After more than twenty-five years of central bank support for financial markets, in times of even moderate distress, debate currently centers on the commitment the Federal Reserve has towards arresting the surge in consumer inflation in one single policy mission. History says this would most likely require official interest rates to be maintained above the real GDP rate for some meaningful timeframe.
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Moreover, inflation has never come down from north of 5% in the US without the Fed Funds rate rising above CPI, so unless CPI decelerates quickly from here, history suggests there will be no Fed ‘pivot’.
Whether or not the Fed will pivot at the first sign of economic or asset price duress is the key question. The challenge for the Fed (and other central banks) will be in convincing the markets that any absence of the “Fed Put” will be semi-permanent at the least. If they pivot too quickly and reverse course, it is very likely that asset markets will re-price higher inflation into global financial markets, thus impeding economic recovery that ultimately comes with low inflation.
Given the power of inflation psychology, this is important. Inflation psychology reflects an expectation of continual price increases, and moreover an almost resignation of increasing prices along all parts of the supply chain, down to the consumer. Not all constituents of the supply chain have equal pricing power, particularly in more inelastic industries such as food and energy.
To pivot would mean the Fed continually chasing its tail – releasing the monetary brakes at the first signs of declining inflation, then having to continuously re-apply them as inflation recovers. Economic growth would become more spasmodic, meaning both economic stagnation and consumer inflation continue to coexist in a more volatile economic environment, at the expense of economic growth potential.
Of even greater challenge to central banks is that the last time the global economy experienced such speed bumps, it was much less complex than it is today:
Ø Passive, or index investing distorts markets greatly today
Ø Zero interest rate policy has misallocated capital
Ø Capital expenditure into fossil fuels is barely existent
Ø Food and fertilizer shortages add to energy shortages
Ø Economies today are lightly regulated compared to the 1970s
Ø Globalisation is contracting today, whereas back then it was stable behind trade blocs
Ø Markets and economies are much more sensitive to liquidity conditions
Ø Credit quality is lower due to abundant liquidity and credit
Ø Unprecedented levels of public and private debt will be more difficult to refinance as interest rates increase
Ø The global economy has never been more sensitive to interest rates
Ø As interest rates increase, so too will the unrealised losses of central bank asset purchases, potentially limiting their future ability to intervene in markets
Ø Declining house prices in an inflationary environment impacting consumption and living standards
Ø Unemployment, as a lagging indicator, further restricting economic activity from a relatively low interest rate base
Ø Divergence between economics, politics and therefore trade conditions
Ø Increasing emphasis and expenditure on national security (this was already present during the Cold War)
Ø Supply chain reconfiguration
Ø Yield curves inverting at the outset of an interest rate tightening cycle
Ø Monetary policy outcomes are far more precise in declining interest rate environments than in tightening phases, especially when lower rates stimulated a leverage boom
Ø While the world in recent years has become more bifurcated between the major powers, globalisation means that increased interdependence will not easily or seamlessly be reversed
Ø Declining house prices means banks will need to recapitalize and increase provisioning
Ø Margin pressure weighing heavily on earnings and therefore price earnings ratios
Ø If debt becomes harder to roll over, companies may need to issue more equity at lower prices than they have been buying back equity
All of the above dynamics react with each other, but the key risk is that of policy error in such a complex set of interconnections.
But what might a policy error look like?
Given the Federal Reserve is leading global interest rate policy, US policy responses would appear to be the place most at risk of policy error at this point in time.
While predicting the future of such a complex adaptive system as the global economy is always flawed, a starting point might be to explore outer some parameters of policy, such as (i) a quick Fed “pivot”, (ii) a slow Fed pivot, and (iii) no Fed pivot.
Quick Fed Pivot
It is difficult (but not impossible) to imagine a scenario where the Fed capitulates on current policy direction within (say) a year or so of today. However, monetary policy over the past 25 years or so has been about lower lows and lower highs. So, what conditions might see such a scenario?
This would likely see an apocalyptic scenario, where asset markets crash following a Fed interest rate hike, the US economy entering a deep recession, and some form of credit crisis. All of which would be reflective of an economy which is far more sensitive to higher interest rates than the Fed might currently believe, based on their narrative. And the Fed was quick to respond to asset market crises in 2009 and 2020.
This time around, however, the fed would know that falling short of arresting current inflation rates would lead to persistently higher inflation. This would most likely lead to a “stop-start” economy, where the Fed is continually raising and easing interest rates. This of course would lead to a more volatile GDP.
