“Some Pain Ahead as Central Bank Fights Inflation” reads the headline on CNBC’s website and accompanying YouTube video (not the full speech). For the full text as posted on the Fed’s website, click here. Fed chairman Jerome Powell’s Jackson Hole keynote address was a mere seven-ish minutes, replete with mistakes and arrogance that will cost Americans dearly. He doubled down this past week, reiterating everything he said in Wyoming.
I found his remarks to be much more hawkish than anyone anticipated. The stock market plunged and bond yields rose, as more of the herd on the Street now understands a recession is coming if not already here. The Street is also beginning to realize just how serious Mr. Powell is about continuing rate hikes, with a very high likelihood of 75bps at the next meeting on September 20-21.
Two months ago I warned that this would happen, here. I hope you’ll take the time to read it and understand my perspective. If you don’t have the time, the summary is 1) the bond market is wrong about the Fed, 2) the bond market wants to call out the Fed for a major policy error in raising rates, 3) even if they are right about the blunder, they’re wrong about the Fed, and 4) the Fed will continue raising rates right into a recession with major defaults and bankruptcies. (Bed Bath & Beyond comes to mind of late). We can see now that my comments at the time were correct, that this Fed is determined to continue to raise rates in the face of inflation, regardless of the economic outcome for the American people’s household incomes and financial stability.
In that piece I also mentioned that I am currently short the junk bond market (thru put options on HYG, VCIT, and IGIB), and I am now short emerging market bonds (put options on EMB) as well as short the housing market (long shares of DRV). To be clear, my portfolio is not large enough and I am not skilled enough to pick individual stocks to sell short, and utilizing ETFs reduces some of the risks of going after individual companies.
Finally, I also mentioned that the policy maneuvers that the Fed will make are beginning to appear like the Tacoma Narrows Bridge. The policy maneuvers are becoming larger and stronger with each swing in the opposite direction, and becoming more and more frequent as well. We are witnessing the mechanical resonance, so to speak, of a monetary aeroelastic flutter, which the Fed will fail to contain.
With that in mind, let’s have a critical look at what the chairman said in Jackson Hole, and then reiterated last week.
The first point in his speech, the overarching goal, according to JP, is to bring inflation down to the long term goal of 2%, because price stability is the responsibility of the Federal Reserve. With the Dallas Fed projecting owner equivalent rents to be increasing by only 7%+ at the end of next year, and OER is 42% of the core CP-Lie, that means that even if everything else in the index is at 0%, we will have 3% inflation by December 2023. This meets the long term trend since WWII of 3.1% per year, but it is a delta of 50% over the Fed’s current 2% goal.
Let’s be clear that 2% inflation is not price stability. No one wakes up on January 1 and turns to their spouse saying, “honey I hope to G-d that prices are 2% higher this year than last.” If price stability was the bedrock of the economy as he asserted, 0% would be price stability rather than constantly rising by unpredictable variations. 0% inflation is in fact a bedrock of any economy because it allows for households and businesses to more reliably predict what their operational budget will look like for the year. 2% inflation, on the other hand, is a destruction of your purchasing power. Have you heard stories from your grandparents that milk used to cost 22 cents a gallon, including delivery? Now you pay nearly $4 at Costco. The main ingredient in that recipe is inflation.
In fact the Fed has proven that it can’t even hit this goal. Recall that for years after the GFC the goal was 2%, then symmetrical around 2%, then to stay above 2% to make up for the time spent below 2%. All this while the CP-Lie lingered below 1.5%. The only part of the ever changing goal post that the Fed accomplished was staying over 2% to make up for the time spent below. As we can now see, this was a terrible goal that is causing millions of Americans to have to make difficult choices regarding their spending habits.
The chairman also said that without price stability we can not achieve a sustained period of labor market conditions that benefit all. He is correct in this assertion. The higher the rate of inflation, the more instability in everything that we’ll see. He is also correct that the people who are burdened most with inflation are those who are poorest. In fact, it is only the wealthiest who stand a chance. Not the poorest and not even the middle class. Those who are in the top tax bracket (which begins at $540K per year) are the only people who stand a chance to survive high inflation, because they directly own diversified assets that include real estate, precious metals, and direct controlling ownership of diversified businesses.
Mr. Powell next asserted that restoring price stability (again he thinks it is 2% inflation) means the Fed must use its most powerful tools to forcefully bring supply and demand into better balance. In truth, if his goal is 2% inflation, all he has to do is coordinate with congressional spending to increase at exactly 2% per annum, less the liabilities of servicing the debt. And in truth, if it is supply and demand balance that he seeks, the best mechanism for that is the free market itself. By utilizing any of the Fed’s so-called tools, all the Fed is doing is distorting the very price discovery they seek!
