Strong Views Lightly Held

A friend – probably sick of hearing about inflation – actually (gasp) asked for an update on Ukraine.  So here goes.

The last few 3 months would seem to support the “stalemate” view of the war.  Except for one minor detail.  The Russians have actually been pushing an offensive with pretty much everything they’ve got.  They just don’t got very much left…

You don’t have to be a military expert to conclude that the attacking side is in deep doo-doo when a “big push” offensive is indistinguishable from “stalemate.”  The Russians have fought themselves to an exhausted standstill.

Ukraine is preparing its own offensive.  With luck, they will punch through somewhere.  If they do, they have a pretty good shot at precipitating a rout – see “exhausted standstill.”  Will Ukraine get a breakthrough?  Napoleon (apocryphally) gives us the most honest answer.

I would rather have a general who was lucky than one who was good. – Napoleon Bonaparte

Watch for a sharp shock campaign of farther-behind-the-lines strikes.  Followed by a big push in the place(s) Ukraine thinks the Russians are weakest.  What specific territory they capture doesn’t matter nearly as much as getting far enough behind enough Russians to spark a rout.  The target is the Russian Army itself, not the geography.

Ukraine does bring a lot to make its own luck.  They…

• …can choose time and place.
• …have a HUGE number of freshly trained (albeit green) troops.  The units getting exhausted fighting Russia to a standstill around Bahkmut don’t need to carry an attack.
• … have brand new Western hardware.  A lot of this equipment is massively advantaged vs the Soviet-era gear the Russians (barely) have.  Russia is now bringing T-55 tanks (built in the 1950’s) to the front because they ran out of 1960’s era T-62’s…  Those things are all one-shot deathtraps for their poor crews.

Most importantly, Ukraine probably have a “secret” stock of longer-range missiles, bombs, and drones than can seriously disrupt Russian supply and command points.  They already did this did this out to a certain range with the HIMARS missiles.  With longer-range weapons, they can blast a whole bunch of new targets.  The way supply chain networks work, even small lengthening of the individual web links sums up to major reduction in total carrying capacity.

So if Ukraine’s luck holds, we could be looking at the War ending (in fact if not officially) in the next few months.  That would be a good thing for markets, the economy, and the world.

What if luck doesn’t show up?  What if Ukraine…

• …doesn’t break through?
• …does break through, but the Russians miraculously re-group and hold?

…then we might be facing a stalemate.

Ukraine will still have “won.”  If they don’t backslide into cronyism, they have won a place in modern, prosperous Europe.  They won’t be a Russian satellite.

Russia will still have lost.  It has destroyed  the weapons stockpiles it inherited from the Soviet Union.  Modern-day Russia doesn’t have the economic capacity to replace it all.  It will take ages to replace what little it can.  Putin is probably dead or near-dead before that happens.

But it would be really nice if Ukraine won big.  Because then Putin and all he stands for will lose big.  The Chinese lose big.  And that is, ultimately, hopefully a good outcome for the US and the world.

I’m not pushing some bolshevik agenda here.  The mechanics do matter.  If price increases led us into inflation, then price cuts might just lead us out?  A downward spiral of price-cutting would be great for inflation, consumers, and the economy as a whole.  It would suck for profit margins (and stock prices) in sectors that can’t maintain informal price discipline.  I am pretty sure Tech comes out OK.  I’m not too clear on what sectors would get hit.

The paper below (pretty convincingly) puts much of the blame for the recent inflation on informally coordinated price increases in key industry sectors.   The “emergency” of COVID created PR/political cover to organize those implicit cartels…

The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. Such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by sector-wide cost shocks and supply bottlenecks.

The good news (for the economy) is that price coordination eventually breaks down in  informal (or even formal) cartels.  Price discipline cracks.  Someone starts discounting.

Arguably the great yearning for a sharp labor market recession is to avoid that collective breakdown.  Once price discipline breaks down, it can turn into a race to the bottom.  If firms can’t count on wage suppression to cushion the blow…

• FYI – It is an open secret that earnings calls are a great mechanism for price-signalling to other industry players.  You can coalesce that informal cartel openly with no legal risk.  But please don’t EVER mention that in polite company.  🙂

The paper also says out loud the unspoken reason – distraction! – so many people are so eager to over-focus on monetary policy and labor market drivers of inflation.  They desperately want to avoid talking about Real Economy price-setting & supply/demand dynamics. 

That conversation might lead to uncomfortable questions of just how competitive our “free market system” really is.  People might also start asking whether crushing the labor market is really the right solution to a problem created on the price-setting side of the inflation equation – Price = Profits + Costs (Labor, Capital, Land).

