Will Fed Tools Work Today?
Not All Causes of Inflation Can Be Fixed By the Fed
Inflation in the USA is at its highest in four decades. The Federal Reserve is set to raise interest rates. The pundits are puzzled about whether the Fed will raise rates by 0.25%, 0.50%, or 0.75%. A better question might be this. Will Fed tools work today to stem inflation without driving the US into a deep and long lasting recession? Raising interest rates and cutting back on their balance sheet will not reestablish the supply chain coming out of China where zero tolerance Covid measures are shutting down factories. Neither will higher interest rates bring the war in Ukraine to a close or prevent the next wave of infections from a new Covid variant.
The US Federal Reserve use three tools to fight inflation. It has the discount rate, the federal funds rate, and open market operations. Open market operations include buying and selling Treasury notes from member banks. Buying securities gives banks more money to lend and selling them reduces available credit and lets the Fed raise rates. The Federal Funds Rate is the tool everyone follows. It is the overnight loan rate between Federal Reserve banks. The Fed Discount Rate is the rate banks pay to borrow funds at the Fed discount window.
Public Expectation Management
At times the most important Fed tool is “fed speak.” Going back to Alan Greenspan the Fed Chairman has had to parse his or her words in order to calm and not spook markets. After announcing a 50 point rate hike after the May 2022 Open Market Committee meeting Chairman Powell led into questioning with reassurance that a 75 point increase is not on the table. This comment was immediately followed by a US stock market rally of 2.81% for the Dow, 2.99% for the S&P 500, and 3.19% for the Nasdaq within an hour and a half running into the close. When talking about Chairman Paul Volcker and the dramatic rate hike in 1979 Powell said that he admired Volcker not for the size of the rate increase but because Volcker always did what he believed was right. Powell said that the FOMC expects to raise rates by 50 basis points monthly for several months.
No Tools for Fixing Supply Shock
An hour after Powell began talking, Bloomberg Surveillance interviewed Dartmouth economist David Blanchflower who contended that Fed tools do not address a supply shock like what is coming out of China due to their misguided zero tolerance Covid policy and more so dramatic shocks to commodity markets due to the war in Ukraine and its fallout. If car makers cannot get computer chips for building cars, raising the interest rates they need to pay to borrow money will not reduce the prices of cars until the general population is hurting and quits buying cars.
Fed Track Record for Handling Inflation
Looking back to the 1970s Chairman Bernanke said that the problem the Fed had was that it succeeded in slowing inflation with rate increases but then immediately cut rates for fear of causing a recession. Volcker’s famous 1979 rate increase was not immediately reversed, did cause a recession, and raised unemployment for the next eight years. The most successful Fed action was in the early 1990s when they successfully slowed inflation and did not drive the economy into recession. The majority of their efforts to tame inflation over the years have overshot to the degree that they have caused at least a temporary recession.
Achieving Price Stability
In his comments after the FOMC meeting Powell noted that price stability is necessary for efficient and profitable business and the ultimate goal of the Fed. The problem for the Fed is that monetary policy changes will not affect Putin’s war in Ukraine, the protectionist policies that have emerged out of fear. Powell calmed markets today but Fed actions going forward are less likely than not to be successful in obtaining a soft landing. Now is not the time to trade alone. Join one of the squadrons at Top Gun Options where we can profit no matter which the economy and the markets go.