Reducing inflation will likely require a sustained period of below trend growth, according to JP. Though I don’t know how he defines sustained, I do agree that below trend growth is necessary. In fact the better scenario is a full blown recession, which means the economy must contract. This will allow all the bad investments of the last 15+ years to flush out and the remaining capital to be redeployed into better opportunities. For this to happen, the federal government must step aside; the Fed must not intervene and the Congress mustn’t give any freebies either. Let the poorly managed companies go bankrupt and let the well run companies continue to run. Let new companies emerge to fill in the gaps.
Powell said there will likely be softening of labor market conditions. I think that’s the understatement of the century, but he believes this to be true because job openings are very high, and unemployment is very low. The whole reason for these circumstances though, is that the labor force participation rate has plummeted since the pandemic. It is currently 62.2, and has not been at that level since May 1977. The pandemic low was 60.2, and the last time it was that low was May 1973. By comparison it was over 66.0 before the GFC. It means that significantly less able-bodied men and women are working, and they aren’t even seeking employment!
The chairman claims that higher interest rates, slower growth, and softer labor market conditions will bring down inflation. Again, he has it wrong on inflation. He just doesn’t understand that the very causes of inflation are the policies his Fed (and his predecessors back to Greenspan) have employed, enabling the Congress to write checks that they can’t cash.
Let’s take a moment to review inflation. To inflate means to expand. Inflation is an expansion of the money supply. To realize a rise in prices, this is not the only component though. We can expand the money supply by $12 trillion, but as long as it sits in a bank vault, there will not be any rise in prices.
That is why the new money needs to circulate throughout the economy. But just because it circulates does not mean anything will happen. If that $12T takes 12 decades to pass through the economy one time, not much will really happen. But if the people find out that there is $12T that was printed and now circulating, they will perceive that prices may soon rise very quickly and thereby spend what they already have before prices actually go up. Don’t believe it? What happens when you find out that chicken this week is $5/lb, but next week it will be $6.50? You buy more now before the price rises. It’s foolish not to, especially if you like to eat chicken.
We must find that all three components are working in concert with each other in order to see a rise in prices. Expansion of the money supply, circulation, and human psychology. If one is missing, you won’t see a rise in prices. These three components are the primary causes of a rise in prices. Secondary causes may include useless ingredients like regulatory fees and tariffs. But these pale in comparison to the three primary factors. Even increasing demand relative to supply is not as strong of a force as the three primary components.
Higher interest rates work to bring down inflation because higher rates actually shrink the money supply, causes people and businesses to reconsider their spending habits, and slows the pace that money actually circulates. However, it’s only the case if there aren’t congressional spending plans that accelerate expansionary payments in opposition to contractionary rates. If you are suddenly paying 22% on your credit card instead of 15%, for example, the additional 7% to service that debt is paid and goes to money heaven.
In the chairman’s eyes, however, higher rates translate into softer demand, just as slower growth and softer labor markets translate into softer demand. This is the Philips Curve talking for him. Fed officials still believe that demand is the engine of the economy. It’s not. The iPhone was created and then the demand appeared, not the other way around. Any economy in the world will grow because of manufacturing and supply, not because there is a demand for products that may or may not exist yet.
As the chairman breathed a sigh of relief that the CP-Lie has pulled back slightly, he also acknowledged that one month’s improvement falls short of what the committee would like to see. Clearly it is not a new trend, and he is not confident at this time that inflation is moving down. He’s correct. We are not out of the woods yet, not even close. And he has probably seen too many TV talking heads brought to shameful tears on comments they made prematurely in these matters, so he is refraining from the same mistake.
“We are moving our policy stance purposefully to a level that will be sufficiently restrictive, to return inflation to 2%.” This comment from Jay Powell is one of the most critical comments he has ever made. If you or your broker had any doubts about where Fed policy is going, let this statement clear the air. If you or your broker believed with complete and perfect faith that we have seen the last 75bps hike already, let there be no more doubts that we have not. Don't say you weren’t warned. You were. Even the Street is coming around now, as James Bianco posted to LinkedIn on Wednesday, August 31, 2022, that the Street puts the likelihood of 75bps hike this month is now at 75%. Personally I would not find it surprising to see a full 1% hike at the next meeting in September, based on the chairman’s speech, though 75bps is the most likely outcome.
2.25-2.50% is the current range for the Fed finds rate, and the chairman said that even though this is deemed to be the long term neutral rate, it is not the place to stop. Does that mean he thinks that the long term neutral 10Y treasury rate is no longer the traditional 6-7% range, but now it should be changed to 3.5-4.5%? This certainly should raise an eyebrow. The 10Y treasury rate at 6-7% has been the benchmark by which all other investments are measured for decades. The common refrain is “since WWII” and even that is already nearly eight decades ago.