I keep poking at the consensus narrative around inflation because a lot of it sits on shaky foundations.  Most investors have unshakeable confidence in a set of monetary policy folk beliefs that have remarkably little support in real world economics or real world data.  I’m not trying to push some bolshie political agenda here.  I’m just trying to get a little closer to the truth than the stuff “everyone thinks is true.”  Seeing a little further towards the truth is kind’ve my day job.

Collective delusions can last for a long time (as I have learned to my pain).  But they, like informal cartels, eventually break down. Reality asserts itself – most likely here in the form of lower profit margins.  Possibly also higher wages, and a stronger Real Economy circular supply/demand dynamic than most expect.

So what industry is most vulnerable to a race to the bottom?  I don’t really know and, judging from price action – the markets aren’t too sure either.

• Definitely not Tech (my specialty).   Prices are already high and protected by other barriers to entry.  🙂
• Durable goods?
• Commodities?
• High fixed cost industry sectors – airlines?
• Consumer goods in general (discounts and sale  offers have started pouring into my inbox after a 2 year absence).

The above was sparked by a question asked in an FT newsletter.  For context, it is below.

It is natural to conclude that the post-GFC margin spike is somehow explained by monetary policy, given that after 2010 policy rates were pinned down and the Fed balance sheet growing. It is not clear to me exactly how this would work, however (remember operating margins are calculated before interest expense). Furthermore, there are other explanations available. Are companies underinvesting, boosting profits (and management pay) at the cost of future growth? This is the view of the economist Andrew Smithers. Or perhaps industry has become less competitive, allowing companies to pad margins without giving up market share? Or perhaps companies have had the upper hand against workers in recent years?

Full abstract of the paper.

The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. Such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by sector-wide cost shocks and supply bottlenecks. We review the long-standing literature on price-setting in concentrated markets and survey earnings calls and compile firm-level data to derive a three-stage heuristic of the inflationary process: (1) Rising prices in systemically significant upstream sectors due to commodity market dynamics or bottlenecks create windfall profits and provide an impulse for further price hikes. (2) To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. (3) Labor responds by trying to fend off real wage declines in the conflict stage. We argue that such sellers’ inflation generates a general price rise which may be transitory, but can also lead to self-sustaining inflationary spirals under certain conditions. Policy should aim to contain price hikes at the impulse stage to prevent inflation from the onset.

The real economy is clearly slowing.  But it may not be slowing fast enough to save Team Monetary Policy.  Says who?  The IMF.  After Hubris comes Nemesis…

The IMF’s revised forecast tells us the rate-rising fiesta risks damaging the financial system faster than it slows the Real Economy.   Politely saying The Fed-only campaign has failed.  We all risk calling in on that airstrike on our own positions.

“More worrisome is that the sharp [monetary] policy tightening of the past 12 months is starting to have serious side effects for the financial sector.”

The IMF is mis-using the term “side effects” given the blunt, inconsiderate nature of the interest rate instrument.  When you carpet bomb a place, everything an anything is a “side effect.”

All rate-hiking campaigns are a breath-holding, damage-taking contest.  The IMF forecast is just telling us rate-sensitive sectors can’t hold out much longer – banking, housing, Commercial Real Estate, auto-sales.  In that, the IMF is really saying the labor market and real economy  – free-market driven supply/demand stuff – aren’t cooperating with Team Monetary’s over-ambitious expectations.

To believe the warning in the IMF forecast, you have to believe that central banks will keep rates high until/as the banking system collapses.  Sampson bringing the temple pillars down upon himself.

I don’t think Central Banks have the guts or political support to pull down the temple.  The bond market doesn’t believe it either.  Especially when 3-5 year inflation expectations are undermining Team Monetary’s inflation horror-show narrative.

12-18 months ago. Team Monetary started this campaign confident a few points of rate rises would bring the Real Economy to heel.  Cue images of smug British colonial officers marching out – “a whiff of powder will teach those foolish natives a lesson.”

After 12-18 months of increasingly desperate yanking on the rates lever, the natives are not cooperating.  Actually, the natives are getting uncomfortably close to the thin red line of not-so-supremely-confident-anymore officers and other ranks.  See “Battle of Isandlwana” clip below  – especially the lunch party scenes…

The IMF report tells us Team Monetary is in the end game.  Holding the lines.  Hoping for a miracle.

