Chance Encounters and Butterfly Wing Flaps – My personal Fed interest rate call for 2022

Guest article by David Schane, Ohio, USA – 30 Dec 2021

For many reasons, I believe inflation will be difficult to extinguish (see recent oil production article link here as just one supporting reference). And the longer inflation runs “hot”, paradoxically the more entrenched it becomes as workers (who are already in short supply, quitting in record numbers, and rethinking their lives and values) will demand further wage hikes to compensate for their diminishing purchasing power. (See related Bloomberg article link here).

Thus, I believe the lessons of the Paul Volcker era need to be re-examined. The biggest one I’d recall here is that it took interest rate hikes to levels hundreds of basis points ABOVE the inflation rate to tame inflation.

Even if one legitimately posits the widespread adoption and integration of technology, transport, and international trade during these last 40 years will be significant and supportive allies for today’s Fed battling the current round of inflation (which were economic backdrops and forces Volcker could not really avail himself or rely on as they hardly existed back then), I don’t really see anybody forecasting the Fed funds rate moving even back to say a conservative 5% level (unlike the Volcker peak rate, which I recall briefly touched 20%). Such rates would most likely cripple our debt, finance, and housing driven economy – with the government deficit (which would rise dramatically due to the interest rate required to finance it) equally crowding out private investment (leading to a slowing economy even further).

As important aside, I’d also posit the constructive global disinflationary forces referenced above have reached their near term peaks, as geopolitics, the Covid pandemic, and national security demand nations restructure their domestic industries and rebuild local supply chains – due to the many Achilles Heels which have recently been more glaringly exposed. While all that may potentially be wise and good on some levels, for this story line it means the deflationary winds of these past 20+ years (as Asian production became deeply integrated and embedded within Western supply chains) will be less powerful over say the next 5 years.

Adding this all up, I believe the Fed is presently dramatically behind the curve – and I believe the current Omicron surge adds more inflationary momentum (by upending production and extending supply chain disruptions).

As such, the Fed needs to move faster than anticipated to break the inflation momentum and incipient wage/price spiral. As such, I see them quickly moving towards hiking 25 Basis Points at each and every meeting starting this spring after the taper ends (in heretofore Greenspan precedent and fashion, which provides them “cover”). With six Fed Open Market committee meetings from May to December 2022 (see Fed calendar here), I’ll thus conservatively forecast 150 BP of Fed rate hikes in 2022 with the risk even towards 200 BP of collective hikes, in 2022 alone. I’d posit then that even if inflation comes down towards say 4% by the end of 2022, the Fed would still be behind the curve (with the Fed Funds rate at say even 2% at year end 2022 resting still 200 Basis Points under the contemporary year end 2022 inflation level) – utilizing even the Fed’s preferred and more sober inflationary metrics and measurements. That’s why Mr. El-Erian recently stated Fed Chairman Powell’s recurring characterizations regarding inflation being “transitory” throughout most of 2021 represented the worst inflation call in modern Fed history. Note, market consensus is not calling for 150 BP (much less 200 BP) of potential Fed rate hikes during calendar year 2022. Thus, a more aggressive Fed in 2022 (like that of Greenspan at the end of his tenure who hiked rates by 25 Basis Points at each and every Fed meeting fourteen consecutive times) is something which I believe has not been fully discounted by market participants just yet.

Moreover, I believe investors have grown decidedly complacent the Fed perpetually “has their back” – and is all talk and NO action. That’s especially in light of ongoing Fed largesse and repeated market friendly interventions over these last two decades in particular. Recognizing the hazard in stating “this time is different”, I believe the Fed has been awakened from its slumber by recent and now sustained inflationary data – and is thus likely to surprise markets in 2022 with more aggressive, hawkish actions.

Supporting this thesis, I encourage readers to contemplate the wider meaning of detailed comments Fed San Francisco President Mary Daly recently offered. To me, Ms. Daly’s transparent interview linked here illustrates the significant and genuine changes afoot within the Fed – especially at the Fed District Level. Recall the Fed Districts’ specific institutional mandate is to be responsive to Main Street businesses and consumers within their local geographies (which is a distinctly different mandate than the Fed Board of Governors). Thus even among more socially aware “woke” Fed officials (a characterization that Larry Summers, who served in the White House for both Presidents Clinton and Obama felt comfortable using), the Daly interview describes the recent real life encounter Daly had with an elderly consumer at a local drug store. Specifically, Daly recounts the distress of this shopper eliminating items at check out, as this consumer’s regular monthly cart of goods had risen in price, due to incipient inflation already biting into her fixed budget!

Thus even among “woke” Fed officials (who previously downplayed inflation as they wanted the Fed to “gun” for maximum employment among disadvantaged demographics whom are the last to receive the benefits of economic growth), the Daly interview suggests there is now a genuine view that inflation is the greater evil (as it bites the budget of the poor the most). This renewed focus on inflation trumping the Fed’s mandate for maximum employment growth comes at a time when weekly jobless claims have plunged to their lowest levels since 1969, according to the recent article here. Thus, the Fed can reasonably claim their max employment mandate has been achieved, allowing them to “save face” and undertake a speedy and substantially different policy pivot without losing all credibility. In sum, I’d submit Chairman Powell’s new inflationary fighting mandate (which perhaps President Biden and Treasury Secretary Yellen impressed on him at the impending start of Powell’s new second term) is now buttressed by a renewed realization of the ravages of inflation on the working poor and the retired pensioner among regional Fed Presidents, like Mary Daly. This suggests Fed District officials will be adding important inflationary fighting “muscle” during Fed meetings and rate hike discussions during 2022!

So while Fed “largesse” over these past 20+ years has in my mind encouraged speculative risk-taking, distorted valuations, subjugated the important market price discovery mechanism, and encouraged rampant bubbles across asset classes (which former Fed Kansas City President Thomas Hoenig presciently warned of), no policy (even the vaunted Fed “Put”) can endure in perpetuity.

If this analysis is correct, I believe this suggests markets could well be in for a potentially challenging 2022 as their “Fed parachute” has less ballast than they thought. In this regard, I’d note Daly’s chance encounter with the elderly shopper may have stiffened the Fed’s resolve and helped facilitate a genuine policy “conversion” – meaning this anonymous shopper could have been the butterfly wing flap which reverberates across the global financial landscape in 2022 and beyond.

SAN FRANCISCO — Mary C. Daly was in line behind a woman in her neighborhood Walgreens in Oakland, Calif., this fall when she witnessed an upsetting consequence of inflation. The shopper, who was older, was shuffling uncomfortably as the clerk rang up her items.

“She starts ruffling in her pockets, and in her purse,” Ms. Daly said in an interview. “And she says: This is a lot more expensive than it usually is. I buy these things — these are my monthly purchases.”

The woman had to put something back — she chose potato chips — because she couldn’t afford everything in her basket.

It would have been sobering to watch for anyone, but the moment hit especially hard for Ms. Daly, who is president of the Federal Reserve Bank of San Francisco. As one of the Fed’s 18 top officials, she is one of the people who sets economic policy to help to ensure a strong job market and to keep prices for goods and services stable.

By Mr. David Schane, Ohio, USA – 30 Dec 2021

david_schane@sbcglobal.net

Disclaimer: The opinions expressed here are his own. Geopolitical Research and other contributors may not necessarily agree with the views of Mr. Schane. All contributors to our website express their own independent opinion based on their research. Thus, their articles are not edited by this website. Furthermore, no comment should be interpreted as an investment recommendation or suggestion.