Fed to Tighten But Party Goes On!
What do you do if you call an end to the party you are hosting but the guests persist with the drinking and dancing? The equivalent of that situation occurred last week following the decision by the Federal Open Markets Committee on December 15 to slow bond purchases and start raising rates. The S&P 500 index hit a fresh record and the yield on the US Treasury rose gently. Nothing to indicate that markets are terrified about a monetary tightening to occur in 2022.
A large part of the gentle response is traceable to Jerome Powell’s history as Chair as well as to his statement during the press conference after the FOMC meeting. He may have recalled his experience in December 2018 as rookie Chairman when his suggestion of further tightening resulted in a market correction and a dovish pivot. This time around, he was careful to mention in his prepared remarks that “even after our balance sheet stops expanding, our holdings of securities will continue to foster accommodative financial conditions.” (Italics mine)
Really? After being forced to take back repeated statements regarding inflation being “transitory,” and consumer prices lately rising at their fastest pace in almost 40 years, the Federal Reserve “will continue to foster accommodative financial conditions”? Not surprising that investors believe that if there is indeed a pullback in share prices in the new year as a result of the shift in Fed policy, the central bank and Powell will again shift toward supporting financial markets rather than stick to their mandate of fostering healthy employment and inflationary conditions.
In case observers still harbored doubts, Powell doubled down on his guidance during the Q&A period. Responding to a question as to why the central bank did not abruptly stop bond purchases on December 15 if it was so concerned about inflation, the Chair insisted that “it’s best to take a careful sort of methodical approach to make adjustments.” Why? Because “markets can be sensitive it.” Again, note the emphasis on protecting financial markets even when inflation has accelerated way over Fed projections.
What could go wrong with Powell’s approach? After having been proven wrong on his expectation that inflation will soon return automatically close to the Fed’s target rate of 2%, he and his colleagues are likely to find out in 2022 that further supply disruptions resulting from the omicron variant will slow economic growth and keep inflation at elevated levels. If further efforts to provide fiscal stimulus are stymied by gridlock in the US Senate, expect the central bank to step in as the savior.
With both President Joe Biden and his National Economics Director, Brian Deese, continuing to insist that inflation is temporary and largely a result of rapid increases in energy prices, expect them both to be supportive of a return to easy Fed policy, especially in a crucial election year. As I have said elsewhere, inflation is unlikely to observe political niceties, and further monetary relaxation is likely to push up inflation and, eventually, bond yields.
Powell may do well going over more than his own experience from 2018 and 2019. It would help to reread the history of Fed Chair Arthur Burns being bullied by President Richard Nixon into increasing money supply sharply during the early 1970s to finance the Viet Nam war. It would also be relevant to go over the lessons from G. William Miller, President Jimmy Carter’s Fed Chair during 1978 - 1979, who believed that the Federal Reserve should work to promote investment and growth rather than fight inflation.
That neither Burns nor Miller came close to achieving their objectives by ignoring inflation should provide a valuable lesson for Powell during 2022.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
December 26, 2021
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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