They may yet get lucky.  A dramatic fall off in the real economy.  I don’t know if we will see that.  I do know that drop that must get mathematically more sudden every month that disaster fails to arrive.  As the IMF notes, the financial sector can’t hold out much longer.  The bond market seems the think its can hold until about year end.  If the real economy isn’t really tanking by June/July…

What if that hoped-for “miracle”  – an extraordinarily deep and fast recession?!? – doesn’t show up?  Then the choice is to either 1).  crash the financial sector (and big chunks of Commercial Real Estate and housing). 2).  Declare victory and move on.

What’s your bet?  1 or 2?  Am I missing a 3rd path?

I’ll leave you with a question to ponder.  What it we’d pulled a “targeted or automatic tax increases” lever 12 -18 months ago instead?  My guess…

1. …near-immediate drop in inflation expectations.
2. …relatively fast drop in measured inflation.
3. …minimal disruption to financial, banking, and Real Estate markets.  They still take a direct hit from tax increases, but no uncertainty-driven disruption.
4. …no bailouts.  Silicon Valley Bank would still be with us.
5. …lower deficit.  Opening up fiscal space for any downturn.

The only problem with the scenario above?  “Targeted tax increases” is a very uncomfortable phrase for a lot of people who really really want to believe the Fed has the one and only magic lever.  Almost as much as they want to believe their economic beliefs don’t have a political color…

FT summary of the IMF Forecast:

Pierre-Olivier Gourinchas, the IMF’s chief economist, said: “Below the surface . . . turbulence is building, and the situation is quite fragile.” “Inflation is much stickier than anticipated even a few months ago,” he said. “More worrisome is that the sharp [monetary] policy tightening of the past 12 months is starting to have serious side effects for the financial sector.”

In its twice-yearly full forecasts published on Tuesday, the IMF said the turmoil in the UK government bond market last autumn and the US banking turbulence last month showed the “significant vulnerabilities [that] exist both among banks and non-bank financial institutions”.

“Risks to the outlook are heavily skewed to the downside, with the chances of a hard landing having risen sharply,” the IMF said. Gourinchas told the Financial Times that, while the banking system was far more resilient than during the 2008 financial crisis, policymakers had to “think about what could go wrong”.

“We can all remember the long time between the failure of an individual institution, whether it was Bear Stearns or Countrywide,” he said, referring to institutions that failed more than a decade ago. “Every time, this was treated like an isolated incident, until it wasn’t.”

Battle of Isandlwana  https://en.wikipedia.org/wiki/Battle_of_Isandlwana

Eleven days after the British invaded Zululand in Southern Africa, a Zulu force of some 20,000 warriors attacked a portion of the British main column consisting of about 1,800 British, colonial and native troops with approximately 350 civilians.^[12] The Zulus were equipped mainly with the traditional assegai iron spears and cow-hide shields,^[13] but also had a number of muskets and antiquated rifles.^[14][15]

The British and colonial troops were armed with the modern^[16] Martini–Henry breechloading rifle and two 7-pounder mountain guns deployed as field guns,^[17][18] as well as a Hale rocket battery. The Zulus had a vast disadvantage in weapons technology,^[19] but they greatly outnumbered the British and ultimately overwhelmed^[20] them, killing over 1,300 troops, including all those out on the forward firing line. The Zulu army suffered anywhere from 1,000 to 3,000 killed.^[21][22]

We live better now because Agriculture went from ~95% of the workforce in the 1800’s to about 2% today.  How did that happen (mostly)?  Labor got expensive.  The industrial revolution gave people higher-paid, more attractive options to back-breaking stoop labor. So they left the farm.  Landowners either adjusted to that or they went bust.  Society was vastly better off for the disruption.

Last week I went camping (Spring Break with 2 toddlers – eeeek!).  We ate out twice in Santa Barbara, CA.  Both restaurants – family friendly mid-range – had converted over to counter service.  Place your order, take a number to your table, and a busboy would deliver it.  No more wait staff – even in a town with a major University. 

Counter-service restaurants are a micro example of how macro-level “productivity gains” manifest themselves.  Productivity gains = more output per unit of labor/capital/land.  You don’t get gains without a shift in how labor/capital/land are employed.  Making something more expensive (e.g. labor) is usually what drives that shift.

Higher Wages and Scarce Labor Force
=> Short Term Inflation
=> Long-Term Productivity Gains.
= Durable Wealth Creation

Labor costs do drive “inflation” shorter-term, but the long-term result is productivity gains if you let the free market work its magic.  If farm labor gets expensive, you buy a combine harvester.  If wait staff get too expensive, you switch to counter service.  The marginal returns from Do you want fries with that? no longer justify the marginal costs of hiring, retention, and wages.  The people who used to wait tables move on to higher-paying alternatives…

Society is long-term wealthier for that exercise of free-market choice.  Admittedly We don’t get “fries with that” anymore.  We also don’t toil in the fields or have butlers and ladies maids anymore.  The economy found more productive (and personally rewarding) uses for labor as its cost went up.

