New Cycle Monetary Management
Doug Nolan
I appreciate that Jay Powell is no ideologue.
His Fed has made some historic missteps, and Powell as Chair has sometimes flailed.
But I’m willing to cut him some slack.
I hold his predecessors responsible for the Bubble.
Greenspan and Bernanke certainly share responsibility for the absolute mess made of contemporary central bank doctrine.
No doubt about it, decades of poor analysis, flawed doctrine, bad decisions and obfuscations are coming home to roost on Powell’s watch.
The future holds so much uncertainty.
One thing seems clear: he’ll be ruthlessly tarred and feathered.
I believe Powell is a good man and wants to do right for the country.
At critical junctures, Greenspan and Bernanke consistently veered toward looser and ever more precarious policy courses.
Never did I witness the courage necessary to accept the short-term pain necessary to improve long-term outcomes (including reducing the likelihood of catastrophic financial and economic crises).
Monstrous egos put our nation’s wellbeing in jeopardy.
When circumstances turned tough, they would resort to BS justification for only more outrageous monetary accommodation.
Greenspan and Bernanke were both dangerous ideologues and inflationists that handed the keys to our nation’s future to Wall Street – in the process nurturing a prolonged cycle of runaway monetary inflation, speculative Bubbles, and deep financial and economic maladjustment.
Powell’s Jackson Hole speech was short and powerful.
No academic elements with the potential to muddle his message or be misinterpreted.
Ideology-free.
Powell’s presentation was also notably short on doctrine.
No talk of the Fed’s “dual mandate” – not a single mention of “maximum employment.”
Powell: “The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2% goal.
Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy.
Without price stability, the economy does not work for anyone.”
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.
Reducing inflation is likely to require a sustained period of below-trend growth.”
“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.
These are the unfortunate costs of reducing inflation.
But a failure to restore price stability would mean far greater pain.”
Markets were anticipating a hawkish Powell.
Yet they were clearly uncomfortable with the Fed Chair demonstrating such uncompromising inflation resolve.
This was more than lip-service.
It was a veritable manifesto.
Powell, addressing unavoidable pain for households and businesses, omitted any reference to a market priority: pain avoidance for the financial markets.
Only a month after misjudging a “dovish pivot,” Wall Street confronts a Federal Reserve pivot to unabashed inflation fighter.
It will take some real back-peddling to convince me that this wasn’t a momentous inflection point for monetary policy management.
As a long-time admirer, Powell Friday, in majestic Jackson Hole, resolutely stepped into Paul Volcker’s fly fishing waders.
Importantly, mention of “financial conditions” was MIA.
Blacklisted.
This is after Powell referred to “financial conditions” 17 times during his May post-FOMC press conference (reduced down to four at last month’s press conference).
This omission was not accidental.
Using market-based financial conditions as a primary policy reaction function was problematic and, in the end, untenable.
Especially with today’s highly speculative and unstable market environment, financial conditions will ebb and flow right along with Fear and Greed – with “Risk Off” and “Risk On.”
While markets over recent decades relished being at the center of the monetary policy-making universe, this framework is ill-suited for the New Cycle’s inflationary backdrop.
While not done formally – or with any fanfare – Powell’s speech suggests a momentous shift in monetary policy doctrine.
The Fed is fixated on inflation, and deemphasized markets will just have to learn to live with it.
Powell is moving the Federal Reserve back toward more traditional central banking.
When Powell (and Fed officials) utters “financial conditions,” market participants smile, nod and think happy “Fed put” thoughts.
Since Bernanke in 2013 proclaimed the Fed would “push back” against tightening financial conditions, markets have increasingly believed market backstops were formally ingrained in contemporary central banking doctrine.
This was certainly crystallised when the Fed repeatedly ratcheted up stimulus measures until markets reversed higher back in March 2020.
No one believes the “Fed put” has been abandoned, though that’s not the crucial point.
Powell’s Jackson Hole speech confirms the newfound ambiguity of the Federal Reserve’s market backstop.
While unspoken, the Fed for years has operated on the basis that it was advantageous to address market instability early – before instability had the opportunity to spiral out of control.
For the free-market ideologue Greenspan, The Maestro was quick with a subtle little helping hand.
All that was required was a well-timed cryptic utterance indicating attentiveness to market concerns.
Off to the races.
Bernanke’s “push back” comment clearly was to get ahead of developing market tumult.