Mr. Powell repeated what he said in his July remarks, that it was the second 75bps hike in as many meetings, and another unusually large increase could be appropriate at the next meeting. Here again, the chairman is preparing everyone for at least 75bps, if not more. The meeting is on September 20th and 21st, with the press conference on that Wednesday afternoon. As of this writing (September 10-11) it is only 10 days away.
Chairman Powell said at some point it will be appropriate to slow the pace of rate increases. He repeated that he wants a restrictive policy stance for some time, and the historical record cautions against letting up too early. This implies not now, and not the rest of this year when it comes to slowing the pace or even halting the hikes. Again, I think the chairman wants everyone to understand that he is serious and will raise rates again this month by at least 75bps, and it is now on the table for the November and December meetings as well.
In fact if the median Federal Funds Rate should be around 4% through the end of 2023. We are currently at 2.25%-2.50%, which means that if September is 75bps, there is room for another 75-100bps to hit that median target. Remember though that this Fed wants to dramatically overshoot the goal in order to fight off inflation, subsequently returning to what it considers neutral. The implication for this year is 175bps (1.75%) of hiking is a sure thing, there could be much more to come next year towards 5% or higher, and only then will we begin to come back to this 4% target.
Mr. Powell stated (at 4:00 in the video) that there are three lessons to be learned from the high inflation of the 1970s, combined with last quarter century of low and stable inflation. And here is where you can really see central banker’s haughtiness, condescension, and arrogance on full display.
1) Central banks can and should take responsibility for delivering low and stable inflation. It is a settled, unconditional matter that there is a responsibility to delivery price stability. He repeated that the high inflation we are experiencing is a product of high demand combined with constrained supply (Phillip’s Curve again). If we look at the data, Mr Powell, demand is not as strong as you’d like us to believe, even though you are correct that supply is constrained for a number of reasons. On the demand side, look no further than the demand for gasoline. It is at a level that is lower now than during the pandemic lockdowns, and that is the only reason prices have come down this past summer. On the supply side, there are problems in China and Taiwan impacting semiconductors, the Biden administration has placed restraints on the fossil fuel industry, fertilizers and grains have been restricted because of tensions between Russia and the Ukraine, natural gas is no longer flowing out of Russia to Europe, and much more. We find that demand is slowing, but the supply side has slowed at a greater pace. I’m sorry, Mr. Chairman, your narrative might be swallowed hook, line, and sinker, by certain media outlets. But real Americans are experiencing a completely different set of circumstances than the picture you are attempting to paint.
Mr Powell also stated that the Fed’s policy maneuvers are working principally on demand. I must wonder out loud here. If interest rates are rising because of the policies he has implemented, and if those rising interest rates are also impacting business free cash flow and investment decisions, why doesn’t a rising rate environment impact businesses on the supply side? While we haven’t seen mass layoffs yet, we have heard announcements from several bellwether companies, and tech startups have also begun laying off a higher rate of workers than the rest of the economy. A one-month uptick in the unemployment rate doesn’t define a new trend, but it is something to watch along with numbers from ADP.
2) Public expectations of future inflation can play an important role in setting inflation over time. Public expectations right now affect inflation right now, not the future. Call me captain obvious; it seems the future hasn’t happened yet! I have not spoken to anyone about inflation who is not worried because they think it will taper in a year. Everyone I talk to is worried about paying their housing and food, paying for gas for their car and heating their home, and paying for new sneakers and shorts for their children. General consensus seems to be “what am I going to pay for lunch today? The only worry about inflation in the future is just how bad it might become. Again, human psychology is one of three major components of inflation, not the only component. If it was the only component then the new iPhone would cost around $1700 instead of $1500.
3) The final lesson for Mr. Powell is that as the chairman of the central bank, he believes it to be his duty to go after inflation until the job is done. The problem here is that whatever policy the Fed enacts will need about a year to work its way through the economy. So too for fiscal policy coming out of Congress. Did you notice that with all the freebies during the pandemic, there was no price inflation to be worried about, even though the Fed maintained 0% interest rates and the Congress dropped several trillion onto the American people? The inflationary price pressures didn’t hit in earnest until the last few months of 2021 and continued to build into 2022. The Fed seems to believe that whatever they do now will have an immediate and noticeable impact. That is why they will keep at it, raising rates much higher than the economy can withstand. The Fed is literally behind the curve on this. It is for this reason that I stated two months ago, and I restated here, that the Fed will be whipsawed around like the Tacoma Narrows bridge collapse.
Mr. Powell quoted former chairman Alan Greenspan, April 1989, as saying, “For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decisions.” I agree, and that level should be no more than 25-30bps surrounding 0.0% inflation/deflation. That is the true level of stability that Americans seek, and it should be the same for their unelected officials at the Fed.
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