The transition is complete. Central bankers have gone from being investors’ best friend to their worst enemy. And, like all worst enemies, central banks have clearly lost the plot. Worst of all is US Federal Reserve Chair Jay Powell. Not because of what he’s done, but because of what he believes in.
Not so long ago, he believed in the Powell Put. The idea that, should anything bad happen in financial markets, the Fed Chair would bail us out with copious amounts of QE and rate cuts if there were any to be had after decades of such cuts.
This implicit guarantee underwrote the market’s rise. It removed the downside risk. That’s why they called it the Powell Put — a reference to the put option, which has the same effect.
But then Chair Powell met inflation. And the Powell Put suddenly went missing. Chair Powell was more interested in spending time with his new ‘friend’ instead of investors like you.
To be fair, for a while, the Fed at least looked to be heading in the right direction, even if this was costing markets dearly. So badly, in fact, that the US stock and bond market chalked up the worst combined performance ever in 2022, once you adjust for inflation.
But inflation had to be brought under control, right? You can’t have interest rates at 0%, with inflation in the double digits, after all. Even if it is coming back down because it’s transitory.
So perhaps we can forgive Chair Powell for chasing inflation in 2022.
The big problem is that he now seems to be overcompensating for his lack of foresight.
After a decade of propping up markets using questionable methods for dodgy reasons, and then passing through good monetary policy focusing on inflation for only a brief toilet break in 2022, the Fed’s now going berserk in its attempt to slay inflation. They’re going to overtighten, hiking interest rates too high, and triggering a financial crash.
What makes me think this? This incredibly clueless statement made by Chair Jay Powell at the Economic Club of Washington that ‘if we continue to get strong labor market reports or higher inflation reports, it might be the case that we have to raise rates more than is now expected’. In other words, the monetary policy beatings will continue until unemployment worsens.
Had he spoken these words 40 years ago, the audience would’ve laughed or jumped out the nearest window in the hope of meeting their stockbroker on the way down and getting a sell order in before the landing. Because people back then know just how dangerous a mistake Powell is making, from experience.
The mistake has a name. It’s called the Phillips Curve. And I never thought I’d see a central banker make it again.
In fact, given the Phillips Curve has been dead and buried for decades, perhaps we should name its new iteration in honour of the man who has revived it: the Powell Curve.
The underlying theory of the Powell Curve is that employment and inflation are somehow related, presumably because employed people spend more money, which pushes up prices.
If you want to slay inflation, all you have to do is get a lot of people fired. And nothing gets people fired like high interest rates.
But employed people don’t just spend money, they also produce stuff. And supply reduces prices. So the net effect of more employment isn’t inherently inflationary.
That’s the theoretical debate. Experience is even more damning of Powell’s claim that, should employment data hold up, he may be forced to hike interest rates further.
You see, wage growth has been lagging inflation, so it can’t be causing it.
Even with the ridiculously low unemployment rate, wage growth can’t even keep up with inflation.
And inflation has slowed just when the US unemployment data looks too good to be true.
So, watching good employment data and using that as your justification for hiking interest rates is outdated economic masochism, at best. It’s a cure that has nothing to do with the disease and is going to prove worse than the disease.
Debt levels are absurdly high, and borrowers relied on interest rates remaining low indefinitely. Hiking pulls the rug out from under them.
The question now is: How long will it take central bankers to wake up to the threat of hiking interest rates? Will it be after the crisis that high interest rates would cause, or before?
It took them remarkably long to discover inflation wasn’t transitory in 2021. Inflation had to hit multiples of their target rates before central banks changed course. Will they make the same mistake in 2023, discovering that inflation has evaporated long before the labour market has turned down?
If central banks don’t reverse rate cuts until unemployment rises, it won’t just be the Powell Put and the Powell Curve that get named after Chair Jay Powell. There’ll be the Powell Plunge too.
Until next time,
Editor, The Daily Reckoning Australia Weekend