Vishnu Kurella is founding portfolio manager of Volar Capital. The views expressed in this article are those of the author and do not reflect those of any affiliated organisation.
Economist Milton Friedman is famous for many insights. None feels as relevant today as the “long and variable lags” he said characterised the delay between the implementation of monetary policy and its eventual impact.
Friedman pointed to data — borne out by subsequent analysis — that suggest it can take up to 24 months after monetary policy changes for economic activity and prices to respond. A common metaphor to represent this lagged effect is adjusting the temperature of a shower with very long pipes.
With this in mind, the fact that we haven’t yet seen much in the way of an economic slowdown or job losses after this year’s rate hikes shouldn’t come as a surprise. Fed chair Jay Powell recently quoted Friedman directly on the subject, and even used the same water pipe metaphor.
After keeping policy too easy for too long, the Federal Reserve has made clear that it now views itself as having a single mandate in the near term: price stability.
Given the lagged impact of monetary policy, the Fed will — by waiting to see inflation drop considerably for several months — necessarily over-tighten. But the full fallout from the coming hikes will probably not be felt until the end of 2023 or even 2024.
Whether these rate hikes will do the job is a separate question. Unfortunately, many of the factors that drive inflation are out of the Fed’s control. Monetary tightening does not increase the supply of goods and services, which is impacted more by macro factors such as energy prices, deglobalisation and supply chain disruptions. Ironically, rate hikes, due to the flow-through effects of higher costs of capital, will reduce supply, ultimately muting the effectiveness of the policy.
The Fed will therefore only be able to quell inflation by pushing extremely hard on the demand side. This will result in an aggressive economic slowdown and considerable spikes in unemployment.
These aren’t side effects, but rather the intended outcomes. So the question is not whether we will have a recession, but how bad it will be.
Paul Volcker, who led the Fed during that early 1980s period, is lauded for “keeping at it” in order to beat inflation. However, his policies benefited from the fact that long term interest rates then had room to move substantially lower, providing a welcome tailwind to asset prices and allowing for cheaper costs of capital. Given the current low level of nominal rates, there is no possibility of such a support blanket; thus, 1982’s downturn may unfortunately represent an optimistic outcome from our current position.
Many market practitioners have focused on the fact that yield curve inversion is a signal for a recession; rather, the more important takeaway is that asset prices would be in a much steeper tailspin if bond yields were in fact higher.
While global central banks are now embarking on concurrent quantitative tightening, there are still many governments employing expansionary fiscal policies and creating large deficits. It begs the question: if central banks are selling and governments are spending, who will buy all these bonds?
September saw a bond buyers’ strike in the U.K., with yields skyrocketing until the Bank of England stepped in and committed to temporary bond buying, an unsustainable policy given the bank’s inflation mandate. This episode should be a cautionary tale for the rest of the world’s governments. Let’s also not forget that with higher yields come larger fiscal deficits and additional bond issuance required to pay the interest.
These new bonds will undoubtedly crowd out private sector investment, and cash will be scarcer, potentially forcing interest rates even higher. The reflexive debt sustainability question becomes alarming as yields approach 5 per cent.
There is also insufficient focus on the correlation between bonds and other asset classes. Since 1980, it has been very rare to see yields rise as economic activity slows; when it has happened previously, the combination has caused substantial damage. Today we have already seen once in multi-decade carnage in retirement portfolios, and the stage is set for derivative-selling casualties in the vein of Orange County or LTCM.
However, the systemic threat will most likely start from abroad. The overpowering strength of the dollar is forcing other central banks to hike aggressively to prevent currency depreciation and worsening inflation. The contagion catalyst will therefore probably be real estate purchased with floating rate mortgages, as interest payments will double or triple in coming months at the same time that lay-offs pick up. Global construction loans are also exposed because borrowing costs will go up simultaneously as demand goes down.
There may also be a ‘sudden stop’ in available financing for higher-risk companies, as the combination of increased costs of capital and slower growth will make it uneconomic for them to continue. As bankruptcies start to hit on various fronts, the impact on credit markets will be swift and broad-based. However, unlike in 2008 or 2020, central bankers cannot be there to save the day.
Yes, the shower is still warm now, but the pipes are filling up with ice cold water for next year. Jay Powell appears to be petrified of becoming the Arthur Burns of his era — the Fed chair who presided during the cataclysmic inflation of the 1970s — and therefore seems determined to keep turning the faucet colder.
Let’s hope the Fed, in an effort to avoid the 1970s, doesn’t lead America to repeat the 1930s instead.
Source: Economy - ft.com