For some politics masquerading as economics unknown reason, a lot of “free market” commentators don’t want to let the actual free market do that work.

To them, rising labor costs must always be met with an immediate, panicked rush into a Fed-driven recession.  Throwing the long-term baby – productivity – out the window with the bathwater – short-term wage cost inflation.

But we also know productivity gains are the ONLY source of real wealth creation in an economic system.  Any other economic shifts just redistribute existing wealth.   Productivity grows the pie.  Everything else slices it differently.  The “free market” political agenda favors wealth re-distribution over real wealth creation…

It isn’t all politics.  I’ll close with a good tweet thread  by Micheal Pettis (economist who specializes in China) on how international factors have influenced the wage dynamic.

This is ideally how things should work. High wages drive automation, and automation drives wages up further as workers become more productive and businesses compete for workers. Meanwhile more spending by workers create more services jobs.

This is what used to happen in the US, but now, economies in a hyperglobalized world compete mainly by subsidizing manufacturing, directly or indirectly suppressing wages to do so. High wages now are more likely to drive offshoring than to drive productivity growth.
https://twitter.com/michaelxpettis/status/1644917558842388481?s=20

18 months into one of the fastest, steepest Fed hiking cycles in history, the market myth of an all-powerful Fed is looking pretty… mythical.

A year ago, “Team Interest Rate” was predicting economic Armageddon in January 2022 whilst expecting a MUCH SMALLER hiking cycle.  The high estimate for rate increases was about 1.75 points.  Those 1.75 points were expected to put the economy on the ropes.  A crushing recession was sure to follow.  The debate was whether it would be like 2001 (do.com) or 2008 (GFC).

18 months later, the Fed has raised rates by 4.5 percentage points.  One of the biggest rate hikes in history.  We have seen some impact.  How much?  We’ll never know.  But it is pretty obvious reality has not met prior expectations.

In bumper sticker terms, karma just ran over that dogma…

But most market commentators keep on seeing reality world through the lens of their preferred myths.  What and why do they see?

I recently struggled through “The Price of Time: The Real Story of Interest”  by a man who believes, deeply, in interest rates.  In his economic worldview, interest rates explain everything.  Rates drive everything. Rates are… everything?!?  It was a little weird (and a turgid read).  Yet I’ve seen it cited a few times (like in the FT).  So it clearly clicked with some folks out there.  People who see the Fed and rates as a one-factor economic driver…

He is sort’ve correct that interest rates REFLECT everything.  But do they drive?  Or are they driven?  Do we understand the world better by looking at the component things that make up “everything?” Or do we understand it better boiled down to a single, desiccated measure of that whole?

The right answer is we should look both ways.  Look at the forest and the trees.  The market consensus, centered around an unhealthy cult of “hallowed be the Fed.” is only looking at the forest…  Breezy talk of “a recession” avoids the specifics of a recession led by what sectors and caused by whom?

The whole over-focus on interest rates (and the Fed) as the “only thing that matters” keeps reminding me of Plato’s allegory of the cave (below).  Decades of experience has trained multiple  generations to just watch the shadows on the wall…

They see big, messy, vibrant economic and political chaos it reflects.  But (perhaps through disgust at that chaos?) they deeply believe the flickering shadows hold some greater truth than the chaos reflected.  Reality just goes on its untidy way.

In sum:  A lot of investors and reporters have grown up with a deep belief that “everything” can be explained by fine-grained movements of the Fed’s short-term interest rate target.  This faith was never well supported by academic economics or the Fed’s own research output.  Reality itself is also not cooperating.

Wikipedia – Allegory of the Cave https://en.wikipedia.org/wiki/Allegory_of_the_cave

In the allegory “The Cave”, Plato describes a group of people who have lived chained to the wall of a cave all their lives, facing a blank wall. The people watch shadows projected on the wall from objects passing in front of a fire behind them and give names to these shadows. The shadows are the prisoners’ reality, but are not accurate representations of the real world. The shadows represent the fragment of reality that we can normally perceive through our senses, while the objects under the sun represent the true forms of objects that we can only perceive through reason. Three higher levels exist: the natural sciences; mathematics, geometry, and deductive logic; and the theory of forms.

Socrates explains how the philosopher is like a prisoner who is freed from the cave and comes to understand that the shadows on the wall are actually not the direct source of the images seen. A philosopher aims to understand and perceive the higher levels of reality. However, the other inmates of the cave do not even desire to leave their prison, for they know no better life.^[1]

The market is betting the Fed will have to cur rates by September-December 2023.

