Fed plans to raise rates as soon as March to cool inflation

[jaichind]

USA Q1 QoQ GDP came in at -1.4% versus an expected 1.0%.  Net exports and inventories seem to be the main reason.  This sort of shows that inflation is driven by excess demand which is beyond what the supply side can produce.   The only way out is to raise interest rates to curb excess demand.    Of course, it seems it is already too late. Stagflation is coming soon.

The other good option would be investing in expanding the productive capacity of the supply side. We could just have more stuff! (Not that hiking inflation rates in the short term isn't a good idea, of course.)

But that very act of investment will in the short run push up demand for capital goods which will be crowed out by excess demand in the economy already.  The only solution is a large rise in rates which would remove excess liquidity in the system as well as remove economic activity which is clearly subtracting value so the freed-up resources can be deployed in increasing capacity which are going to value adding.

[jaichind]

Just to get a sense of the excess demand in the USA economy, 2022 expected exports will be around 2.6% higher than 2014 exports but 2022 expected imports will be around 30.6% higher than 2014 imports.  And this is on top of a 2014 economy which already had a significant trade deficit.  The fiscal and monetary policies of the USA which made the assumption that the underlying issue was one of demand being too low to consume the productive capacity of the economy instead created the opposite problem.  In that sense the Obama, Trump, Biden administrations as long with the Fed should all take the blame.  Demand is so high now that it needs greater and greater net imports to fulfill.  The USA being the world reserve currency means that this can be spontaneous  financed world excess savings but on the long run there is no free lunch.

[jaichind]

JPM CEO Jamie Dimon in an interview with Bloomberg said

a) Federal Reserve should have moved quicker to raise rates 
b)  There is a 33% chance of the Federal Reserve’s actions leading to a soft landing for the U.S. economy and a 33% chance of a mild recession.

[jaichind]

Fed raises rates 50 bp but rules out 75 bp increase in the future.  Disappointing.  Fed is taking the risk of having to take much more dramatic steps next year.

[jaichind]

The reception in the stock market was positive, probably due to the prospect of abatement in inflation.

Market went up because many including me expected a 75 bp move and the Fed communications seems to rule out future 75 bp moves.   Long term Inflation swaps went up as this means high inflation is expected to last longer.

[jaichind]

BOE raises rates by 1% and indicates that

a) Inflation will peak out at over 10% in the UK
b) There will be a recession in the UK in 2023

India's RBI also did a surprise unscheduled 0.4% rate hike and there will be a lot more to come as the inflation surge in India is deemed to become out of control.

[jaichind]

Former Fed economist Andrew Levin said in an interview with Bloomberg

"Unfortunately, the Fed is still not following the basic principles of sound monetary policy that it has laid out on its own website.

What really matters to the economy is the inflation-adjusted interest rate, which is the rate minus inflation. At this stage getting to a neutral rate, where it is no longer pushing inflation even higher, is the top priority. The monetary policy stance is neutral when the federal funds rate is just a bit higher than the underlying trend of inflation.

Right now the underlying level of inflation is running at about 5% once you take out transitory factors, so the inflation-adjusted interest rate is deeply negative (about -4%). Getting to neutral, as Fed Chairman Jerome Powell said himself Wednesday, is still a long way off. He appeared to take the possibility of a 75-basis-point increase off the table, preferring to stick with smaller hikes in coming months. And that means the Fed could still be adding fuel to the inflationary inferno, even by the end of this year.

And as we talked about in our previous chat, it's very plausible that inflation will be headed higher this year, not downwards. So it's clear the Fed has a long way to go. If it's going to start following the principles of sound monetary policy, then that may well call for a federal funds rate in the range of 5% to 8%."

Which is my point about the Fed rate needing to be above inflation especially when you are trying to control inflation.   

[jaichind]

Market way down today as it dawned on investors that a slow rise in Fed fund rates means the party goes on longer but also means a much more aggressive rise in rates will most likely take place leading to an even bigger downturn.

At this stage the Fed's choices are

a) significant chance of a medium-sized recession in 2023

OR

b) Even bigger chance of a very large recession in 2024

[jaichind]

Mohamed El-Erian, a closely followed bond-market strategist, says the Federal Reserve has a trust problem with financial markets and the nation over inflation by ruling out a 75 bp rate increase in the future.

[jaichind]

For the first time since the Summer of 2019 the real 10-year treasury bond yield (yield minus inflation swaps for that same duration) turned positive.  I like to see that go up another 0.5%-0.7% to be in 2018 levels but this does seem to indicate that long-run projections pricing are beginning to move toward normal levels and the medium maturity bond rout is more than halfway done.  It is the short-term rates that are crazy low and there will be a lot more turmoil ahead as the Fed tries to avoid a large crash in the next couple of years.

[jaichind]

https://www.marketwatch.com/story/fed-isnt-ruling-out-75-basis-point-moves-forever-mester-says-11652198364

"Fed isn’t ruling out 75 basis point moves forever, Mester says"

Markets that were up over 1% fell to negative territory on this news.  The Fed's communications on what they plan to do are terrible this cycle.

April YoY CPI numbers are coming out tomorrow which are expected to be 8.1% which is a drop from March YoY CPI numbers but that will be a base effect with MoM still expected to be positive.  I suspect the Fed is hedging itself in case the numbers end up worse than expected.

[jaichind]

April YoY CPI came in at 8.3% which is lower than March YoY CPI of 8.5% but higher than the expected 8.1%.  There will be somewhat more pressure on the Fed.