Powell began his term with agitated markets demanding – and receiving - a big dovish pivot.
Powell’s speech can be interpreted as the Fed raising its threshold of acceptable market instability.
Especially after witnessing the recent rally briskly cutting 2022 losses in half, I would expect the Fed to be atypically dismissive of the markets’ next bout of “Risk Off.”
This could quickly become an issue for the markets.
It is, after all, the second leg lower where already shaken bear market nerves can get really rattled.
The past two months' rally has engendered acute vulnerabilities.
Market hedges have been unwound or simply expired.
A major short squeeze forced the unwind of short positions.
And I’ll assume the leveraged speculating community was forced to jump on board the rally.
All this creates a marketplace susceptible to weakness, spurring abrupt shifts in positioning and hedging strategies, with clear potential to unleash selling-begetting-selling crash dynamics.
“Higher for longer is the new watchword,” Bloomberg quoted Peter Hooper, Deutsche Bank’s global head of economic research.
Powell pushed back against market expectations for a loosening of monetary policy in 2023.
Powell: “Restoring price stability will likely require maintaining a restrictive policy stance for some time.
The historical record cautions strongly against prematurely loosening policy.”
“In particular, we are drawing on three important lessons.
The first lesson is that central banks can and should take responsibility for delivering low and stable inflation…
Our responsibility to deliver price stability is unconditional…
Fed's tools work principally on aggregate demand.
None of this diminishes the Federal Reserve's responsibility to carry out our assigned task of achieving price stability.”
“The second lesson is that the public's expectations about future inflation can play an important role in setting the path of inflation over time…
During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decision-making of households and businesses…
As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, ‘Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations…’”
“That brings me to the third lesson, which is that we must keep at it until the job is done…
The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years.
A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year.
Our aim is to avoid that outcome by acting with resolve now.”
“We will keep at it until we are confident the job is done.”
It was an ominous end to an ominous week.
A while back, it became clear that elevated inflation wasn’t transitory.
It was as if there was suddenly recognition that even the recent dramatic inflationary spike might not prove transitory either.
The Fed was not the only central bank adjusting to what appears to be a secular shift to highly elevated inflationary risks.
August 26 – Reuters (Balazs Koranyi):
“Some European Central Bank policymakers want to discuss a 75 basis point interest rate hike at the September policy meeting, even if recession risks loom, as the inflation outlook is deteriorating, five sources with direct knowledge of the process told Reuters…
While no policymaker has publicly advocated such a large move, back-to-back 75 basis point hikes from the U.S. Federal Reserve and a stubborn deterioration of the euro area inflation outlook strengthen the case for such a discussion.”
August 26 – Bloomberg (Jana Randow):
“Some European Central Bank officials want to begin a debate by year-end on when and how to shrink the almost 5 trillion euros ($5 trillion) of bonds accumulated during recent crises.
Deciding how to go about the process -- known as quantitative tightening -- is the logical next step after the ECB raised interest rates for the first time since 2011 in July, people familiar with the plans said…
The Governing Council hasn’t discussed the issue yet, and it’s unclear when the best moment would be to start reducing the balance sheet, given the increasing likelihood of a recession in the 19-member euro zone, according to the people.”
August 23 – Bloomberg (William Mathis):
“Power prices for Wednesday soared to records around Europe, heaping further pressure on governments to accelerate plans for how to shield households from devastating bills and rising inflation…
Fresh highs are becoming a nearly daily occurrence for Europe’s power markets…
Wednesday rates rose to records in the UK, France, Germany, Italy and the Nordic region.
In France, where traders are paying the most, the day-ahead contract gained 5.5% to 645.54 euros ($640.83) a megawatt-hour on the Epex Spot SE in Paris.
That’s more than seven times higher than a year ago, when prices had already risen far above the longer-term average.”
Global central bankers must these days contend with powerful forces that didn’t even exist during the previous cycle.
European gas supplies from Russia were cut further this week for Nord Stream 1 “maintenance.”
Many fear Putin could completely halt energy exports into Europe ahead of the winter heating season, as extraordinary geopolitical risks take center stage.
Meanwhile, it was as if a lightbulb went off regarding rapidly mounting climate change impacts on inflation and growth dynamics.
August 24 – Washington Post (Christian Shepherd and Ian Livingston):
“The unprecedented heat wave that has engulfed China this summer has dried up rivers, wilted crops and sparked forest fires.
