This guest commentary was written on 8/4/22 by Chief Market Strategist Mike O'Rourke of JonesTrading.
The past couple of weeks have made it clear that the Federal Reserve has a communication and credibility problem in dealing with the market.
This is not surprising after more than a decade of exceptionally accommodative monetary policy consisting of extended periods of zero interest rate policy (ZIRP), Trillions of dollars of asset purchases and countless dovish pivots.
It is well known that monetary policy is applied asymmetrically with an easing bias. The financial markets have been conditioned to believe that not only dovish commentary will lead to easing, but also hawkish commentary will result in easing as well, as the economy slows.
This mentality has been established and reinforced over the past two decades during a globalization driven benign inflation environment. That persistent price stability offered the FOMC a large degree of flexibility that even prompted the central bank to adjust its framework to create inflation.
As China temporarily blockades Taiwan due to Speaker Pelosi's visit, it should be clear that the deglobalization trend that started with Trump Administration has only gained momentum under Biden.
The benign inflation environment that fostered frictionless dovish pivots no longer exits. The Fed's poor communication is likely to prove dangerous as the central bank commences its most aggressive tightening cycle in 15 years. This is a policy tightening which could transform into something great depending upon the progress of Quantitative Tightening.
Therefore, it is important for the central bank to quickly reconcile the disconnect between current market expectations and the FOMC forecast (chart below). At last week's FOMC press conference, Chairman Powell repeatedly attempted to direct the market back to the June FOMC meeting's Summary of Economic Projections (SEP) to reconcile the differences.
He was unsuccessful. Furthermore, several FOMC officials hit the speaking and media circuit this week reiterating the SEP forecast, stating that they expect the Fed Funds rate to reach 3.875% in the next 4 to 7 months, and that the Fed Funds rate cuts the market is predicting for 2023 are highly unlikely. In an essay published at the end of June, St. Louis Fed President Jim Bullard laid out the policy approach necessary to tame inflation.
The essay is titled " Getting Ahead of U.S. Inflation: A Lesson from 1974 and 1983 ." In the essay, Bullard notes the Fed's unsuccessful approach of the 1970's stating "It kept the policy rate relatively low, even in the face of rising inflation. As a result, the ex-post real interest rate (e.g., the one-year Treasury bill rate minus the inflation rate) was exceptionally low, similar to today's ex-post real interest rate."
Bullard contrasted that with FOMC's successful approach in 1980's and 1990's, noting "These three experiences provide useful guidance for today's monetary policymakers, namely that the approaches of 1983 and 1994 are better examples to follow. In those cases, the FOMC kept the policy rate relatively high above the inflation rate, and therefore real interest rates were relatively high."
That "real interest rates were high" is the key and why the Chairman needs to get to a "positive real policy rate." A "positive real policy rate" or “positive real Fed Funds rate” will occur through a combination of additional Fed Funds increases, but the majority of it will come from inflation trending lower.
That means the FOMC can't even consider easing until inflation crosses below the Fed Funds rate creating a positive real policy rate. Currently, the real Fed Funds rate is negative 4.4%.
The chart below illustrates the real Fed Funds rate constructed with headline PCE inflation dating back to 1970. Core PCE inflation year over year is also plotted to illustrate the stability of inflation during the time periods Bullard referenced.
Inflation was also stable over the past decade with a milder negative real Fed Funds rate during the globalization driven benign inflation environment. For those wondering where Chairman Powell stands on this, he has loosely indicated that he shares Bullard's perspective.
That said, we would note he has not advocated this perspective with the frequency and clarity necessary for markets to embrace it. At last week's FOMC meeting, Powell stated "I mean, there are precedents for the FOMC moving very quickly, for example, 1994, 1980, even more so.
So, we've been known to do that when it's the appropriate thing to do." At this juncture it is necessary for Chairman Powell to publicly address the situation and reconcile FOMC and market expectations. Asserting the goal of a "positive real policy rate" would do so. The Fed's Jackson Hole conference is three weeks away.
That appears to be too long to wait to deliver this message. Nonetheless, the Chairman can start the messaging and lay the groundwork now to culminate with the crystallization of expectations at Jackson Hole.
This is a Hedgeye Guest Contributor piece written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.