The inflation issue
The Fed is effectively “fighting the last war,” according to BofA global economist Ethan Harris, referring to a phrase that implies officials are looking back at previous economic cycles rather than focusing on the unique characteristics of the current one.
In this case, the Fed is up against an adversary it hasn’t seen in decades: persistent inflation caused by factors unique to the Covid-19 pandemic. Supply chain bottlenecks, unusually high demand for goods over services, and widespread labor shortages are all factors.
However, rather than attempting to control inflation, the Fed has encouraged it. Last year, the central bank adopted a new policy regime in which it will tolerate higher levels of inflation in order to promote full and inclusive employment.
This comes after falling short of its 2% target for more than a decade, owing to an aging workforce, lower productivity, and increased automation.
Harris, on the other hand, believes the Fed is too focused on its past failures rather than the issue at hand — that inflation may not be as transitory as policymakers believe.
“We have never felt that the previous cyclical recovery was a good template for the current recovery,” wrote the economist. “There is an increasing risk that the Fed will be forced to make a major policy pivot in the next two years.”
According to the current policy framework, the Fed will soon begin gradually reducing the amount of monetary stimulus it has been providing to the economy through monthly bond purchases. After that process is completed, it will begin gradually raising interest rates back to a more normal position.
However, this is heavily reliant on keeping inflation under control while unemployment falls. When things don’t go as planned, the Fed has a history of having to backtrack on policy.
“History shows that when the Fed is fighting relatively embedded inflation, a soft landing is very difficult to pull off,” Harris said. “Fighting inflation also jeopardizes the same less-advantaged workers who benefit the most from the economic recovery.”
Indeed, Fed Chairman Jerome Powell has stated on numerous occasions that interest rate increases can be used to control inflation. However, if the Fed moves too quickly, it may cause disruption and harm to the people it is attempting to help through its full and inclusive employment efforts – those at the bottom of the wage scale and belonging to demographic groups such as women and minorities who did not share equally in the previous economic boom.
Earlier Wednesday, investor Paul Tudor Jones warned that the Fed was on the wrong track when it came to inflation.
“We have a Federal Reserve Board that creates inflation, not fights it.” “That’s a huge deal,” Jones said.”
‘What if this is just the start?’
According to Harris’ analysis, the Fed faces several critical questions that must be answered in order to avoid the potential policy mistake he mentioned.
“It’s too early to give definitive answers to these questions,” he said, “but clearly the risks are rising.”
Among them is whether the rate of natural, or full, employment is higher than it believes after a period in which the unemployment rate peaked at 3.5 percent.
Wage inflation caused by a labor shortage has contributed to the current inflation picture and may raise expectations if the current pace continues.
“What if some of the recent wage growth isn’t solely due to reopening, but rather reflects more structural changes in the job market?” Harris penned an essay. “Recent data is shining a light on these issues.”
He also stated that the Fed must recognize that inflation expectations are rising and posed the question, “What if this is just the beginning?”
Finally, he notes that the fiscal response has been much more aggressive this time around, with Congress spending more than $5 trillion while debating another infrastructure package.
“The current fiscal expansion is much larger than the previous cycle,” Harris said. “This begs the question: is unusually dovish Fed policy required to achieve this result, or are they stoking the fire?”
What to expect from FED
The market has rebalanced, re-entered the upward rally path, and will soon enter the best seasonal period. These are facts, but they are now widely accepted. If the tape settles, a 2% to 3% decline would be completely normal and consistent with a base building above the early-October lows.
Many of the short-term indicators resemble late-June/early-July conditions. That was the last time the S&P 500 rose six days in a row, and the last time the weekly AAII survey showed the same Bull-Bear split. The NAAIM pro tactical managers have also chased the rally in order to increase equity exposure to summertime highs. The uptrend slowed and narrowed slightly at that point, dipping into mid/late July but not stopping.
These aren’t timely contrarian signals in and of themselves, but they indicate that the market has already burned off much of the pessimism that was prevalent two to three weeks ago and helped set the stage for this rebound rally.
It’s encouraging to see weekly jobless claims come in lower than expected once again, and leading economic indicators continue to move in the right direction, indicating that the real economy is at least making steady progress. Spending is holding steady, with a slight shift toward services, though consumer-cyclical stocks are shaky (outside of TSLA and the like).
Bond yields resume their upward march, with shorter maturities moving the most as the market incrementally moves the expected date of the first rate hike forward and global yields (German 10-year, for example) continue to rise. The Fed meeting on November 2-3, which is now firmly in sight, will begin to become a fixation. We disagree on the aggressiveness of a tapering move and inflation rhetoric – at a time when a Fed chair must be nominated (or re-nominated) very soon.
Stocks almost never reach a serious peak with the first rate hike, but there are often scares and drama on the way. Fundamentally, taper is a non-event; it is now merely a signaling tool.
TSLA is fully back in gear, with the quarterly results serving as an excuse for the wild binge on upside call options that has traditionally powered the stock during its most ferocious rally phases. The intraday high today is $900.00. January’s all-time high was $900.40. Such a mechanical manifestation of public fervor. In the short term, things are heating up. It accounts for roughly half of the Nasdaq 100’s 0.4 percent gain today.
Also, for fun, compare TSLA to bitcoin over the last six months. If there is a connection, it is not that TSLA owns a small amount of bitcoin, but that they are both driven by the same flow of animal spirits from a similar constituency. (Of course, it could be coincidence; however, there isn’t as strong a link in the long run.)
Earnings are broadly “just fine,” with the usual push-pull of reactions; there isn’t yet a critical mass to project what this means for fourth-quarter profit revisions, but there hasn’t been much aggressive estimate-hiking. Margin squeeze is a theme, and companies that fail to meet it are punished more harshly than usual.
Market breadth was soft/mixed, with a 35-65 up-down split on the NYSE and nearly the exact opposite on the Nasdaq.
Credit markets are pleasant and stable. The VIX is hovering in the 15s, which is a safe bet. As previously stated, it has been the floor this year, and traders have been hesitant to bet on incremental calm when it has fallen to this level. That’s partly because a market squall quickly appeared; there’s no guarantee the same thing will happen this time, but volatility traders will probably be slow to grow more comfortable from here.