In the history of the Federal Reserve, the most revered presidents are William McChesney Martin, Paul Volcker and Alan Greenspan. All earned their reputation for decisive monetary policy actions at times when stock and bond markets did not want or expect them to act.
William McChesney Martin was blamed for creating the recessions in the late 1950s and early 1960s due to his efforts to tighten monetary policy early, before inflation could take hold.
Paul Volcker is widely credited with ending the runaway inflation of the 1970s, pushing the US economy into a double-dip recession.
The Fed just raised interest rates by 0.75 percentage point and that is being compared to the 1994 rate increase of the same magnitude under Alan Greenspan. But in 1994, the Fed raised interest rates long before investors expected rate hikes or before inflation really became an issue. Not only was the Fed “ahead of the curve” but it dictated to the market what interest rates would be.
Meanwhile, the Fed’s darkest period was the late 1960s and early 1970s, when weak presidents were swayed by politicians who asked them to cut interest rates to avoid a recession or who reacted to a supply shock like the oil crisis raising rates.
In my opinion, the Fed under Jerome Powell repeats these mistakes. Recall that until early January, the Fed was advocating a moderate path of rate hikes that would reach 2% in 2024, while bond markets priced at a much faster pace to 2% in late 2022. At its January policy meeting, the Fed suddenly changed course and raised its guidance in line with what markets had priced.
In February, Russia invaded Ukraine – a supply shock similar to the 1973 oil crisis and the Iraqi invasion of Kuwait in 1990. In 1973, the Fed panicked and began raising rates. We now know that this was one of the biggest policy mistakes in the history of the Fed and the beginning of the stagflation of the 1970s.
Compare that to 1990, when the Greenspan-led Fed did… nothing. Yes, oil prices rose 170% from August to November of that year and inflation was rising to the highest levels since the 1970s. Still no rate increases. Investors were panicking over inflation, but the Fed had learned its lesson from the 1970s.
Jerome Powell did the opposite. Since the Russian invasion, the Fed’s monetary policy stance has become more aggressive and signaled faster rate hikes. At its June meeting, the Fed rose even more aggressively than previously anticipated as markets threw a tantrum after surprise inflation data. Its dot plot used to signal policy expectations now shows the Fed Funds rate hitting 3.4% by the end of the year.
The charitable interpretation of the Fed’s actions is that its economists were just catching on to what the bond market already knew. In my opinion, this charitable interpretation misses the point. The Fed has been bullied by the market into increasingly aggressive rate hikes in light of a major supply shock.
I estimate that about two-thirds of current inflation is directly or indirectly due to supply shocks in the energy and food markets that cannot and should not be tackled with higher interest rates. Instead, the correct policy action would be the one taken by Alan Greenspan in 1990: look at core underlying inflation and demand dynamics, not overall inflation.
Clearly, there is a strong job market and strong demand that justifies raising rates. But to know how much you should raise rates, you have to know how much of core inflation is due to this demand shock. Also, you should focus on core inflation, not total inflation.
A strong Fed would be able to explain this to the public and resist market pressure to raise rates quickly. Instead, under Powell, we once again have central banks that let their tails wag and let outsiders dictate monetary policy.
The result is clear. It is no longer a question of whether we enter a recession, but when. The combined effects of high energy prices and rate hikes will sap growth from the economy and create a recession. By succumbing to market expectations of rapid rate hikes, the Fed will create the very recession that the bearish stock market already anticipates.
Joachim Klement is head of strategy at Liberum, an investment bank. This is adapted from their Substack Klement on Investing newsletter. Follow him on Twitter @JoachimKlement.
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