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Good morning. Ethan here. Rob is on hiatus and, after today, so is Unhedged. Regular service resumes September 5, when Rob will make his much-anticipated return. While we’re off, why not read Martin Sandbu’s always interesting Free Lunch or listen to Katie Martin talk about quantitative tightening?
For the next couple weeks I’ll be helping out elsewhere in FT-world. In the meantime, complaints, ramblings and new ideas are always welcome: [email protected].
The Fed-markets disconnect
Here are some snippets from Federal Reserve officials’ speeches yesterday.
Hard to scream much louder than this:
[St Louis Fed president James] Bullard said he isn’t ready to say inflation has peaked and it remains important for the Fed to get its target rate to a range of 3.75 per cent to 4 per cent by year-end . . . He also said that he sees about an 18-month process of getting price pressures back to the Fed’s 2 per cent target
“We need to get inflation down urgently,” [Minneapolis Fed president Neel] Kashkari said . . . “We need to get demand down” by raising interest rates. Economic fundamentals are strong, he said, but whether the Fed can lower inflation without sending the economy into a recession, “I don’t know”.
[Kansas City Fed president Esther] George said the pace and ultimate level of future rate rises remained a matter of debate. “To know where that stopping point is . . . we are going to have to be completely convinced that [inflation] number is coming down.”
Why the disconnect? I can think of three potential reasons:
Markets are optimistic about inflation. They think it will moderate fast enough that the Fed can pivot to slashing rates. Unhedged disagrees, but you can find smart people like the Institute of International Finance’s Robin Brooks or JPMorgan’s Marko Kolanovic making this case.
Markets don’t believe the Fed’s commitment to fighting inflation. They think a weakening economy will force the Fed into lowering rates, even if price pressures stay hot.
Market pricing, for some reason, isn’t reflecting a fundamental view of the economy. I have no idea how to assess the likelihood of this. But for what it’s worth, the FT reported yesterday that technical factors, such as hedge funds closing out short positions, have been behind the recent equities rally.
Whatever the reason, former Fed vice-chair Bill Dudley argues in an op-ed yesterday that markets’ disbelief is harming the US central bank’s policymaking. It is loosening financial conditions right when the Fed wants them tighter. Dudley wants chair Jay Powell, who will speak publicly next Friday, to ram his message through Mr Market’s thick skull:
Powell must take care to disabuse markets of the notion that the Fed will soon be done tightening monetary policy. Many investors appear to have reached this conclusion based in part on Powell’s statement in July that future interest-rate increases will be data-dependent, ignoring his repeated [insistence that the Fed is projecting] a peak considerably above what financial markets expected . . .
Powell must make clear that even if the Fed pivots to smaller interest-rate increases in coming months, that does not necessarily indicate a lower peak . . .
Many see his warning as mere rhetoric, designed to keep inflation expectations down. They think that once the economy slows, unemployment rises and inflation falls, the Fed will start cutting interest rates long before the 2 per cent target has been achieved.
Dudley’s point is about messaging. And yes, if markets think the Fed’s inflation-fighting pledge is suspect (reason 2), some tougher talk — perhaps a Bank of England-style promise to prioritise inflation over growth — could scare them straight.
But if, instead, markets believe inflation is about to subside (reason 1), what can Powell say to dispel that? The Fed has no more insight into where the economy is going than investors. And if markets are right, it’s hard to believe the central bank would raise rates in an economy that’s slowing fast while inflation numbers tumble. That is the bind of the Fed being data-dependent: it applies on the way down, too.
Readers reply on credit risk
Wednesday’s newsletter made the point that how scary credit risk looks depends on where you think interest rates are going. A number of readers wrote in to register their thoughts.
Pascal Blanqué of the Amundi Institute noted a few reasons to be optimistic about corporate credit:
Defaults were after all rather muted in the 70s. Corporates reimburse in nominal terms. Real rates are still low. This happens when you target nominal growth with low real rates. Buying time.
Inflation helps debtors, and that’s no less true for corporate debtors. But there is a more pessimistic view — that inflation will stop central banks from intervening when the credit cycle turns down.
Deutsche Bank’s Jim Reid makes this argument well (thanks to Dec Mullarkey at SLC Management for sending along). Reid argues that structurally higher inflation will limit how much loose monetary policy is possible. If a US recession comes in late-2023, chances are Congress will be controlled by Republicans, likewise limiting fiscal policy. A recession plus little policy support gives you a big rise in defaults:
This view, of course, hinges on the Fed sitting back and watching it happen. Would it do that? Mullarkey adds:
I think there will continue to be sensitivities around the risk of financial contagion and employment dislocations when recessions hit. Therefore, some version of stewardship will continue. However, if dogged inflation neutralises central banks’ flexibility then high real rates will likely prevail and push average default rates higher.
In the end, it’s all about inflation.
One good read
RIP to Pixy, the flying selfie drone.