As expected, Jerome Powell and the Federal Reserve raised interest rates by 75 bps for the fourth consecutive time this year, to the 3.75% – 4% corridor.
This was in line with market expectations since the CME’s FedWatch Tool showed an 85%+ chance of a three-quarters percentage point hike just prior to the FOMC announcement.
As far as the powers of the mighty central bank extend, Powell has certainly flexed the institution’s muscles. However, the policy actions seem to have disproportionately influenced areas of the economy that are highly vulnerable to the interest rate environment.
For instance, in a recent piece, I discussed how real estate investor George Gammon was forecasting a possible 50% drop in home prices over the next couple of years.
Year to date, equity markets have also sunk, the floor has fallen out from under bond prices, and now mortgage rates are above an eye-watering 7%.
At the same time, inflation remains high – in the case of the CPI and the Fed’s preferred measure, the PCE. Moreover, the core measures of each have accelerated in the past months, signalling that the Fed may not have quite as tight a grip on inflation as they once thought.
Hawkish Powell and dot plots
In his speech, Powell’s tone was perceived as more hawkish than expected, dispelling the notion of any slowdown in hikes in the near future.
The combination of high inflation, high earnings and continuing resilience in the labour market with historically low levels of unemployment, indicate that rates need to head higher.
The NASDAQ composite, heavily compromised of highly levered tech and growth stocks, was hit hard during the announcement, receding 3.4% on the day.
Initially, the market may have expected a more dovish message, judging from the initial uptick in share prices.
Ramin Nakisa, a veteran investment banker and founder of Pension Craft said,
…a surge in the NASDAQ and S&P 500, but just moments after that I think markets realised that Powell wasn’t saying anything that was suggesting a pivot or a slowdown, in fact, he was saying the opposite…and then markets tanked.
Yet, the labour market has continued its strong run and has even seen a super tight 1.7 vacancies per worker, now rising to 1.9, threatening to ignite the wage-price spiral in the long run (which you can read about in this May piece).
This rising demand for employees may be in response to the high degree of savings that many households built up during the pandemic and associated fiscal support schemes. Moreover, skyrocketing inflation may be forcing some purchases forward.
In my earlier article on the Fed’s September meeting, I discussed the dot plot and where the members saw rates headed. Given the aggressive stance assumed by Governor Powell at this juncture, the December dot plot may have the potential to shift higher.
Despite the Fed’s consistent signalling that it would be raising December rates by 50 bps, the CME’s FedWatch Tool shows that probabilities of either a 50 bps or 75 bps hike are split virtually through the middle.
This seems to suggest that the market perceives that a higher rate pathway is entirely possible in the near term.
The Fed’s pace of quantitative tightening shifted to its maximum intended of $95 billion per month in September, through a combination of government paper and mortgage-backed securities.
Instead of reinvesting the coupon and principle, the Fed shall retire these instruments to suck excess liquidity out of the system.
Liquidity increased significantly with the Fed’s program of injecting $120 billion per month into the economy via quantitative easing in the wake of the pandemic.
Although the effects of monetary policy and QT are not yet evident on the mainline indicators such as CPI and the Fed’s preferred PCE, the Fed’s balance sheet is beginning to shrink. Since its peak on 13th April 2022, the balance sheet has shrunk by 2.704% as of 26th October 2022.
Due to liquidity drying up, inflation control, which is central bank speak for demand destruction seems to be affecting borrowing and repayment conditions among small, mid and large firms.
Source: Senior Loan Officers Survey, Pension Craft
Given the Fed’s hawkishness and determination to keep raising rates, highly-leveraged, unprofitable enterprises will find it increasingly challenging to stay afloat.
In a study by the Bank of International Settlements, the proportion of zombie companies in 14 select economies rose to 15% in 2017, as compared to 4% in the 1980s, a result of easy money policies.
Swiss Re economists Jérôme Haegeli and Fiona Gillespie anticipate that high yield default rates of 15% could materialize if a recessionary environment were to unfold. This is compared to the average high-yield default rate of about 4% in the last 10 years.
The authors argue that this wave of defaults would be beneficial to capital allocation and delaying this may lead to a rise in stagflationary risks.
They suggest that authorities should consider bailing out entities that show potential for success in the long run, a job that is likely easier said than done.
Small-cap and growth stocks will likely be especially vulnerable and see a string of liquidations, having only recently emerged from a prolonged, seemingly never-ending environment of 0% rates.
In an earlier article, I noted that Joseph Wang, a former senior trader at the Fed’s open market felt that new tools including swap lines, the repo facility and debt buy-backs to manage treasury market turmoil, corporate bond market volatility and banking crises, respectively, could extend the rate hikes.
In essence, he argues that the Fed will continue to hike by being able to intervene strategically when cracks emerge.
Thomas Hoenig, Former Kansas City Federal Reserve President and CEO also believes that the Fed has no end-point for its rate hikes at this point, which would of course spell disaster for the majority of struggling enterprises.
Although this may be true, I expect interest payment burdens to weigh on the Fed, as well as the political unpopularity of constraining lending in the economy.
Regardless, the hangover and criticism from 2018-19’s pivot would be fresh in the collective minds of the Fed. The institution undoubtedly wants to restore credibility among its naysayers, and we should not expect a pivot in rhetoric or action any time in Q1 2023.
Part of the struggle to restore credibility is to unwaveringly signal the Fed’s willingness to crush inflation in the face of mounting social and financial costs.
The 2% trap
Perhaps global central banks, in a bid to maintain credibility have committed themselves too firmly to the 2% level.
As per my knowledge, there is nothing hallowed about this number and it certainly would make little sense that it be uniformly applicable across so many countries over decades.
The Economist discussed the rise of the 2% target in these terms,
When New Zealand’s parliament decided in December 1989 on a 2% inflation target for the country’s central bank, none of the lawmakers dissented, perhaps because they were keen to head home for the Christmas break…owes its origin to an offhand remark by a former finance minister…Should the somewhat arbitrary goal of 2% be changed?
The flexibility to admit that inflation will likely have to head north, in the long run, to say 3% may have afforded much-needed breathing space to monetary authorities.
However, today, the inflation-targeting central banks have boxed themselves into a corner, that has the potential to inflict huge costs on economies in search for this 2% number.
Any capitulation on their part could drive stagflationary forces and a loss of credibility.
Even though no immediate pivot is likely, the Fed’s 2% mandate will continue to weigh heavily on zombie companies and will contribute to significant job loss in this area.
Although we are unlikely to see a pivot in Q1, the Fed has left the backdoor open, stating,
…the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
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