Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D
“Yet knowing how way leads on to way, I doubted if I should ever come back. I took the one less traveled by, and that has made all the difference.”
– Jack London, “The Road Not Taken”
The highly anticipated Federal Reserve (“Fed”) March Meeting takes place later this week where the market may finally see its first rate hike since the onset of the global pandemic when the Fed lowered its benchmark overnight interest rate to 0% and embarked on an aggressive quantitative easing program, resulting in a $9 trillion balance sheet filled with U.S. Treasuries and Mortgage-Backed Securities. So, at the risk of running with two well-worn tropes (Jack London’s “Road Not Taken” and Homer’s “The Odyssey”), we discuss the challenges and possible surprises awaiting us at this week’s Fed meeting. This article also comes with the disclaimer that the macro and geopolitical environment remains especially fluid – in other words, this article can become irrelevant (or in social media parlance – ‘not aging well’) should Russia escalate its attacks (i.e. direct military threats to NATO) or Western sanctions imposed on other countries (i.e. China and India).
Figure 1 displays the Fed’s main road for its upcoming rate hike travels – the expected rate hike projections over the next year. Fed Funds Futures are pricing in a 0.25% rate hike at the upcoming March meeting that will kick off a tightening campaign expected to produce approximately seven rate hikes by the end of 2022. This would take the benchmark overnight lending rate from 0% to 1.75% by year-end. The Fed is also expected to provide more clarity on plans to pare back its balance sheet through maturity run-offs and outright sales that will likely lead to a decrease in bank deposits held at the Fed. Barring a major escalation in the Russia/Ukraine conflict, the market expects few surprises at the March meeting, whether in policy decisions or in forward comments following the meeting.
Figure 1 – 0.25% Rate Hike Locked in For Fed March Meeting But an Additional 0.50% Rate Hike at the Next Meeting May Not Be Out of the Question
Source: Bloomberg WIRP (3/14/2022)
However, given the challenging environment of supply-driven inflation (aka supply chain shortages exasperated further by Russia/Ukraine conflict) and post-pandemic driven demand for goods and services, world central banks find themselves in a bind as to how best to stay ahead of inflationary pressures without pushing the world economy into recession in reaction to such tighter monetary policies. Raise rates too fast and you could tighten financial conditions (Figure 2) too much that could cause the global economy to seize up. But world central bank policies are falling further behind the inflation curve as the ‘transitory’ timetable for high inflation keeps getting extended, helping to harden longer-term expectations of higher inflation (Figure 3) via wage-price spirals.
Figure 2 – Tighter Financial Conditions (the ‘Charybdis’ of the Fed’s Rate Hike Odyssey) Already Threaten a Fragile Economic Recovery
Source: Bloomberg (3/14/2022)
Figure 3 – From ‘Transitory’ to ‘Hardening’ as Short-Term Inflation Expectations Seep Into Long-Term Expectations (the ‘Scylla’ of the Fed’s Rate Hike Odyssey)
And courtesy of Northern Trust (Economic Weekly Update 3/14/2022), the Russia/Ukraine conflict is producing a major price spike in raw materials and foodstuffs (Figure 4) where this region serves as the major exporter, with the emerging markets expected to bear the brunt of the resulting inflation spike versus developed markets. It goes without saying that the conflict will only complicate central bank efforts to tighten policy.
Figure 4 – Distinguishing Between Commodities Directly Affected by Russia/Ukraine Conflict Versus All Non-Oil Commodities
The First ‘2nd’ Road (The Transition Road)
This leads us to our postulation of a 2nd road (actually two ‘2nd’ roads) for the Fed to take at the March meeting. One alternative ‘surprise’ action would entail leaving the benchmark rate at 0% but accelerate the balance sheet reduction via outright sales (as opposed to run-off of maturing securities). The Federal Reserve is a model-driven institution where its researchers have reams of econometric data on the impact of interest rates across different inflation regimes but lack similar data on the impact from quantitative easing. The Fed would likely be more confident modeling the impact of higher interest rates than on the impact of a meaningful reduction in its balance sheet – the only other episode of such a reduction occurred back in 2018 during the height of the U.S./China trade conflict. This episode produced a vomit-induced sell-off in equity and credit that it forced the Fed to backtrack both rate hikes and balance sheet reduction in the subsequent year prior to the COVID pandemic shutdowns.
But using the backdrop of the Ukraine/Russia conflict, the Fed could cite geopolitical uncertainty as an excuse to delay rate hikes so as not to exasperate the tightening financial conditions referenced above. This would better enable the Fed to ‘ease’ the quantitative tightening transition while maintaining a low interest rate policy. Reducing the balance sheet would likely see a reduction in bank deposits held at the Fed, which could result in higher interest rates for longer maturity U.S. Treasuries and mortgage-backed securities. Apart from higher interest rates, it is less clear how a reduction in bank deposits at the Fed would manifest itself across the financial liquidity food chain (an issue hotly debated among Fed watchers in the Twitter sphere). Hence, why it would be conducive for the Fed to baby step its rollback of quantitative easing taken during the height of the pandemic, especially if such a rollback helps address higher inflation (by raising long-term interest rates) while keeping short-term rates low in the event there is an immediate need for liquidity.