• We don’t (yet) know if the market is pricing in a fast drop in other economic sectors.  Many commentators (and the Fed’s own projections) expect a big drop-off, but the market’s mind is inscrutable.
• We know the probability of such a rapid downturn shrinks with every “not-so-bad” month of data we get.  If things don’t start to drop fast soon…
  

So what if we keep getting ho-hum data and the market keeps pricing in Fed cuts?

• The good news is the market is likely pricing in “no major downturn ahead.”  The Fed cuts to head off a banking crisis, not a recession.
• The bad news is we’ll need to adopt a more nuanced perspective on the economy.

One way or the other, the objective facts of the last 12-18 months have not supported a widespread belief that the Fed’s rate policies are “the” one-shot driver of the economy.

It is possible we see the scenario reflected in the Fed’s forecasts.  A dramatic, immediate decline in not-so-rate-sensitive sectors.  The whole economy slows to near-zero growth .  Unemployment goes up.   Rapidly over the next 6-9 months.

In that case, the Fed can declare victory and cut rates.  Everyone will forget how little impact the rate increases had for how long.  The Fed’s economic forecast lines up neatly with the market’s rate-cut forecast.  Faith in the Fed will stay as fervent as ever.

But that broader slowdown must come quickly if it is to come at all…

Maybe we don’t see a tire-screeching economic halt?  A lot of indicators don’t point that way.  The Atlanta Fed’s GDPNow forecast is at 3.2% for 1Q23.  Other indicators (the HYG index, for example), aren’t showing elevated risk.

Maybe we just see more of the same gradual fade of activity and inflation?  Caused mostly by wages not keeping up with higher prices and other supply/demand factors.  Along with the (so far surprisingly contained) damage the Fed has done to rate-sensitive sectors like Banks and Real Estate.

• Tidy Story:  The steely eyed, technocratic Fed will raise rates and cause “a recession.”  They will press until unemployment goes up…
• Messy Reality:  If Fed keeps rates high enough for long enough, it will mechanically force a banking crisis in concert with a Real Estate Crisis.  A Banking and Commercial Real Estate crisis would definitely cause a major recession.

The Fed doesn’t want to be directly responsible for sparking that crisis.  That hoped-for unemployment would bloom over the corpses of the Regional Banks and a lot of (mostly private) private Real Estate fortunes.  Piled up at the Fed’s door

In that case, the Fed probably declares victory and cuts rates anyway to head off a banking/CRE crisis.   The “gradual fade” scenario above could be the actual forecast embedded in market expectations for rate cuts by the end of the year (80%-90% chance in November-December 2023).  The rate cuts coming mostly heading off a banking/CRE bust, not a plain-vanilla recession.

The good news is its rate cuts would immediately affect rate-sensitive sectors.  So the Fed has the power to stop a Banks and Real Estate death spiral (because “rate-sensitive”).  The market knows that.  It expects the Fed to act.

The Fed’s calculus is tough. Their biggest achievement so far is a wholly avoidable Bank run. Yet credibility is a key asset.  There is nothing more damaging than following through on a long-repeated “terrible threat” only to discover the consequences/costs aren’t nearly as big as imagined.

• How long can the banks hold out?  How many Real Estate investors can avoid ruinous re-financing?
• How to balance that against how little impact to date the Fed’s rate increases have had elsewhere…?  Other, less rate sensitive, sectors keep delivering month after month of “not obviously succumbing to interest rate pressure...”
• How to save face?  Powell & Co. also set out 12-18 months with great faith.  The economy was certain to fold after they put a few rate cuts on the table.  They were forced to double down.  Then double down again.

Never forget that Powell isn’t an economist.  He’s a Wall Street capital markets guy.  He had great faith in his institutional powers.  Along with most of his peers.  Because “everyone” knew the Fed was the one-shot factor in the equation.  Today, Powell is looking perplexed, uncomfortable, and a wee bit nervous.  Faith hasn’t been enough to carry the day.

For devotees of the (missing and suspected dead) Phillips Curve cargo cult, the Fed can’t stop raising rates until we see major unemployment.  I do not share their faith in the defunct Phillips Curve or an all-powerful Fed.  I agree the Fed can deliver that unemployment.  In this cycle, the Fed would do that by sacrificing a bunch of Regional Banks and the (huge) family/dynastic wealth tied up in Commercial Real Estate (CRE).

Is the Fed likely to make that sacrifice? 

“All animals are equal, but some animals are more equal than others.”  – George Orwell, Animal Farm.

