The worst policy makers in my lifetime

The phrase “don’t fight the Fed” was adopted to indicate that the markets should follow the policy measures taken by the Fed and not resist it. Under Jerome Powell at the Fed and Andrew Bailey at the Bank of England, this phrase no longer applies. Instead, both the Fed and the Bank are now taking their policy cues from the market, not the other way round.

In the history of the Federal Reserve, the most revered chairmen are William McChesney Martin, Paul Volcker, and Alan Greenspan. All three of them have gained their reputation by decisive monetary policy action at times when markets did not want or expect them to act.

William McChesney Martin was heavily criticised and blamed for creating the recessions in the late 1950s and early 1960s due to his efforts to tighten monetary policy early before inflation could take hold.

Paul Volcker is widely considered to end the runaway inflation of the 1970s by pushing the US economy into a double-dip recession. That he could do that was due to the fact that over the decade before he took office, inflation had been high for so long that the public and politicians were finally willing to accept harsh measures to fight it.

The latest interest rate hike by the Fed was 75 basis points and it is now commonly compared to the 1994 rate hike of the same magnitude under Alan Greenspan. But back in 1994, the Fed hiked interest rates long before markets expected rate hikes or before inflation really became a problem. The Fed not only was “ahead of the curve” but it dictated to the market what interest rates were going to be.

The same held true after the financial crisis. Fed QE measures were announced before the market anticipated them and the market was hanging on every word the Fed uttered (if you don’t believe me, look up the taper tantrum of May 2013). Again, the Fed and the Bank of England in the UK were telling the market what to do, not the other way round.

Meanwhile, the darkest period of the Fed and the Bank of England was the late 1960s and early 1970s when weak chairmen were influenced by the wishes of politicians who asked them to avoid a recession by cutting interest rates or by a misinterpretation of the sources of inflation when they reacted to a supply shock like the OPEC oil crisis by hiking interest rates and acting pro-cyclically instead of countercyclically. During that period, the markets and the court of public opinion undermined central bank independence and ‘dictated’ monetary policy.

In my view, both the Fed under Jerome Powell and the Bank of England under Andrew Bailey have repeated these mistakes this year. Remember that until early January, both the Fed and the Bank were arguing for a moderate path of rate hikes while the markets priced in a much faster pace to some 2% at the end of 2022. In their January policy meetings, both Powell and Bailey suddenly changed tack and came out with very hawkish statements, that essentially followed the guidance of the markets.

Then in February, we had another supply shock similar to the oil crisis of 1973 and the Iraqi invasion of Kuwait in 1990. In 1973 the Fed panicked and started to hike interest rates in order to rein in inflation. Today we know this was one of the biggest policy mistakes in the history of central banking and the start of the stagflation of the 1970s.

Compare this to 1990 when under Alan Greenspan the Fed did… nothing. Yes, in August to November 1990 oil prices rose by 170% in three months and inflation was rising to the highest levels since the 1970s. Yet, the Fed and the Bank of England did nothing. No rate hikes whatsoever. Investors were panicking about inflation and markets dropped into bear territory in anticipation of the recession that arrived in 1991. But the Fed and the Bank had learned their lessons from the 1970s not to fight supply shock with rate hikes and didn’t budge to calls to hike rates. So, the recession in 1991 was mild and short. Meanwhile, inflation started to drop some 6 months after the invasion of Kuwait and reversed to the low rates of around 2% that we have come to expect.

Jerome Powell is certainly no Alan Greenspan because he and Andrew Bailey reacted to the supply shock from the Russian invasion of Ukraine like the headless chicken at the helm of the Fed and the Bank in the 1970s. Their monetary policy stance became even more hawkish and they signalled even faster rate hikes.

Last week, finally, we got strike three when the Fed and the Bank gave in to market demands once more and hiked even more aggressively than previously anticipated in reaction to markets throwing a tantrum in reaction to one surprise inflation number.

But let’s go through the timeline to see what happened. In the days before the US inflation data for the month of May (published on Friday, 10 June), the members of the Fed Open Market Committee were asked to submit their contribution to the famous ‘dot plot’, i.e. their projections where they expect policy rates to be at the end of 2022, 2023, etc.