The Other ‘2nd’ Road (Albeit a Much Rockier Road)
However, we believe a bolder approach would be for the Fed to surprise the markets with a 0.50% rate hike, or a 0.25% hike at the March meeting followed by a strong warning to expect an inter-meeting 0.25% rate hike. The markets generally do not like ‘Fed’ surprises (the last series having occurred in 1994 which led to major blow-ups in mortgage derivatives, the Asian debt crisis in 1997 and the Russian debt crisis in 1998 followed by the collapse of Long-Term Capital Management).
As unlikely and unpopular as this policy option would be (Fed Chair Jerome Powell pretty much ruled out a 0.50% rate hike at the January congressional testimony), it is an option the Fed may need to strongly consider, nonetheless. Writing for Bloomberg Opinion (“Fighting Inflation May Require the Fed to Be Brutal”), Clive Crook arrives at a similar conclusion that persistently higher inflation will force the Fed to act more aggressively, regardless of the economic and market consequences. Even though long-term inflation expectations remain anchored around 2-3%, those expectations have crept higher as ‘transitory’ inflation, caused by supply chain shortages and post-pandemic demand, extends beyond what economists and businesses have expected. As Crook writes,
“Here’s the problem: At some point, successive episodes of transitory inflation start to feel a lot like persistent inflation. Workers and employers might get used to it — and adapt by building higher inflation into their wage demands and pricing decisions. That would make it more persistent still. In due course, to get inflation back down, the Fed might need to tighten aggressively after all — perhaps, as in the 1980s, by enough to induce a recession. If it comes to this, would the Fed be willing to do what’s required?”
Crook goes on to argue that the “anchoring” of long-term expectations will begin to lose its power if the Fed loses market confidence as an inflation-fighter (similar to what happened to the Arthur Burns chaired Fed of the 1970s). Indeed, one could argue that the successor chair, Paul Volker, was compelled to raise interest rates to double digit levels, not only to restore confidence in the Fed at the cost of an economic recession, but also to restore exchange value to the U.S. dollar which had become quasi-tied to oil prices (for an excellent retrospective argument for how the U.S. dollar became the petrodollar – listen to the Grant Williams’ podcast interview with Luke Gromen).
Even if one could argue that 0.50% rate hike would be meaningless in the face of inflationary pressures that are both cost-push and demand-pull, consider the tangible and psychological impacts of what a surprise 0.50% rate hike could have:
- Pullback in commodity prices as the U.S. dollar becomes more competitive as a store of value.
- A strong U.S. dollar could add more ‘oomph’ to Western-imposed sanctions on Russia following the invasion of Ukraine.
- Demonstrate to the world the US is serious about inflation as inflation has supplanted COVID and market volatility as the primary political risk heading into the 2022 midterms.
In theory, the Fed should be able to look past short-term inflation pressures as ‘noise’ whose imbalances will eventually work themselves out, but we’re in a different time where this generation of consumers are not used to experiencing double digit spikes in basic essentials (food, energy). Consumers experience this most acutely at the gas pump (Figure 5), as gas prices serve as a layperson’s view of inflationary pressures, as opposed to ‘core’ inflation preferred by the Fed and mainstream economists. Higher inflation is driving a downbeat view of expected inflation-adjusted income (Figure 6) – a lower consumer appetite may induce a pullback in post-pandemic demand, but not necessarily for basic essentials, which are less price elastic.
Figure 5 – Higher Gas Prices Present the ‘Headline’ Challenge for Central Bank Efforts to Stay Ahead of Inflation
Figure 6 – Downbeat Consumer Sentiment Driven by Downbeat Expectations of Inflation-Adjusted Income
Of course, central bank policy tends to have a greater impact on ‘demand’ whether in goods and services or in financing, with little effect on ‘supply’ which is more influenced by the business considerations such as return on capital, productivity of capital employed, regulations, effective supply chains, etc, although raising interest rates could raise cost of capital projections which could constrain considerations for new capital expenditures.
The hope is that the Fed can restore the longer-term anchoring of inflation expectations to much lower levels from the current high single digits of year-over-year inflation readings. Market surveys (Figure 8) still see this anchoring holding, at least so far, but as Crook warns, the Fed runs the risk of losing this anchoring.
Figure 8 – Long-Term CPI Outlook Continues to Remain Well Anchored at Levels Well Below Current Headline Inflation. But for How Much Longer?
Perhaps, this is what Fed board member Steve Bullard is warning about as he has been pushing the Fed to take a more hawkish stance. This past month’s surge in commodity prices may be the impetus to push the Fed in that direction, regardless of the potential market fallout.
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