Here is where messy politics complicates the tidy narrative…    If you only see the forest, you overlook that some trees are more important (and more vocal) than others.  Banking and Commercial Real Estate are VERY important trees – loved and protected by many in power.

Where will a wealthy mob carrying pitchforks and torches go when they look for retribution for their personal losses?  The path from higher rates to the Fed’s doorstep would be obvious.  Especially if that doorstep is littered with dead/dying regional banks clutching defaulted CRE loans.

• The Fed cares a LOT about the banks.  That is where Fed staffers go to get jobs.  The 48 Senators and 409 Congressmen who are NOT from New York also care a lot about “their” local banks run by their friends and donors.
• The top 10% cares a LOT about CRE as an asset class.  The Fed wouldn’t be blowing little people out of their homes in Vegas (like 2008).  The Fed would be blowing up dynastic wealth that underpins most “millionaire next door” fortunes outside of the major mega cities.  Commercial Real Estate underpins the fortunes of a lot of Congresspeople themselves, much less their donors and neighbors.  Real Estate underpins the fortune of a deeply selfish Orange-Haired demagogue who doesn’t play fair.  Look at how immediately effective (and comically pained) the SVB’s depositors howls were.  Now multiply those howls from that same class nationwide.
• The Fed cares MOST about its independence, prestige, and mystique.  Those will all come under attack if they end up blamed for “Blowing up my community’s regional bank and destroying MY family’s hard earned fortune.”  Congress is not full of people inclined to sacrifice for the greater good.  Payback would be brutal.  It might even be pre-emptive.  Facing this well-heeled mob, the Fed likely comes out a shadow of its former self.  The Fed knows that.  It will avoid that conflict.

So the tidy market narrative of “The Fed stays the course and we get a recession” decomposes into messy political reality of “If the Fed stays the course, it would be calling in an airstrike on its own position.” 

Maybe you genuinely believe that steely eyed Powell has the stones to do that.  From what I’ve seen so far, I don’t think he will.  They will cut rates before too many banks go under.

They are playing for time.  Hoping to get some economic softening, lower CPI numbers, and a bit of unemployment.  That gives them a fig leaf to justify the move.  The economic numbers will likely give them that.

But if they don’t get that fig-leaf, they do the rate cuts naked.  Because the path to a deep, unemployment-driving, Phillips Curve Cargo-Cult recession leads through too much pain in sectors that have too much political pull.  That is the messy reality.

The cult of the all-powerful Fed will paper over the (obvious) cracks in their narrative and declare this another great victory.  But the world will know this a little more in its heart;  Interest rates are a blunt-force instrument with wildly differential impacts across different economic sectors.  There are other, better tools for managing the economic cycle.  At some point, the fever dream will break and we’ll go back to a more balanced toolkit.

The lady doth protest too much, methinks. (“used in everyday speech to indicate doubt of someone’s sincerity, especially regarding the truth of a strong denial)”.  Fed quotes from Friday March 24…

• WASHINGTON, March 24 (Reuters) – St. Louis Federal Reserve president James Bullard said Friday the U.S. likely will need higher than expected interest rates to contain inflation as the economy remains strong and stress in the banking sector likely eases.  (how is stress in the banking system – caused by higher short term rates – going to ease if short term rates go higher than expected?)
• Federal Reserve Bank of Atlanta President Raphael Bostic acknowledged banking sector woes made the central bank’s interest rate hike call this week challenging, but he said the Fed’s main job must remain focused on getting inflation lower. Speaking in an interview Friday with National Public Radio, Bostic said “there was a lot of debate but this wasn’t a straightforward decision” to raise rates this week even as the banking sector is under stress. But, “we have to get inflation under control and back to our target,” Bostic said.

A lot of people expect the Fed to keep raising rates to drive “the economy” into a recession.  They don’t give much thought to the route we’d take to get there;  What sub-sectors of the economy are (or are not) taking the most damage right now?  Banking and Commercial Real Estate (CRE).  They are already bending. Pressed harder for longer, those sectors will break.  That break would likely cause the recession so many seek. 

So that belief boils down to the Fed will raise rates and force a Banking and Commercial Real Estate crisis (to get that hoped-for recession).

That belief boils down to the Fed has the courage and/or stupidity to call in an airstrike on its own position.

I don’t believe Powell has that courage.  He’s a politician.  He also isn’t stupid.  It would be a horrendous mistake for his reputation, the Fed’s independence, and the economy as a whole.  Better to suffer the ghastly fate of… 2.75% inflation.

