The Credit Strategist - February 2022
“In many important ways, the financial crash of 2008 had never ended. It was a long crash that crippled the economy for years. The problems that caused it went almost entirely unsolved. And this financial crash was compounded by a long crash in the strength of America’s democratic institutions. When America relied on the Federal Reserve to address its economic problems, it relied on a deeply flawed tool. All the Fed’s money only widened the distance between America’s winners and losers and laid the foundation for more instability. This fragile financial system was wrecked by the pandemic and in response the Fed created yet more new money, amplifying the earlier distortions.”
Christopher Leonard, The Lords of Easy Money (2022)
The Fed made it clear at its January 25/26 meetings that it will end QE and start raising rates in March. The Fed engaged in similar “double tightening” (as Peter Boockvar calls it) in 2018, triggering a sharp stock sell-off in 4Q18 that led it to panic and reverse course in January 2019. But economic conditions are very different today. In 2018, the Federal Funds rate was +2.5% while today it sits at zero, and CPI/PPI inflation were below 2% in 2018 and today hover above 5%. The Fed therefore has plenty of room to raise rates before approaching its target inflation rate of 2%, the current CPI/PPI of over 5%, or the much higher real-world inflation rate. It needs to get inflation down as quickly as possible to help consumers and vindicate arguments that its profligate monetary policies were not the cause of higher prices. People can debate the degree to which it retains credibility with respect to its tightening credentials, but the current test may offer a make-or-break moment on that count.
Immediately after Fed Chair Jay Powell’s January 26th press conference, markets were pricing in a 76% chance of a fifth rate hike this year. I doubt we will see five rate hikes this year and even four would be ambitious, but markets are playing a far different tune than just a few weeks ago. But now that the “transitory” inflation narrative has lost whatever credibility it possessed, the people who are supposed to know these things (and are therefore usually the last to know) are outbidding each other regarding how many rate hikes the Fed will impose this year.