings and are renting… they are getting killed by inflation. The Fed hears this… they hear it loud and clear.”
In the same interview, Jon Ferro asked Victoria Greene (G squared CIO) about the possibility of recession. She explained “I don’t think Europe will avoid recession and I don’t think we will avoid it here. I think if you look at all the price pressures, the world is getting smaller, it’s going to be harder to grow… the situation in Ukraine is going to pour more fuel on inflation.”
“You are going to see a more dower outlook. You will see more margin pressure… inflation is going to bite almost every sector around. How are you going to get multiple expansion, how are you going to grow in this economy when you are feeling the pricing pressures from labor and inflation? I don’t like where this market is going at all.”
“I think the Fed is going to do 50bp; why wouldn’t they? Inflation is going to be absolutely insane for March. An off the charts number… look at gas prices, food prices, used cars, new cars, all of these areas haven’t seen any relief… It’s gonna be the end of easy money and it might be a harder road to go.”
“When expectation and reality don’t line up you see the most equity shock. Bull markets are killed by policy error, and this is shaping up to be a big one.”
In an interview, Mohamed El-Erian of Cambridge Queens College and former PIMCO CEO added his voice of caution. (6)
“The Fed is increasingly being forced to consider what is the least bad policy mistake it wishes to be remembered for: meeting its inflation target by causing a recession, or allowing high and potentially destabilizing inflation to persist well into 2023.”
Bond yields moved up dramatically after the Fed meeting. “These are massive moves and this is disorderly. The Fed will end up breaking something in the economy. The Fed making a mistake is a high probability… inflation is 8% and may well go to 10%. We are going to see a depression in Ukraine and Russia, we will see a recession in Europe, we will see stagflation in the US. The markets haven’t priced this in…”
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