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Why 'Don't fight the Fed' now has a different meaning

One of the defining events for global finance in 2022 happened during the Wall Street Journal Future of Everything Festival at which Fed Chair Jerome Powell spoke on 17 May and - finally! - got the message out. The world's most powerful central bank is now singularly focused on bringing inflation down towards 2% (from 8%-plus).

His admission this would not be possible without causing some pain, including the unemployment rate rising, would have rattled a few, but that was the explicit intention.

Relying on the 'Fed put' to save markets

For many years, investors have relied on the Federal Reserve to bail them out (the so-called 'Fed put') when markets showed their vulnerability and proved at risk of breaking down. With the 2020 experience still fresh in mind, many an investor the world around has become used to the fact that buying-the-dip is a simple but highly effective strategy.

Now the Fed is no longer aiming to prop up the economy through rising financial assets, and thus attitudes towards risk-taking and spending need to change. Across the USA, but preferably including the rest of the world too.

While inflation is stuck between ongoing Covid restrictions and supply-side disruptions and challenges, with the Russia-Ukraine war adding its own twist, the only way to tame inflation is by reducing demand. And in order to reduce demand, consumers need to become less comfortable with their financial situation and prospects.

Central banks have no control over global supply chains, but they wield enormous leverage over credit and financial assets. Bringing down asset values, and thus make consumers feel a lot less comfortable, seems but the most logical policy aim to pursue in 2022.

Risk is back in play

The exposure of US households to US equities has never been greater. Plus add a whole new generation of young 'investors' who don't genuinely know the practical implication of 'risk' and believe, with conviction, that owning cryptocurrencies and NFTs is the quickest route to becoming a billionaire before celebrating their 30th birthday.

In Australia, a similar observation can be made about a general perception that housing prices never fall, mate.

The Federal Reserve needs to change all of that in order to successfully rein in what it had mistakenly considered as a temporary, ‘transitory’ phenomenon throughout 2021. For the record: it is still possible inflation post-2020 might prove transitory on many accounts, but central bankers can no longer afford the luxury of sticking with a wait-and-see approach.

The risk of inflation becoming embedded is simply too high and would be many times over more damaging than the pain inflicted through an aggressive path of tightening. The Fed is all too aware of this. Note, for example, how Powell himself has recently started to include references to Paul Volcker, the central banker widely credited with slaying the inflation dragon in the early 1980s.

The Volcker Fed's aggressive tightening caused two economic recessions at the time, but it did pull down high inflation to manageable levels.

The message Powell has been trying to get across is that today's Fed is just as determined to put inflation back in its bottle. However, after more than a decade of explicit central bank support for financial assets in order to stave off structural deflation, most investors still have failed to comprehend the deeper meaning of the change in central bank messaging.

Redefining 'Don't fight the Fed'

We know what to do, and we know how to do it, Powell declared at the WSJ Festival, adding there should be no doubt, the Fed will do what is necessary.

"What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that" - those were his exact words.

Judging from price action since, it appears markets have finally understood the old saying of 'Don't Fight The Fed' now has a different meaning. The Fed wants less risk-taking, less confidence and less spending. Jobs will be lost. Asset prices will come down. But it's the pain that needs to happen, because inflation is a much, much bigger threat to everybody's wealth and future prospects.

Of course, it goes without saying, the Fed does have an ideal scenario in mind:

"What we need is to see really growth moving down from the very high levels that we saw last year, moving down to a level that’s still positive, but that will give the supply side a chance to catch up, and a chance for inflation to come down as we get supply and demand back together."

This sounds great, except for the fact that Powell also acknowledged the Fed does not control everything that impacts on the economy.

"There are many global events going on ... that are really not under our control as well."

But, and this was clearly the message Powell was pushing across, it won't deter this Federal Reserve from executing on what, simply put, needs to be done:

"We know how people are suffering from high inflation. And we have both the tools and the resolve to get inflation back down. And no one should doubt our resolve in doing that."

What Don't Fight The Fed in 2022 means for investing

The world of investing has shifted since 2021:

  • bond yields need to be higher, demand for credit needs to be tempered
  • asset prices, including equities and real estate, need to be lower
  • demand for products and services needs to be lower, which implies economic growth needs to be tempered.

Fighting inflation is now the main goal and everything else is of secondary importance, at best.

"What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down. And if we don’t see that, then we’ll have to consider moving more aggressively."

Let's all hope inflation is, indeed, transitory, and highly susceptible to slowing growth and rising interest rates. The alternative might prove devastating in a way only few among us are willing to contemplate.

But it also means bond yields may not have much further to rise from here, but the focus already is shifting to economic growth and corporate margins and profitability. Key question: how low?

 

Rudi Filapek-Vandyck is Editor at the FNArena newsletter, see www.fnarena.com. This article has been prepared for educational purposes and is not meant to be a substitute for tailored financial advice.

 

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