Gravity

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Photo by Maxim Hopman on Unsplash

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The same Federal Reserve (Fed) that used to say, “we only fear deflation, we know how to fight inflation,” now says “we only fear inflation, we know how to fight recession (and deflation).”

I closed my previous blog arguing that Fed Chairman Powell would need to send a message to investors, and he sent it loud and clear at the end of yesterday’s Fed policy meeting:

  • He emphasized that however you measure it, inflation is way too high and shows no signs of coming down; with the labor market tight and consumer spending fueled by record-high savings, it will not come down by itself — more rate hikes are needed.
  • In fact, he warned, interest rates will need to go higher than the Fed previously thought and stay there for longer. It’s way too early to even talk of a pause — the point where the Fed will stop hiking and watch higher interest rates take their toll on the economy.
  • He stressed that no-one should doubt the Fed’s commitment to bringing inflation down. He needed to, because the Fed’s dovish history engenders skepticism on its ability to stomach the reduction in employment and asset prices needed to bring inflation back to 2%.

Regime change

But here lies the biggest change in the Fed’s attitude, and financial markets still can’t quite accept it: for the past two decades the Fed always de facto prioritized asset prices. Whenever equity markets faltered, the Fed eased policy. More: with zero interest rates and massive Quantitative Easing the Fed deliberately pumped up asset prices, encouraging markets to take more risk.

So you can forgive investors for thinking that, with equity markets down 20% so far this year, the Fed would soon reverse course, stop hiking and start cutting rates.

Except it won’t.

Gravity has reasserted itself. With a big push from recklessly loose fiscal policy, inflation has surged and risks getting entrenched at an uncomfortably high level. That would undermine both economic and financial stability. So the Fed doesn’t really have a choice.

It gets worse: every time stock prices rally, financial conditions get looser, offsetting some of the Fed’s tightening effort and making its job harder. Therefore now the Fed has to push against financial markets, taking a more hawkish stance whenever investors get their hopes up — this was the clearest takeaway from yesterday’s press conference.

Remember MMT?

Until just over a year ago, the prevailing mantra was that the world had changed, inflation and interest rates would forever be low, weak aggregate demand had consigned economies to secular stagnation, deflation was the only real and present danger, monetary policy had to stay ultra-loose and governments could borrow for free and should do so with abandon. Modern Monetary Theory (MMT) — which claims governments do not have a budget constraint because they can print as much money as they want — was taken seriously by many. US macro policy became de facto an experiment in MMT.

It ended the way any sober economist expected: a massive surge in inflation. The world has not changed that much after all and the basic laws of economics and common sense still hold: too much money chasing too few good results in inflation.

Today the only one who follows MMT’s wisdom is — you’ll be surprised — Rishi Sunak, the new UK Prime Minister. I am only half joking: MMT argues that in the unlikely event that inflation should rise, the government should raise taxes. Sunak is indeed set to tighten UK fiscal policy, though he’s guided by a much more orthodox perspective: when interest rates rise, you need to reduce borrowing to reassure financial markets.

The devil you know is back

Back in those days, when anyone suggested that persistent ultra-loose monetary policy could eventually cause an inflation problem, the Fed responded, don’t worry, we know how to fight inflation, it’s deflation that we fear. Better the devil you know, in other words. Well, the devil you know is back and looks a lot scarier than you remembered…

Which explains the “pivot” in the Fed’s hierarchy of fears: inflation has jumped to the top, recession and deflation suddenly look a lot less concerning.

I think the Fed is doing the right thing, and I believe it will show the fortitude to keep its word and bring inflation down — though this will likely take longer than many expect. I also think the Fed will finally be forced to look at the whole chessboard — they can’t afford to ignore growth and employment risks the way they ignored inflation risks. I hope the government will eventually do the same, adopting responsible fiscal policy and supply-boosting reforms. The time for MMT-inspired populist spending is over.

For financial markets, this becomes a brave new world, one where asset values will depend a lot more on fundamentals, a lot less on policymakers’ largesse. The adjustment is painful, and it’s not over.