Everyone is right, everyone is wrong

  • Markets were disappointed by hawkish Fed sentiment.
  • But markets are both right and wrong; as is the Fed.
  • Looking more at monetary developments would have avoided confusion.

Markets were disappointed by the Fed’s latest action. Slowing interest-rate increases to 50bps from a series of 75bp rises had been heavily flagged and was therefore already factored in. But the relatively hawkish tone of the accompanying statement, heralding further monetary policy tightening was not.

Markets are right to be disappointed; but they are also wrong. This is because the Fed is also both right and wrong. And part of the issue is (as usual) that the Fed – and therefore also markets – ignore monetary developments. More attention to broad money would have meant less confusion on both sides.

To unravel all this, we need to consider that there were two forces in conflict at yesterday’s FOMC meeting (and today when the Bank of England and the ECB set interest rates as well). On the one hand, inflation, while it has eased somewhat in recent months, is still extremely high by the standards of the past four decades. The Fed were, as has been well documented, caught by surprise, both by the strength of inflation and by its duration. So there is still a need to show that the central bank is on top of developments and unwavering in its determination to bring inflation down towards, if not all the way to, its target. Moreover, the balance of risks between deepening a slowdown/recession and failing to control inflation, are probably skewed towards the latter. In other words, tightening policy too much in order to bring down inflation, is easier to reverse and will have less negative consequences than letting inflation accelerate again in the hope of averting a recession. Hence, the Fed is right to remain hawkish.

This is where markets are wrong. By focusing on recent slower inflation, a feeling seems to have begun to spread that the Fed’s job is more or less done, inflation will fall of itself and its time to stop worrying about it. This disregards the risk that inflation could, for whatever reason, accelerate again and become more entrenched.

Moreover, history shows that the Fed can very quickly change from tightening monetary policy to easing it. A look at a chart of the Fed funds rate shows that interest rates are rarely held at their peak for very long. The period from July 2006 to August 2007 is probably the longest in almost seven decades. Usually, the Fed starts easing within six months of interest rates peaking. So if, which, on current Fed rhetoric seems likely, interest rates peak in the first half of 2023, we could well expect a first cut towards the end of next year.

However, the Fed is also wrong, in that its (admittedly downgraded) outlook for the economy is probably too optimistic. With the publication last week of the Financial Accounts of the United States for the third quarter, I have updated and revised my US broad money series (equivalent of the old M3 measure). This now shows that broad money growth has weakened steadily since November 2021, dropping from a twelve-month rate of 11% then to -3.1% in the year to last month. On a six-month annualised basis, the stock of broad money has been shrinking since last May. Such prolonged weakness has not been seen since the period of the Great Recession. More to the point, just as the surge in broad money growth in 2020/2021 heralded current inflation (well before the extra impetus from the Russian war on Ukraine), so this collapse in broad money growth signals an almost certainly rapid slowdown in inflation from mid-2023 onwards.

And this is therefore where markets get it right. The economy is weak and weakening. Even if they US does not see two quarters of falling GDP in 2023, it may well experience a recession in its own terms (remember, in the US, a recession is defined by the NBER, not by GDP developments). And absent a surge in energy, food and other commodity prices, inflation should come down fairly quickly on its own.

Of course, if the Fed ascribed any importance to monetary developments, it would have a better picture of developments. It would also make markets look at money; and that would enable a better analysis of Fed moves. But don’t hold your breath waiting for a revival of interest in monetarism. In the meantime, American – and British and Euro Area – interest rates will continue to climb. Not, fortunately to infinity and beyond. But well above 5%. (When the Bank of England’s Governor says that market expectations of a Bank Rate peak at 5.2% are too high, it is almost certain that they will exceed that number.) And perhaps more importantly, on the way down, they will not go to where we have been used to seeing them in recent years.

Gabriel Stein