Rabobank: "That's Not How The Fed Works"

By Michael Every of Rabobank

Today is Fed day. A 50bp is a shoo-in: as absolutely nobody was predicting a year ago when they told us inflation was all about lumber and used cars and was “transitory”.

The FOMC sit down to their decision against the backdrop of a JOLTS report that says there are now 11.5m open job positions in the US. That’s vastly more than the number of people looking for work. So, there are only a few strategic choices:

• Allow wages to rise so people come back to the labour force again;
• Allow inflation to destroy living standards such that workers will happily take any job; or
• Destroy demand for the extra jobs so workers also get back in line.

The Fed won’t do the first – you didn’t believe all that guff about inequality did you? They won’t do the second, despite making a good fist of it last year. That leaves the third option, and so the real interest will be on what the Fed says about how many hundreds of basis points of future hikes we will see going forwards.

As Philip Marey notes here, “The Fed is trying to catch up by taking steps at every meeting. However, it is probably too late to engineer a soft landing. The Fed’s main policy error was to ignore the rise in inflation last year as we feared in Is the Fed going to be blindsided by inflation? This has set in motion a wage-price spiral that will be very difficult to reverse without hiking the economy into recession.”

The Fed doesn’t listen to former members either given an interview with ex-vice-chair Quarles, who also says, “Given the intensity of inflation, the degree to which unemployment has been driven down – to bring that back into an equilibrium, it’s unlikely the Fed is going to be able to manage that to a soft landing. The effect is likely to be a recession…. For an economy that has accustomed itself to interest rates as low as they have been for as long as they have been, it doesn’t take a very large nominal increase in interest rates to be a very significant percentage of debt service for a number of heavily indebted actors. The effect on the economy could be fairly strong.”

The Fed additionally never listens to other central banks, more’s the pity, but the RBNZ just flagged that a “sharp” decline in housing prices is “plausible” as it raises rates: the RBA are pretending the cross-Tasman internet cables just got cut so it didn’t hear it.

Quarles, who is naturally now an asset manager, also suggested the Fed would have acted earlier on rates but was hampered by uncertainty over President Biden stalling on who would be Chair: “We would have been better served to start getting on top of it in September. That was hard to do until there was clarity as to what the leadership going forward of the Fed was going to be.” Doesn’t that say a lot about how politically independent they are?(!) Or does it sound like Harry Hindsight?

Of course, Quarles still believes “The Fed will get on top of inflation.” The issue is what else they get on top of first.

It’s hard to be bullish unaffordable housing when rates are rising; cash when US inflation is 8.5% y/y, diesel is pushing $6, and natural gas $8; equities when rates are rising; bonds, unless you think the market has already priced in everything the Fed might (over)do – which is what the market also thought a year ago; crypto, EM FX, or even gold. Usually, other commodities too – but as long as this (economic) war goes on, so will upward pressure on most all of them.

Today is also Star Wars Day (“May the Fourth be with you”). And there is a link with the Fed.

The iteration of Star Wars that began in 2015 has been divisive. Some loved it, but mainly those who never liked Star Wars before, and don’t spend money on it. For most hard-core fans, “It was as if a million voices cried out in pain; and were suddenly silenced.” I walked out of ‘So-so-lo’ thinking I didn’t care if I ever saw a Star Wars film again; I went back to see ‘The Rise of Skywalker’ and wished I hadn’t. Like ‘The Book of Boba Fat’, and maybe the upcoming ‘Oh-no-bi-Wan Kenobi’, Star Wars now seems led by those who don’t understand it; or script-writing; or Campbell’s monomyth of ‘The Hero’s Journey’.

Things just happen on screen because they look good, or are fun, or because we need a certain Member Berries. Events and actions have no connection with what happened before or what happens next – consequences, shmonsequences, canon, shmanon. It’s the synaptic difference between watching media made by people who read books and watching media made by people who ‘read’ TikTok. Ironically, it is much like watching a very young child playing with Star Wars action figures: ‘Bang! Pow! Zap! I win! I win! I win!’ – not very entertaining for anyone else. My point is summed up by the line in the first sequel where Harrison Ford exclaims, “That’s not how the Force works!”

The link to Fed is that we are seeing epic real-life space-opera playing out around us. There is war and heroism, and destruction and evil from people saying they want ‘to end this destructive conflict and bring order to the galaxy’. There is economic war, ironically over the taxation of trade routes, as the dull Star Wars prequel trilogy covered. There is fear of the end of democracy to thunderous applause, as it covered too. And yet we have a huge chunk of the markets playing with their action figures – ‘Bang! Powell! Zap! I win! I win! I win!’ Yes, markets are reeling now… but there is still a belief that this is just a Fed head-fake before we get back to the usual plot of assets going up.

Yet perhaps “That’s not how the Fed works!” against the current backdrop; nor the economy; nor the global trading system. Yes, we were never going to see an onshoring shift if it came from the Left – we don’t live on Naboo! But if it is coming from the national security Right and from big businesses, even with automation as R2-D2 to that whinging C-3PO, things look very different.

The Fed doesn’t talk about geopolitics, but it also doesn’t talk about politics when we know it is aware of them. We now have a former Fed Chair as Treasury Secretary talking about ‘friend-shoring’, and a Vice Fed Chair married to Kurt Campbell, the White House “Asia co-ordinator” or “Asia Tsar” under the NSA.

As Robin Brooks of the IIF puts it, that, “It’s a terrible indictment of the group think in macro that everyone talked with great enthusiasm about R* when inflation was low. But now that inflation is up, no one talks about it at all. It’s as if R* never existed. For the record, our proxy is up to 3.1% from 1.0% pre-COVID.”  He is trying to say ‘The Fed Awakens’.

Also consider that the Fed wants a strong dollar to crush commodities; and, as Jane Foley notes in ‘USD – Win, win?’, if in doing so it crushes the US economy and world markets, you still have to buy the dollar when global risk comes off.

Luke Skywalker: “I am not afraid”

Yoda: “You will be. You will be.”