It has grounded ships, caused hydropower shortages and forced major cities to dim lights.
Receding waters have revealed long-submerged ancient bridges and Buddhist statues.
Among the many striking images is a pattern left in the mud flats around Poyang Lake, usually the largest freshwater body in the country, which has shrunk by more than two-thirds.
Chinese media dubbed the branchlike patterns carved by trickling waters ‘Earth tree,’ calling the lake’s condition a warning about a dangerous future of intensifying extreme weather.”
August 25 – Bloomberg (Brian K Sullivan):
“Rivers across the globe are disappearing.
From the US to Italy to China, waters have receded, leaving nothing but barren banks of silt and oozing, muddied sand.
Canals are empty.
Reservoirs have turned to dust.
The world is fully in the grip of accelerating climate change, and it has a profound economic impact.
Losing waterways means a serious risk to shipping routes, agriculture, energy supplies — even drinking water.
Rivers that have been critical to commerce for centuries are now shriveled, threatening the global movement of chemicals, fuel, food and other commodities.”
Powell:
“When inflation is persistently high, households and businesses must pay close attention and incorporate inflation into their economic decisions…
The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.”
There is every indication that geopolitical and climate risks will only intensify going forward.
How secure are global supply chains in a world hamstrung by today’s energy and climate uncertainties?
We will all be forced to incorporate this unique inflationary backdrop into our economic decisions.
Will Europeans have sufficient energy to make it through the winter?
What might global inflationary and economic consequences be if China’s (and the world’s, for that matter) extreme drought persists into next year?
It appears the Federal Reserve and global central bank community have begun to appreciate that slower growth and weaker financial markets are prerequisites for reducing the likelihood of entrenched expectations of higher inflation.
The unspoken reality of the situation is that previously unimaginable debt growth (i.e. the U.S. and China) must slow significantly to thwart an inflationary spiral.
This is a New Cycle Dynamic, and it’s categorically negative for financial assets.
The S&P500 this week sank 4.0%, the Nasdaq100 4.8%, Germany’s DAX 4.2%, and France’s CAC40 3.4%.
Much of the losses were suffered during Friday’s session (S&P500 down 3.4% and Nasdaq100 4.1%).
High yield CDS surged 29 (largest one-day jump since June 28th) Friday to a one-month high 499 bps.
The VIX (equities volatility) Index surged 3.8 points Friday (5 points for the week) to a six-week high 25.56.
Europe’s high yield (“crossover”) CDS surged 35 to a one-month high 560 bps.
Italian yields jumped 20 bps to 3.70% (high since June 20th), with Greek yields up 27 bps to 3.96%.
Spanish (2.59%) and Portuguese (2.49%) yields rose 20 bps – to two-month highs.
It was a curious week for Treasury prices.
Powell was unambiguous: higher for longer.
Yet Powell’s speech was good for only a 1.5 bps increase in 10-year yields (2-yr yields up 3bps).
The Fed Chair pushed back against market expectations for a 2023 rate cut.
Yet there was little movement in market pricing for peak Fed funds in March 2023.
My read.
There’s little Powell can say at this point that would change market expectations for easing measures next year.
The bond market peers out at the horizon and sees distinct Crisis Dynamics.
And while the equities market frets “Fed put” ambiguities, it actually matters little to the Treasury market.
After all, deferred monetary stimulus only ensures acute crisis.
For the Treasury market, lower rates and additional QE are virtually a foregone conclusion.
It was interesting to listen to Wall Street analysts praise Powell’s speech.
They liked the inflation fighting message.
And discussions quickly shifted to 50 or 75 bps at the September meeting - or how next week’s data (including Friday’s August payrolls data) might impact Fed thinking.
The nuance of Powell’s message just did not register. Most analysts and pundits remain trapped in the previous cycle’s mindset.
Believe it or not, it’s possible that financial markets no longer command central bankers’ undivided attention.
I believe Powell and at least a core group of top Fed officials now recognize they face a serious inflation problem.
The Fed Chair appears to have ample support within the FOMC, from both sides of the political spectrum, and from the public to mount an aggressive inflation fight.
For how long is an open issue.
For now, however, Jay Powell appears willing to lead the charge.
Perhaps even Volckeresque.
I seriously doubt this can go smoothly.
Has the world ever faced such a litany of major uncertainties?
I fear the next phase of financial asset repricing will be both disorienting and destabilizing.
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