Is that a forecast from some left-loony MMT opinion?  No.  The Cleveland Fed’s Center for Inflation Research put this paper out 3 months ago.  I’m reading “would not be optimal” as Fed-speak for “fantastically stupid…”

“Our model projects that… core PCE inflation moderates to only 2.75 percent by the end of 2025: inflation will be higher for longer. A deep recession would be necessary to achieve [2% inflation].  A simple… welfare analysis… suggests that such a recession would not be optimal.

This is Powell’s way out…

More on why blowing up the Banks and Real Estate would be an airstrike on the Fed’s own  position tomorrow.

Markets now see a a 97.6% chance of a Fed rate cut by September 2023.   Market consensus is “the Fed will have to cut rates because we will have a recession.” But what if we get a rate cut without a (major) recession?   What if the Fed starts cutting rates while many sectors of the economy are doing OK?

The Fed itself is predicting only 0.4% GDP growth in 2023.  The consensus view is below (per DataTrek)

Takeaway: Markets walked away from today’s FOMC announcement and Chair press conference even more convinced that the Fed will have to cut rates before the end of the year. The yield on 1- and 2-year Treasuries, which fell today to 4.51 and 3.96 percent, confirms that sentiment. That goes counter to the FOMC’s latest Summary of Economic Projections, as we will shortly discuss.

The important question is “what does the market think it sees”? The short answer is the growing risk of a US recession. During his post-meeting press conference, Chair Powell was very clear in his message that the Fed will not try to predict what effect a slowdown in bank lending may have on the American economy. Rather, it will wait and see what the incoming economic data has to say about both economic growth in inflation. The market seems rightly concerned about that idea. After all, by the time growth is clearly slowing and inflation is waning, it may well be too late to adjust monetary policy enough to avoid a significant economic slowdown.  (DataTrek Research 23March23)

Either we are going to have a mega-fast deceleration over the next 3 Q’s or….  we won’t.  The problem?  The real economy doesn’t look to be cooperating.

• A 3.6% YoY growth forecast from the Atlanta Fed’s GDPNow estimate for the March quarter.  This is usually directionally correct by this far into the quarter.   https://www.atlantafed.org/cqer/research/gdpnow
• Unemployment is at 3.6% (the Fed’s expectations are 4.5% by year end but “everyone” knows that is a low-ball vs their real expected number).
• The labor market is showing no signs of cracking.  Jobless claims went down this week.  Vacancies remain high.  Wage growth is solid.

Again, we do likely get a slowdown.  Economic data points to deceleration.  But there aren’t a lot of obvious signs of a screeching, shuddering, smoking-tires, next-3-6-months hard stop.  Which is kind’ve what you’d need to see for the the Fed to start cutting rates big-time (97% chance) by September 2023.

Maybe the market is wrong about the rate cuts?  Those expectations have bounced around a lot.

Or maybe the market is right about the rate cuts, but NOT because of a general recession?  Maybe (ahem) incipient signs of crisis in sectors near and dear to the Fed’s institutional heart?**

Certain sectors – Banking and Commercial Real Estate – are definitely sliding into crisis.  How fast and how deep and how bad?  It depends partly on how you weight various scenarios.  It depends mostly on the future trajectory of Fed rate decisions.

The Fed and the Treasury are ALREADY (quietly, but obviously) panicking.  How else would you describe the last 2 weeks?  What are they worried about?  Bank failures.  Driven by high rates (directly hurting bank profits) and by Commercial Real Estate (indirectly threatening bank loan books – especially smaller regional banks).

How does the Fed prevent those nightmare scenarios?  They cut rates.

Even if the economy is NOT in a tailspin recession.  Even if most of the economy is chugging along.  Because the banking sector and Commercial Real estate are systemically important.  They are also institutionally important to the Fed.  And those sectors are pretty clearly already in a recession.

Seen in this light, the Fed is praying the headlines go its way on inflation and the economy.  Declining headline CPI and some economic softening to provide a fig leaf of cover for a move the Fed is going to have to make anyway.

** Yes, a major Banking and Real Estate crisis would almost certainly cause a general recession.  What I am saying is the Fed will act to save its children before we get to that major crisis and subsequent recession.  We likely don’t get a real crisis if rates only stay high until September-December (per the market’s prediction).  The crisis risk goes up as/if rates stay high into 2024.  The problem with the Fed’s Higher for Longer promises was always the “for Longer” part.

More Context on the Slow-Rolling Crisis:  From the Financial Times (subscription required). 

But even if SVB-style dramas can be avoided, the pattern is creating “a long tail of zombie banks”, as the hedge fund Bridgewater says. “Policymakers can stop a bank run but unless the Fed cuts rates they can’t stop the repricing in banks funding costs.” That feeds into a third issue: a credit crunch. As funding costs rise, banks will cut loans.