Such economic uncertainty would mean higher risk premia, higher credit spreads and lower price/earnings ratios. With this higher tolerance of inflation, wages pressure would also likely increase, further compounding the Fed’s dilemma. Additionally, any market scepticism of the Fed’s commitment to arresting inflation might also see a form of bond market revolt.
Slow Fed Pivot
Should the Fed’s commitment to dealing with inflation last longer than a “quick pivot”, there are a lot more global macro issues to consider. As official interest rates are higher for longer, the likelihood of a deeper US recession also increases. It would also reflect a greater tolerance for lower asset prices. Savings rates would also increase, creating further pressure on economic growth.
Credit quality would also be under pressure, which would see wider credit spreads and increasing defaults. Ultimately, this would squeeze “zombie companies” that can only survive with ultra-low or zero interest rates, which would ultimately be a positive for optimal resource allocation. Creating a structurally lower inflation rate would also be favourable for resource allocation and real GDP growth. That said, supply-side interruptions in food and energy prices are less impacted by interest rate increases than other forms of consumption, meaning inflation might be more stubborn than the Fed might believe.
In the bigger global picture, higher official US interest rates for longer imply a stronger US dollar for longer. This will create pressure in emerging markets, as well as on those currencies that are pegged to the US dollar. In a geopolitical environment as volatile as today’s, such policy would add to the number of pressure points around the world, and increase the likelihood of a global recession.
The greatest challenge for the Fed under such a scenario is balancing their policy actions between leading and lagging economic indicators. It will require far more art than science in determining policy settings where unemployment is a lagging indicator in an unprecedented era of leverage. The US economy’s sensitivity to higher interest rates will only be knowable with hindsight, and reversing course in the event of deeper than expected economic malaise will not be as easy to achieve in a world with both demand-side and supply-side inflation.
No Fed Pivot
Such a scenario would be a Volker-like commitment to erasing inflation in one committed attack. In the late 1970s and early 1980s, this meant that official interest rates were set above the inflation rate until there was a convincing retracement in inflation. Today, that would mean US rates would need to be above 9%, and the resulting level yield curve inversion would be unprecedented, which would see credit conditions further contract.
Back then, this was akin to an economic reset. While the long-term benefits were significant, the ability of the US economy to withstand 9% interest rates today would be minimal without a great recession, or even depression taking hold. With an aging demographic, it is extremely difficult to imagine incumbent governments would be willing to risk the damage such conditions would have on the capital of retirees and those preparing for retirement. Especially given that the US is still around ten years away from peak baby boomer retirements.
Bankruptcies would skyrocket, as would unemployment. Bank lending would halt, as banks would need to recapitalize and increase provisioning in debt and equity conditions that would be unfavorable for capital issuance. Property foreclosures would be greater than in 2009, as the amount of mortgage debt is higher now than back then.
Such an environment would contrast greatly with the Global Financial Crisis, as the Fed, and by extension the US Government, would be allowing the insolvent to fail. Public unrest would be palpable, particularly if food and energy prices remain stubbornly high, and geopolitical tensions would also increase.
Which scenario is more likely?
Due to the immense economic strain that “no pivot” would put on the US economy, it is very difficult to imagine that the Fed will not pivot prior to inflation being irrevocably contained. In rising interest rate environments, politics and economics diverge, creating less predictable outcomes. But in the case of “no pivot”, the amount of economic destruction is probably the most predictable outcome of these three scenarios.
Therefore, it is a much safer route to have the option of reversing course, or even setting official interest rates at a “lower high” than a “no pivot” approach would necessitate.
The question would then become of where on the continuum between quick pivot and slow pivot the Fed begins to reduce official interest rates (or at least cease increasing them), while convincing asset markets that they are serious about managing inflation expectations. For the US Government, this will involve straddling their constituency’s increasing cost of living while not putting too much pressure on their retirement account balances.
Regardless of where the Fed rests on the timing of a policy pivot, the propensity for policy error remains high, and most likely will involve a higher inflation rate tolerance than the targeted 2% rate of recent years. Convincing the bond market that a higher inflation tolerance is a good thing will not be easy. Therefore, it is likely that the US economy will be more volatile than before, and potentially become a “stop-start” economy.
Given that China is already experiencing “stop-start” activity, Europe is entering winter with a severe energy shortage and Japan is defending its bond market at the expense of its currency, the four major economic regions of the world are less predictable than they have been for a very long time, and the pressures on each of them are accordingly greater.
If the Fed is willing to tolerate a higher level of inflation, the world will become a lot more volatile. And investment losses will be of a more permanent nature, as central banks cannot manage both inflation and corporate solvency.
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