POWELL SAYS THE FED HAS A PATH TO A SOFT LANDING. THIS QUANT SAYS IT DOESN´T ADD UP. / BARRON´S MAGAZINE

Powell Says the Fed Has a Path to a Soft Landing. This Quant Says It Doesn’t Add Up.

By Lisa Beilfuss

The Federal Reserve believes it can beat inflation and keep the economy growing as it unwinds pandemic-era easy-money policies./ Tom Brenner/Bloomberg

There’s something standing in the way of what the Federal Reserve says it will do and what it actually can do: math.

That is the takeaway from a discussion this week with Solomon Tadesse, head of quantitative equities strategies North America at Société Générale . 

He is an outlier. 

While traders and strategists are pricing in aggressive policy tightening as the Fed starts chasing inflation from a 40-year high, Tadesse says the Fed is already almost finished lifting interest rates. 

He sees one more rate hike in June—meaning a maximum of 0.5% more in rate increases this cycle—despite Fed Chairman Jerome Powell’s hint Wednesday that multiple half-point hikes are coming as well as subsequent smaller ones. 

Markets expect the policy rate to hit at least 2.5% by the end of 2022.

Tadesse says his call is purely quantitative. 

There are two key elements to his model. 

First, he says his research shows that the maximum amount of tightening the Fed can conduct is two-thirds of the total easing it did in the cycle leading up to the tightening. 

Second, there are shadow rates, meant to account for large-scale asset purchases that began in response to the financial crisis of 2007-08 and were conducted over the past two years. 

Used to measure the economy when policy rates are at or near zero, shadow rates attempt to show what the policy rate would really be when unconventional measures like quantitative easing are figured in.

Taking quantitative easing, liquidity facilities, and fiscal aid into account, Tadesse says the shadow policy rate was roughly negative 5% in the spring of 2021. 

Using that data point together with the cycle-peak policy rate of 2.5% in December 2018, he considers the prior easing cycle to have been almost 800 basis points. 

Two-thirds of that is about 550 basis points. 

Now consider that since June, the shadow policy rate has climbed about 250 basis points, or 2.5%. 

The idea is that while the Fed’s explicit tightening started in March, financial conditions have been tightening in anticipation of Fed moves.

Now subtract that shadow tightening from the 550 basis points that Tadesse says is the Fed’s capacity to tighten. 

Then back out this past week’s half-point hike and March’s quarter-point hike. 

That leaves just 2.25%—and that is before getting to balance-sheet reduction. 

Tadesse says the first $100 billion in so-called quantitative tightening will be equivalent to about 12 basis points in rate increases. 

As the balance sheet shrinks, each $100 billion translates to progressively more tightening; he doesn’t see the Fed shrinking its portfolio, which doubled over the past two years to about $9 trillion, by more than $1.8 trillion. 

Even then, Tadesse says, QT will soak up much of the Fed’s remaining tightening capacity.

Tadesse acknowledges that math is one thing and human decisions—especially given the fraught politics of inflation—another. 

The point is that if the Fed tightens more than his models show, a hard landing is guaranteed. 

Powell says otherwise. 

For him to be right, Tadesse says the Fed can’t go over 1% and tighten its balance sheet at the indicated pace for more than a year and a half. 

But to sufficiently cool inflation, it will have to.

The outcomes are binary. 

A soft landing means the Fed stops as Tadesse’s models suggest, meaning more inflation, probably alongside slowing growth and thus stagflation. 

If the Fed follows through on its vow to bring prices down, it will have to tighten more than the economy can handle before contracting. 

It can’t have it both ways.