[jaichind]

US equities futures which were up over 1% before the CPI numbers came out all go wiped out when the CPI numbers came out.  It is now in negative territory and heading lower.

What is also interesting is that April chain CPI YoY was up 8.1% just March chain CPI YoY.  Last few months the "gap" between chain CPI and regular CPI was large which means that the price surge was more limited to a set of items that there were alternative products that could be used as substitutes.  The closing of the gap between chain CPI and regular CPI means that inflation pressure is now getting more across the board, at least in the goods area.  The Fed is running out of arguments like "the inflation surge is because of X, once X is out of the way things will be back to normal" as the price increase are becoming more broad-based and likely self-perpetuating.

[jaichind]

Hopefully, now the Fed faces reality and put a 75 bp and in my view a 100 bp increase on the table for the next Fed meeting.  The market pricing clearly thinks this is the case (at least the 75 bp part)

[jaichind]

April YoY PPI at 11%  Market expected 10.7%.   Par for the course given recent trends

[jaichind]

Hopefully, now the Fed faces reality and put a 75 bp and in my view a 100 bp increase on the table for the next Fed meeting.  The market pricing clearly thinks this is the case (at least the 75 bp part)

So we should expect mid-term stagflation?

I would say that the equities markets are pricing in around a 50% chance of a recession next year.  I think if it falls another 5% or so then the chances of a recession next year is very high. 

[jaichind]

About what I assumed, although we might get the official "recession" as soon as next quarter.

Anyway, I have already started buying the dip a bit, but not sure how much I should leave for later. Think we could lose more than 10% to ATL from this point?

The way the inventory cycle works makes the chances of official recession unlikely next quarter.  Still, economic growth clearly is slowing down.  There is still some reason to believe that when the likely recession comes it will most likely be more shallow than 2008 and more on the order of 2001.  Right now inventory levels are not that high and the usual reason why recessions are deep is large inventories that companies then burn through while they lower production.  This time around this factor will work in favor of shallow inflation.  The Fed still has dreams of holding down unemployment while rates rise to push down inflation.  This just seems unlikely and the Fed should accept reality and not risk a even worse recession and unemployment later down the line.

[jaichind]

Now Powell Reiterates 50 bp Hikes Are Likely in June and July. Sigh.  the Fed communications on this are all over the place and this signals significant divisions within the Fed.

[jaichind]

University of Michigan Consumer Sentiment Index continued to stay at a very depressed level.  It is at the worst level since the early 1980s with the exception of being slightly above late 2008-early 2009 levels (Great Recession) as well as the Summer of 2011 (Budget crisis).

[jaichind]

University of Michigan Current Economic Conditions Index  came in at 63.6.  The only 2 months that were worse than this since 1980 is Oct 2008 and Nov 2008.  Every other month over the last 42 years is better than this reading for May 2022.

[jaichind]

University of Michigan Current Economic Conditions Index  came in at 63.6.  The only 2 months that were worse than this since 1980 is Oct 2008 and Nov 2008.  Every other month over the last 42 years is better than this reading for May 2022.

A stock market bear market, 8% inflation, record high housing prices, and a slowing economy is an amazing combination of things that aren't supposed to all happen at once.

Many people do not remember this but inflation was a major concern in late 2007 and most of 2008.  The Fed fund rate had to hit 5.25% in late 2007 and in July 2008 CPI YoY hit 5.6%.  I remember food prices were surging in early 2008 and inflation became a bigger concern which all were erased by the economic and financial crash of late 2008.  Just to be clear, the markets started to fall in late 2007 and had fallen over 20% from their peak by July 2008 before the big crash in Sept 2008.  At the same time unemployment in late 2007 was around 4.6% which was fairly low.

So today really looks a lot like mid-2008 in many ways with the exception that the Fed funds rates today are way behind the curve relative to 2007 2008.

[jaichind]

https://www.nytimes.com/2022/05/16/business/ben-bernanke-predicts-stagflation.html

"Ben Bernanke Sees 'Stagflation' Ahead"

Former Fed Chairman Bernanke said Fed leaders were too slow to react to surging U.S. inflation and as a result face a period of stagflation or a combination of stagnant growth and high inflation.

[jaichind]

https://news.yahoo.com/goldman-sachs-economist-slowdown-consumer-spending-151957462.html

"Goldman Sachs economist sees 'a slowdown in consumer spending'"

The same GS economist Jan Hatzius also said in an interview with Bloomberg said "Borrowing is going to be a short-term driver of spending, and I think has been to some degree" and "Consumer spending is going to be relatively slow. Income is going to be quite weak in 2022."

It seems if consumers are using leverage to deal with inflation then the economic slowdown is going to be worse than expected.  The Fed is riding the tiger and now it is getting harder and harder to get off.

[jaichind]

Walmart and now Target's profits both fell well short of expectations and had deep stock price declines.  So there goes the "inflation is high because of greedy capitalists/corporations" line.  Of course, that line never made since I am pretty sure capitalists/corporations were greedy before 2021.

[jaichind]

Fed Reverse Repo Facility Demand Jumps to a record $1.973 trillion.  This pretty much shows there is excess liquidity in the system as market players run out of places to stash short-term cash.    Another data point points to the need to drain liquidity from the market via aggressive raises in the Fed fund rate as well as unwinding the massive Fed balance sheet.  When that does happen the long term cost of the Federal debt will become clear there will have to be a fiscal adjustment as well after the economic downturn is over.