TKer's 2022 word of the year: 'Pain' 🥊
The Federal Reserve reaffirmed its hawkish stance on Wednesday.
At the conclusion of its December policy meeting, the Fed tightened monetary policy further by hiking the target range for its benchmark short-term interest rate by 50 basis points to 4.25% to 4.5%.
The central bank also signaled that it expects to raise interest rates to higher levels than expected. Specifically, the Fed estimates its benchmark rate to top out around 5.1% in 2023, up from the 4.6% it previously forecast in September.
These actions represent the latest update in the Fed’s months-long effort to bring down inflation by cooling the economy through tightener financial conditions. It’s a battle that Fed Chair Jerome Powell warned could come with some economic “pain.” Indeed, the central bank sees the unemployment rate climbing to 4.6% in 2023, up from the 3.7% level it is today.
“We will stay the course until the job is done,” Powell said during a press conference on Wednesday.
“Worse pain would come from a failure to raise rates high enough and from us allowing inflation to become entrenched in the economy,” he added.
That means more pain in the economy and more pain in the financial markets.
Word of the year: ‘Pain’ 🤕
Every time members of the Fed speak, everyone looks for even the smallest changes in the language and tone. For some, these changes inform the economic outlook. For others, they inform trades.
So it was a big deal when Powell began using “pain” to characterize how monetary policy would be deployed.
“There could be some pain involved in restoring price stability,“ Powell warned during a Wall Street Journal event on May 17.
At the time, it appeared inflation was cooling from what many thought were peak levels. The March consumer price index (CPI) report showed headline inflation reached a year-over-year rate of 8.5%, which at the time was the highest print since December 1981. This was followed by an 8.3% print in April.
But Powell’s words signaled the central bank was nevertheless concerned about how high those levels remained.
In recent history, the Fed would tighten monetary policy when economic conditions were strong to get in front of what could be high inflation. The thinking was that economic growth was resilient enough to handle a little bit of pressure from moderately tighter financial conditions. Growth could cool, but it didn’t have to stall. And stock prices could rise as earnings headwinds were manageable.
This time was different.
Inflation had gotten much hotter than expected as supply chain pressures persisted amid very strong demand. It was a very complicated mess that had the Fed considering the possibility that it may have to slam the brakes on the economy to get inflation under control. And that would mean pain.
(You can read more about how we got to this point in the May 19 TKer: “SPECIAL EDITION: The complicated mess of the markets and economy, explained 🧩“)
We later learned March wasn’t the peak for inflation.
Prices heated up again in April and a new peak was established with the May CPI report, which was published on June 10.
The Fed’s inner hawk was unleashed.
The Fed’s claws could come out 🦅
After that stunning CPI report, experts warned that the Fed would have to get much more hawkish. Barclays economists were among the first to predict that the central bank was likely to increase rates by 75 basis points — instead of the 50 basis points most experts were expecting — at its June 15 policy meeting.
A 75-basis-point rate hike would’ve been the largest increase the Fed made in a single meeting since 1994. Initially, Barclays was well outside the consensus.
But on June 13, The Wall Street Journal’s Nick Timiraos, one of the most well-sourced Fed reporters in the business, wrote a story with the headline: “Fed Likely to Consider 0.75-Percentage-Point Rate Rise This Week.“
And on June 15, the Fed announced a 75-basis-point rate hike, the first of four such hikes in a row.
“We have to restore price stability,” Powell said that day. “It’s the bedrock of the economy. If you don’t have price stability, the economy is not going to work as it's supposed to.”
"The worst mistake we could make would be to fail [on lowering inflation],” he added. “We have to restore price stability. We really do."
In the June 13 TKer, I explained how all of this presented a conundrum for the stock market. From the piece:
The Fed’s job can be defined simply: Promote maximum employment and stable prices.
But it really only has one way of doing that work: Buy and sell securities in the bond markets to loosen or tighten financial conditions. One of the primary manifestations of tighter financial conditions is lower stock market valuations.
…
It’s also not a stretch to say the Fed does not want to see stock prices rally right now since that would be a reflection of looser financial conditions. This speaks to the conundrum in markets: As long as inflation is uncomfortably high, the Fed will act in ways that are unfriendly to stock prices.
Two days before the Fed’s June policy meeting, the S&P 500 closed down more than 20% from its January high, confirming it had entered into a bear market. At the meeting, Powell all but confirmed this was what the Fed was hoping for, saying: “Over the course of this year, financial markets have responded and have generally shown that they understand the path we're laying out.”
(For more on the June Fed meeting, read: “JPMorgan economists evoke God (and Samuel L. Jackson) in a chilling research note about central banks 🔥“)
Having seen inflation make a false peak earlier in the year, the Fed wasn’t going to make the mistake of declaring the mission accomplished after just a few months of declining inflation reports.
And so as long as measures of inflation remained above the 2% target, then you had to assume the Fed would remain hawkish in a way that would be unfriendly to financial markets.
‘Some pain’ now or ‘far greater pain’ later 🤕
At the risk of oversimplifying, not too much has changed since the June meeting.
While many measures of inflation have cooled from peak levels, the bottom line is that inflation continues to be significantly above the Fed’s 2% target. And so, the central bank continues to tighten monetary policy and act in ways that are unfriendly to financial markets. (For much more detailed discussion of all this, check out the reviews of macro crosscurrents in TKer’s weekly newsletter.)
There have been occasions when some experts thought that the trajectory of the economic data justified a dovish pivot from the Fed.
But Fed officials have always been quick to come out and push back.
Notably, Powell came out forcefully during his August 26 speech to the Jackson Hole Economic Symposium (emphasis added):
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
The S&P 500 plunged 3.4% that day.
And the following Monday, Minneapolis Fed President Neel Kashkari signaled that weak stock prices are among things the central bank has been aiming for.
“I was actually happy to see how Chair Powell's Jackson Hole speech was received,“ Kashkari said to Bloomberg News.
So it’s not too surprising to see the stock market struggle to embark on a sustainable rally.
And that brings us to present day.
On Tuesday, we learned the consumer price index in December was up 7.1% from a year ago. The measure of inflation is down from peak levels. But it continues to be considerably above 2%.
“Now, it's good to see progress,” Powell said on Wednesday. “But let's just understand we have a long way to go to get back to price stability.“
“I wish there were a completely painless way to restore price stability,” he added. “There isn't.“
At some point, the Fed’s tone will change as it acknowledges that inflation has been contained or is on a clear path to becoming contained.
For now, we should expect the Fed to continue to tighten monetary policy, which means tighter financial conditions (e.g., higher interest rates, tighter lending standards, depressed stock valuations). All of this means the market beatings will continue and the risk will intensify that the economy sinks into a recession.
For more, read TKer’s weekly review of the macro crosscurrents.»
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