In some senses this is what Fed officials want, since slower credit creation will curb inflation. But the rub is that it is extremely hard to predict the impact of a credit squeeze since it can create a self-reinforcing downward spiral of recession and defaults. So while the crisis in American banks was initially sparked by interest rate (and liquidity) risks, it could now slowly morph into a problem of credit risk too.

The $5.6tn commercial real estate lending market illustrates the problem. At present 70 per cent of these loans comes from small and medium-sized groups. “Small banks’ absolute dollar exposure to CRE lending has grown at an accelerating rate over the past ten years,” notes Morgan Stanley;

Even before the interest rate cycle turned, CRE values were starting to come under pressure because the rise of internet shopping and homeworking hurt retail and office space. But with rates rising, “all of a sudden those assets become very hard to roll over” as Rick Rieder of BlackRock says. Since $2.5tn of loans are due to be refinanced in the next five years, this will eventually create pain for borrowers — and banks.

This was supposed to go out Tuesday night, but the power went out here.  It still holds pretty well. 

Addendum:  The Fed did raise rates 25 bps, but made noises about slowing down etc…. In “potential bar fight” terms, the guy is still shouting threats and looking tough, but his feet are ever so slightly edging backwards.  Market sees that – now pricing in rising probabilities of rate cuts between September 2023 (77%) to December ’23 (95%).

By that time headline CPI is probably fading and the Fed will have an excuse to rush to rescue of the banks and commercial Real Estate.  Maybe labor markets and wages have tanked, but that would have to be a pretty dramatic deceleration over a a very short time period.  More likely the economy is humming along and maybe we just have to get used to (gasp) 3% inflation….

Tuesday Night Post

The fix might be in. The Treasury and Fed have now both placed mutually self-destructive bets on the table.  They don’t want to lose those bets.  That suggests the Fed’s rate-raising campaign peters out from here.

If US regional banks go bust, both the Fed and the Treasury face embarrassing, publicly obvious losses.  Cue howls of protest and (maybe literal) pitchforks, and torches.  That  might happen if we tumble into a banking crisis, but regulators do set the odds of their own success.

What were those bets?

• The Treasury just stated they will guarantee the deposits of all US regional banks.  Writing a blank check (OK, the FDIC is writing the blank check but the Treasury’s neck is now stuck out).  Betting it never gets cashed (in a bank failure).
• The Fed (in its role as bank regulator) is buying (OK, “guaranteeing”) bank’s debt holdings at 100 cents on the dollar.  Knowing full well the fair market price today is (say) 85 cents.  They are deliberately over-paying to pad the banks balance sheets.  Betting that over-payment (and/or losses) never gets marked to market (in a bank failure).

Neither the Fed or the Treasury wants to lose these bets.  How do they avoid losing?  By ending rate rises sooner vs later.  Reducing the pressure on the banks.

After the Treasury announcement today, chances of a Fed rate cut in December 2023 went from 98% (2 days ago) to 58%.  We now go out to May 2024 before the betting is near-certain (96%) for rate cuts.

Is there an explicit deal here?  Probably not.  Is there an implicit deal between the two entities responsible for protecting the banks and financial system?  Probably.

The Fed (who controls rates) moved first.  The Treasury (who has a very big bully pulpit and a lot to do with banks and the Treasury market) moved second.  Now they are both publicly committed.  Tidy bit of game theory.

Mapping it out, the bank regulatory dyad (Fed/Treasury) have two paths forward.

1. Make damn sure the banks don’t go bust on, for example, soured real estate loans, rising deposit rates, and a major economic downturn.
2. Press on with rate rises – increasing the risk on those bets.  The blank check guarantees get cashed and the over-payment valuations get busted.   Cue howls of “bailout” from people who like to howl about things that rile up their base – Elizabeth Warren and Marjorie Taylor Greene for example.

My bet is they go with #1. In which case the fix is in.  The Fed steps off the gas from here and the Treasury does its bit along the way.

This might all sound a little too “political.”  But that is because it all is political.  Watch Yellen squirm here.  Powell never wants to find himself squirming alongside her.  This Oklahoma Senator does a great job of getting that point (and threat) across.  Senator Warren (originally from Oklahoma) will be happy to do the same to Powell and his precious place in history.  A few days later, Yellen says all the banks get their deposits guaranteed.  Pure politics well played,

Ohhhhh boy 👀 pic.twitter.com/sHFHjHxve3

— mike hobart (@theemikehobart) March 16, 2023