Powell’s Interest-rate Antibiotics Could Succeed
There has been renewed speculation in recent days about the U.S. Federal Reserve’s commitment to its rate-hiking cycle. Fed Chair Jerome Powell has been unwavering in his clear message that the beatings will continue until discipline improves: In August he said rates could keep going up “for some time”, and in early September that hikes would continue “until the job is done.”
That job, of course, is to get inflation back down to the Fed’s 2% target range, from the 8.3% consumer price index reading in mid-September. That print saw the curve bending further downward from the peak reading of 9.1% in June. (The next CPI report will come Oct. 13.)
I’ve seen a handful of optimists speculate that we could bend the curve so fast that we’d wind up seeing rates drop back down again in 2023. That includes more than a few cryptocurrency speculators who would love a rate cut, which would send capital back into “risk-on” mode and likely juice (highly speculative) token prices. But the idea that we’ll actually whip inflation that fast strikes me as verging on delusion – or what we in the cryptoverse call “hopium.”
What’s more interesting are the growing signs that rate hikes are slowing down the real economy, and tentative voices from within the Fed itself that suggest some (very mild) resistance to Powell’s unwavering rate-hiking agenda. This has been seized on by the hopeful, who would love to see Powell reinstate the Alan Greenspan-era “Fed put” after staggering stock market losses. Such a reversal still seems, at best, optimistic.
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The flavors of hopium: A soft landing or a Powell capitulation?
The hopeful narrative does correctly identify the horns of the Fed’s dilemma: To bring inflation down, a central bank must by definition tighten the money supply to shrink both asset prices and the economy. The question is whether rate hikes can cure inflation with a sharp dose of interest-rate antibiotics that leave the economy healthy, or if Powell is committed to more radical measures that could risk killing the patient.
For now, within the U.S., rising interest rates haven’t proven fatal. Consumer spending, one of Powell’s main targets, remains relatively solid. Unemployment reached a historically low 3.5% in September. Lots of jobs are going unfilled.
Of course, that means different things to different people. While they’re good for workers, sticky unemployment and wages are one of the core factors making the Fed’s efforts to tackle inflation difficult. Here, as with supply chains, COVID-19 is the culprit. Wages and employment remain high largely because labor force participation is still 1% below February 2020 levels, thanks to factors from early retirement to long COVID. Raising interest rates isn’t going to counter those forces.
Outside of the U.S., things look far grimmer – and U.S. interest rates are exacerbating those worries, particularly through devastating drops in dollar exchange rates worldwide. On Thursday morning, the managing director of the International Monetary Fund announced a pending downward revision in its global economic forecast. The United Nations issued a similar warning just a few days before. It’s not the Fed’s job to directly concern itself with international impacts, but a global slump could in turn slow the U.S. economy, so these signals must have some amount of resonance.
If you really squint, maybe you can connect those dots to a speech last week by Fed Vice Chair Leal Brainard that some saw as at least slightly more dovish than Powell’s party line. Among other points, Brainard warned that the effect of rate hikes can take time to reach the real economy.
From one angle, that might be a sotto voce call for caution in near-future hikes because impacts of the high-G launch from 0.25% in March to 3.5% by late September have almost certainly not fully trickled down yet. Of course, if you’re reading Brainard’s statement from Main Street, your takeaway might be a little more visceral: Hang on tight, things could get worse.
One looming X-factor is Europe’s possibly imminent energy crisis. With Russian oil largely inaccessible, winter could bring huge electric bills or productivity cuts, or both. The recent upheaval in U.K. bond markets has been cited as another sign of financial markets pushed to the brink by rising global rates – though you could also look at Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng’s ideological pipe-bomb of a fiscal policy agenda and see a quite inverse lesson about the value of predictability.
Regardless, one might argue that international markets are poised to do a bit of the Fed’s work for it: a more expensive dollar and an international recession could help U.S. inflation by pushing import prices down, and the U.S. is very import dependent.
More money, more problems
These and other factors, along with the drops we’ve already seen in U.S. inflation, could be interpreted as part of the case for Powell to pause rate hikes. The time-lag element of inflation measurement makes it all even more nerve-wracking because responding to lagging indicators could lead to an overreaction and an excessive economic contraction – a cure that kills the patient. (Analyst Omair Sharif recently made a particularly important point about the risk that lagging health care cost measurement is currently distorting CPI upward.)
But the simple truth is that 8.1% is still way, way above 2%. And there remain signs in the real economy that there’s room to tighten – including, like it or not, in crypto.
Venture capitalists are still betting big on cryptocurrency and blockchain, despite growing competition from lower-risk bonds for marginal dollars. Crypto VC hit record levels in the first quarter of this year, before the extent of the crypto crash was clear and with interest rate hikes barely started. But the crash and further hikes didn’t scare them off: In the second quarter, crypto VC declined only slightly from that record high. I heard anecdotal signs of continued strength in VC numbers when I was at Messari’s Mainnet conference last month, and funding announcements for individual projects are continuing at a breakneck pace.
This is certainly great for crypto, and suggests deep faith in the sector among professional investors. But if you’re Jerome Powell, it all goes into one big pool called “speculative investing” that you might consider a proxy for excess funds sloshing around the economy.
The catch is that those funds also represent jobs, and even if Powell could target monetary tightening only to certain sectors or uses (which he can’t), he’d still be slowing down the economy. The real question is whether that slowdown can happen without either broad immiseration, or the kind of chaotic unwind that made the 2008 financial crisis so terrifying.
So far, the good news is that cooling both the U.S. and global economies has been, at a high level, a relatively gentle process. Even the sharp turmoil in U.K. bonds over the past week didn’t lead to credit or liquidity freezes in bond markets there, as analyst Toby Nangle told Bloomberg’s Odd Lots team. Former New York Fed President William Dudley told the Wall Street Journal that “so far, there haven’t been any really bad surprises.”
That is (again, so far) a vindication for reforms that strengthened bank capital requirements and other financial backstops after 2008. Those protections have meant air could be let out of the tires gently. On some level it’s remarkable, perhaps even an achievement, that the S&P 500 has declined nearly 25% since the start of the year without a frightening number of financial blowups or corporate bankruptcies.
On the other hand, it’s an open question just how much confidence we should gain from the lack of catastrophe “so far.” The battle against inflation is far from over. Arguably, it has barely begun. Gentle economic declines can become sudden, vacuumous sinkholes without much warning – and the risks that really matter are the ones that are hidden from talking heads like me. Otherwise, they wouldn't really be risks.
But while it’s reasonable to have some anxiety about a Fed overcorrection, it’s important to remember that the same mechanism that’s reining in the economy is creating headroom for revitalizing it if things do go south. While persistent inflation would make the decision much dicier, a Fed rate at 3.5% also means we now have a lot of room to lower rates to fight a future recession. That’s another way to think about Jerome Powell’s persistence: As he fights inflation today, he’s also storing up basis points for winter.