The Fed Is Fighting Inflation

To investors,

Below is a guest post from Nik Bhatia, financial researcher and Adjunct Professor at the University of Southern California Marshall School of Business and author of the Substack newsletter The Bitcoin Layer, examining the possible paths for monetary policy in the next couple of months. Enjoy.

The S&P 500 had its worst day of 2022 on Tuesday after market pricing for Fed policy rates went haywire. In this update, we’ll cover the recent inflation data, the latest expected path for monetary policy, and how the Fed’s decisions are affecting risk markets.

Before diving into the latest inflation numbers, we must first bring back the words of Fed chair Jerome Powell from his Jackson Hole speech in late August: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance… reducing inflation is likely to cause a sustained period of below-trend growth.” The act of forceful tightening is something that risk markets have toyed with this entire year, and unsuccessfully.

What does forceful really mean? It means the Fed won’t stop unless it absolutely must. Let’s take the rounds across various factors that would warrant a Fed pause—and we should mention that the next move will be a pause, not a grand pivot to cutting rates and QE. The process of QT is just getting started, and the Fed has its eyes on a $2 trillion total reduction in the size of its balance sheet. Whether or not it gets there over the next couple of years is yet to be seen, but balance sheet transitions require many months of advance communication from the Fed. For now, the Fed is set for at least the next half-year on balance sheet reduction.

The first potential cause: a stock market in crash-mode would get the Fed to halt, but one 4% down day doesn’t make a crash. Stocks are still above their June lows and almost 20% higher than where they were before the pandemic. Nothing for the Fed to see there.

Next, financial stress. We usually see stress in repo markets, LIBOR funding, and/or high-yield corporate spreads. Nothing, aside from some modest weakness in corporate spreads, seems to be any cause of concern. And corporate spreads, like stocks, are in better shape today than they were in June when runaway inflation was the market’s big worry.

What else would cause the Fed to pause? A deep recession? A wave of unemployment? Negative real GDP doesn’t have the Fed convinced we are in recession, as it can point to a healthy labor market as the counter indicator. Oddly enough, at this very moment, the Fed still has cover on the economy. We are watching ISM, retail sales, and housing data for more cues on the path of the economy, as well as stocks and funding/credit markets for additional indication on what the Fed might do.

In addition to Powell’s forceful usage of the word “forcefully,” the Federal Reserve has also employed a new communications channel, WSJ reporter Nick Timiraos. In June, Timiraos provided us with an inside track on the 75 basis point hike (versus market expectations of 50 basis points). And again last week, we had word from Timiraos that another 75 was likely—and then again Tuesday morning after the inflation numbers, he started hinting the Fed could get even more aggressive, meaning a 100 basis point hike was now in play for next week.

On inflation, CPI came in slightly ahead of expectations. I thought we might see more evidence of a slowdown in inflation due to falling energy prices and tighter monetary policy, but the data said otherwise. Core inflation rose 0.6% month-over-month, and that was enough to send Treasury yields and policy rate expectations soaring. As of this writing, two-year yields have increased by 30 basis points to 3.8%, and 10-year yields threaten their highs for the year at 3.5%. But the dramatics in Fed Funds expectations surpassed Treasury price action. Next week’s Fed meeting has a very real chance now of seeing a 100 basis point hike from the FOMC, and the terminal rate has skyrocketed above 4%. With the upper bound potentially reaching 3.5% with two meetings left in 2022, a 4% Federal Funds rate is now firmly within the market consensus.

This new reality is what caused such a spill in risk markets. And it’s also what makes a market—investors are on opposite sides in terms of the near-term outcome. Some, like myself, believe that peak inflation is behind us, slowing growth and inflation are upon us, the Fed will pause soon, and risk markets will respond positively. Others believe that the Fed will continue hiking rates to 4%-5% in order to properly check inflation, and this level of restriction will cause mayhem in risk markets, and that much lower levels are in store.

With a 1% rate hike next week, the Fed will be putting the entire financial system in a chokehold. Mortgage rates at 6% are already drastically shifting affordability and buyer behavior—what will 7% rates look like? Is this what is needed to bring inflation back down to 2%? There are certainly some members of the FOMC that believe so, and until the reality of soaring unemployment or crashing stocks sets in, nothing will affect said rhetoric.

Zooming out, we have seen a permanent bailout impulse, both monetary and fiscal, from central banks and governments around the world since 2008. Now, Japan’s central bank is rediscovering this impulse after a yen in freefall, and China’s central bank and communist party have firmly returned to easing mode due to city lockdowns and an overleveraged property sector. But on this side of the Pacific, as well as in Europe, no pulse can be found when searching for the bailout impulse. It is, in fact, the mirror image. The Fed is committed to preserving its reputation as a central bank that can not only ease when the system demands it but can tighten when prices are out of control. Soon enough, a fire will bring the Fed back from the precipice. Knowing which fire, or when it will start, is our challenge as investors.

We’re approaching peak drama in markets, with a fixation on when the Fed will pause. The fallout of over-tightening could spur a deep recession, or an extended pause could leave us with stagflation as CPI inflation normalizes. Will the Fed commit further policy error, or will cooler heads prevail? At The Bitcoin Layer, we cover bitcoin through this global macro and rates lens to identify regime shifts from easing to tightening and back again.

This was a guest post from Nik Bhatia, financial researcher and Adjunct Professor at the University of Southern California Marshall School of Business and author of the Substack newsletter The Bitcoin Layer, examining the possible paths for monetary policy in the next couple of months.

Hope you enjoyed it.

-Pomp

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