An article published last week in Bloomberg, according to which history shows that the Fed stops raising interest rates on average 22 weeks after inflation has peaked (which supposedly means that the interest rate hike last Wednesday was also the last in the current cycle), ignores the connection between the phenomena.
In the previous interest/inflation cycles, inflation came mainly from the demand side. Therefore, the Fed had enough data from about six months since inflation started to moderate to be convinced that its monetary policy was working. In the current cycle, however, the decline in inflation is, at least for now, the result of a change on the supply side and is in no way related to Fed policy.
The Fed knows this very well and therefore it is also very likely to assume that Wednesday’s interest rate hike was not really the last interest rate hike of the current cycle. Powell’s remarks at Wednesday’s press conference illustrated that very point. According to Powell, the labor market (that is, the demand side) is still very strong and therefore “the Fed’s policy is still not sufficiently restrictive”.. “There are more interest rate increases in the pipeline”. Inflation towards the target of 2%”.
Despite all this, it seems that investors are not really buying Powell’s hawkish messages, certainly not at the price Powell would like. The futures contracts on the Fed interest rate currently imply that the peak interest rate will probably arrive at one of the next two meetings and will be only 50 basis points higher than the interest rate today (ie one increase of 50 basis points or two increases of 25 basis points). Not only that, but the market It also means that at the end of 2023 the interest rate will already be lower than the current one.
So what makes investors think the Fed is bluffing? Mainly the expected recession that is getting closer and closer to the American economy. The collection of macro data published after the Fed’s decision, including the retail sales data, the New York and Philadelphia production indices, and industrial production illustrated how weak the economic environment in the US is. But the labor market is strong, isn’t it? So that’s it, it’s not safe at all. That employment data may be significantly biased upward Last week, the Philadelphia Fed released its quarterly employment data and supported this assessment by noting that in the second quarter alone, the BLS’ monthly job additions were likely biased upward by 1.1 million jobs (!!)
Why should we believe the Philadelphia Fed and not the BLS? First, because the employment report that comes out immediately after the end of the month sacrifices a little of its accuracy in order to come out as quickly as possible. Second, we have already mentioned here the reasons why the employers’ report is probably biased (seasonality deduction that went wrong with Corona, a shift from full-time to part-time jobs and based on affluence due to participation low of the firms in the survey) and to these reasons we will now add another reason that is becoming clearer as the economic situation deteriorates: the PPP program (too large grants under conditions that are too easy for firms during the Corona period) led to the opening of quite a few “zombie” companies in the US just to receive the grants of the program. Since a large part of the employment report is based, as mentioned, on estimation (in the last report only 49% of companies responded to the survey), the BLS actually assumes that many new businesses were created and therefore, so to speak, many new jobs were also created. It is likely that in the January update we will see the number of jobs in the US updated sharply downwards and that the American labor market will suddenly look much less tight than it looks today.
Therefore, the really important question is to what extent will the Fed keep poker face and stick to its policy even into a recession? On the face of it, the trauma of the last two years and the Fed members’ recognition that they were wrong (no small thing) and allowed inflation to run away should make the Fed members prefer to continue raising interest rates even into the recession. The reason is that the Fed prefers not to risk that monetary easing will lead to a renewed increase in inflation to an abnormal level in the next business cycle. Powell and his friends have clearly stated quite a few times recently that this is the direction they prefer to go, even at the cost of a recession. However, as anyone born before 1990 knows, during a recession things look different and that’s exactly what investors build on. The Fed may sound hawkish now simply because it’s convenient for him, but when unemployment rises and political and social pressures intensify, Powell may take solace in the fact that in the next economic cycle he will no longer be the chairman of the Fed and abandon current policies.
On the poverty table in Europe, the risks are higher
Not only was the US Central Bank in the headlines last week, but also that of the Eurozone. As you know, the ECB raised the interest rate by an additional 50 basis points and accompanied the decision with even more hawkish messages than Powell’s. According to Lagarde, the bank will continue to raise the interest rate by 50 basis points at each of the meetings in the near future so that the interest rate will reach a significantly higher level than the current one. Moreover, Lagarde also clearly said that those who think that the ECB is close to a pivot are simply completely wrong, what Which is in line with the bank’s updated inflation forecasts according to which inflation will not reach the target even in 2025. If all this was not enough then Lagarde also dropped the bomb when she said that the financial markets simply do not internalize how much the interest rate will have to rise in order to stop inflation.
Who would have believed that the Europeans, who turned walking between the drops into an Olympic sport, know how to say such sharp and clear things? Just like in the case of Powell, Lagarde is also playing poker with the markets, only that in the case of Europe it is a game with a less good hand and a much larger jackpot. Every overly hawkish comment by Lagarde puts pressure on the bond market of the peripheral countries in general and Italy in particular. Accordingly, every increase in yields on Italian bonds puts pressure on Lagarde and her friends again. The fear of the 2012 scenario in the European bond market is still relevant, and if the markets want to expose the ECB’s bluff, it is not certain that the cards in its hand will be enough. It will be necessary on the one hand to make a quantitative reduction and on the other hand to make a quantitative expansion what is known in the macro department of the summits QEIIBTIG (quantitative easing in Italy but tightening in Germany). In principle, this is an experiment that can be done, but the reality, as we know, is not a controlled environment for experiments, and such a move would clearly give the Italians an incentive to expand fiscally, which would make the move inflationary.
Moreover, it is not at all certain that the Germans and the French, who are forced to freeze in winter and find it difficult to implement an expansionary fiscal policy due to inflation, will be happy to see their central bank helping their neighbors in the sunny south to adopt such a policy. Therefore, it is more difficult to assume that the entire QEIIBTIG process (all rights reserved to the summits) will pass without political and financial shocks than it is that from now on FIFA will choose the hosts of the World Cups according to sporting criteria.
On the other hand, rummy is played in Israel
As we saw last week, inflation in Israel has not yet reached its peak, but it seems that this peak is already just around the corner. In a certain sense, the work of the Bank of Israel is actually easier than that of the Fed or the ECB for two reasons: one is that inflation in Israel is not as high as in the world and the other is that the probability of a deep recession in Israel or something that will “break” in the financial environment is much lower. Not only does the Israeli economy benefit from a consumer whose real income has hardly been eroded, but also that a significant part of exports (which is itself a significant part of GDP) enjoys a comparative advantage that softens the negative fluctuations in it. Even if Europe or the USA enter a recession, the firms there cannot simply decide to cancel their cyber policy, for example, so that the demand for the export of Israeli high-tech services is relatively immune.
In addition to all of this, the government’s fiscal situation has greatly improved over the past year thanks to huge tax revenues from the technology and real estate sectors. Although it is clear that these revenues will not continue and it is even likely that we will see a decrease in the state’s tax revenues, the fiscal situation is such that it will allow the government to support the economy in the event that the deterioration is severe Therefore, the Bank of Israel will continue to raise interest rates in the coming months just like the rest of the world, but will do so without fearing that these increases could lead the economy to a crisis.
**The author is the chief strategist of Psagot Investment House**