In the history of the Federal Reserve, the most revered chairmen are William McChesney Martin, Paul Volcker and Alan Greenspan. All earned their reputations through 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 of the late 1950s and early 1960s because of 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 by pushing the US economy into a double-dip recession.
The Fed just raised interest rates by 0.75 percentage points and this compares to the 1994 rate hike 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 a problem. Not only was the Fed “ahead of the curve,” it was dictating 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 reacted to a supply shock like the oil crisis by raising rates.
In my view, the Fed under Jerome Powell is repeating these mistakes. Recall that until early January, the Fed was arguing for a moderate rate hike path that would exceed 2% in 2024, while bond markets rose at a much faster pace to 2% at the end of 2022. January policy, the Fed suddenly changed course and raised its forecast based on what the markets had expected.
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 interest. Today we know that was one of the biggest policy mistakes in the history of the Fed and the early 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 at the highest levels since the 1970s. Yet no rate hike. Investors are panicking over inflation, but the Fed has learned the lesson of the 1970s.
Jerome Powell did the opposite. Since the Russian invasion, the Fed’s monetary policy stance has become more hawkish and it has signaled faster rate hikes. At its June meeting, the Fed hiked even more aggressively than expected as markets went into a rut after the surprise inflation data. His “dot chart” used to signal policy expectations now shows that the Fed Funds rate will hit 3.4% by the end of the year.
The charitable interpretation of the Fed’s actions is that its economists were just catching up with what the bond market already knew. In my opinion, this charitable interpretation misses the point. The Fed was bullied by the market into increasingly aggressive rate hikes in light of a large supply shock.
I estimate that around two-thirds of current inflation is due directly or indirectly to supply shocks in the energy and food markets which cannot and should not be combated with inflation rates. higher interest. Instead, the right policy action would be the one taken by Alan Greenspan in 1990: look at underlying core inflation and demand dynamics, not headline inflation.
Clearly, there is a strong labor market and strong demand warranting rate hikes. But to know how much you need to raise rates, you need to know how much of underlying inflation is due to this demand shock. Also, you need to focus on underlying inflation, not headline 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 again have central banks wagging their tails and letting foreigners 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 suck growth out of the economy and create a recession. By succumbing to market expectations of rapid rate hikes, the Fed will create the very recession that the equity bear market is already anticipating.
Joachim Klement is head of strategy at Liberum, an investment bank. This is adapted from his newsletter Substack Klement on Investing. Follow him on Twitter @JoachimKlement.
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