At that time the Cleveland Fed inflation nowcast indicated that headline inflation would be stable while core inflation would decline slightly. The dot plot of the Fed published last week Wednesday showed that policy makers expected the Fed Funds Rate to be at 3.25% at the end of this year which was in line with a rate hike of 50bps in June and July and possibly September before going back to 25bps rate hikes for the rest of the year.

On Friday, 10 June we got the inflation data in the US showing a surprise jump in headline inflation but a decline in core inflation very much in line with the nowcast of the Cleveland Fed. Then the market through its tantrum and tanked on Friday, Monday, and Tuesday. On Wednesday then the Fed came out with a 75bps rate hike and a signal that it will hike rates by another 50 to 75bps in July, something that the market had already priced in by that time, and that puts the Fed on course to end 2022 at a Fed funds rate of 3.75% or some 50bps more than what they thought a week earlier. As a result, stock markets gained on Wednesday since the Fed did what the market had told it to do.

In the UK, we don’t have that much evidence about the daily changes in policy measures of the members of the Monetary Policy Committee, but on Thursday, the Bank of England obliged market expectations and continued to hike in line with market expectations. But compared to previous meetings the Bank seems to prepare markets for faster and bigger rate hikes. It does so by predicting even higher inflation later this year as well as opening the door to the possibility of larger rate hikes in future meetings. With three out of eight voting members already voting for a 50bps rate hike this time, it will take little to switch to a larger hike at the next meeting or at an emergency meeting after the next inflation data release.

The charitable interpretation of the Fed and the Bank's actions is that economists were just catching up with what the market already knew. In my view, this charitable interpretation misses the point. Both the Fed and the Bank of England have been bullied by the market throughout 2022 into more and more aggressive rate hikes in light of a large supply shock.

I estimate that about two thirds of current inflation are due directly or indirectly to supply shocks in the energy and food markets that cannot and should not be fought with higher interest rates. Instead, the right policy action would be the one taken by Alan Greenspan in 1990 in reaction to the oil shock of the Iraqi invasion of Kuwait. Look at underlying core inflation and the demand dynamics, not the headline inflation.

Clearly, there is a strong labour market and strong demand that justifies rate hikes by the Fed and the Bank of England. But to know how much you must hike rates you have to know how much of core inflation is due to this demand shock. Plus, you must focus on core inflation, not headline inflation that includes volatile food and energy prices. And as the latest inflation data in the US and the UK shows, core inflation is declining and most of current inflation is driven by supply shocks, not demand shocks.

A strong Fed and Bank of England would be able to explain this to the public and withstand market pressure to hike rates fast. Instead, under Powell and Bailey, we once again have central banks that let the tail wag the dog and let outsiders dictate monetary policy.

The result in my view is clear. It is no longer a question of ‘if’ we get into a recession, but ‘when’ The combined effects of high energy prices and rate hikes will suck growth out of the economy and create a recession. The faster the Fed and Bank of England hike rates, the sooner this recession will start. By succumbing to market expectations of fast rate hikes, they will create the very recession that the bear market in equities already anticipates.

Going forward, the Fed and the Bank will face the same dilemma that they faced in the early 1970s. After hiking rates fast in reaction to a supply shock in oil markets, the economy in 1974 entered recession, and unemployment rates after some delay suddenly rose very quickly. Public pressure quickly changed from fighting inflation to fighting a recession and both central banks started stimulating the economy right when declining oil prices led to a recovery in consumption and investments anyway. Public opinion is fickle, and it bullied policy makers into making the biggest mistake in its history.

As we approach 2023, I fear that if Mr. Powell and Mr. Bailey don’t find their spines, they will be bullied by the market into cutting rates just when inflation was coming down anyway and the demand was accelerating. After last week, I am not too hopeful that the Fed and the Bank will be able to avoid repeating the mistakes of the 1970s. Rather, I expect Jerome Powell and Andrew Bailey to go down in history as the weakest policy makers in my lifetime.