Powell's Problem: To Pivot Or Not To Pivot
Or, Better Yet, Find A New Strategy On Inflation
Judging by Wall Street’s serial panic attacks over the demise first of Silicon Valley Bank last Friday and Signature Bank of New York over the weekend, one might well believe Jerome Powell’s inflation-fighting strategy of raising interest rates has finally “broken” something, and that the Fed will now be forced to lower interest rates and ease monetary conditions to shepherd the banking system through the latest crisis.
Certainly Wall Street has long held that view of Federal Reserve interest rate hikes.
When the Federal Reserve starts to raise interest rates, it generally keeps doing so until something breaks, or so goes the collective Wall Street wisdom.
So with the second- and third-largest bank failures ever in the books happening just over the past few days, and worries of more to come, that would seem to qualify as significant breakage and reason for the central bank to back off.
With the BLS set to release the February Consumer Price Index Summary, and with the FOMC scheduled to meet next week to decide the next federal funds rate hike (if any), Powell has some very awkward decisions to make soon, not the least of which is whether the Fed should pivot and lower interest rates (or just hold them steady) or simply stay the course and raise interest rates as previously planned.
Prior to last week’s bank closures, it was considered almost a given that a 50bps rate hike was in the works. As of March 10, the CME Group’s FedWatch tool viewed the 50bps rate hike as the most likely alternative.
As of yesterday, Wall Street believes the 50bps rate hike is off the table, and there is a growing possibility the Fed will not raise the Federal Funds rate as all.
No or is it hard to fathom why Wall Street is anticipating the Fed will at last “pivot” away from rate hikes. The last week has been beyond horrible for bank stocks, with the S&P 500 Financials Index down over 12% since last Monday (March 6).
The major bad news, of course was Friday’s abrupt closure of Silicon Valley Bank, in what was the 2nd largest bank failure in US history.
The collapse of SVB was the largest bank failure in the US since Washington Mutual collapsed in September 2008 at the onset of the Great Recession, and likely ranked as the second largest bank failure in US history.
In what was almost an afterthought, the third largest bank failure in US history came over the weekend, when regulators seized Signature Bank of New York.
On Friday, Signature Bank customers spooked by the sudden collapse of Silicon Valley Bank withdrew more than $10 billion in deposits, a board member told CNBC.
That run on deposits quickly led to the third-largest bank failure in U.S. history. Regulators announced late Sunday that Signature was being taken over to protect its depositors and the stability of the U.S. financial system.
Nor should it be forgotten that the carnage began with the voluntary liquidation of Silvergate Capital earlier in the week.
Crypto-focused lender Silvergate said it is winding down operations and will liquidate the bank after being financially pummeled by turmoil in digital assets.
“In light of recent industry and regulatory developments, Silvergate believes that an orderly wind down of Bank operations and a voluntary liquidation of the Bank is the best path forward,” it said in a statement Wednesday.
The bank’s plan includes “full repayment of all deposits,” it said.
With the US banking system reeling under so much bad news, it might only seem plausible that the Fed would opt to hit “pause” on its interest rate hikes, or perhaps even pivot to lowering them, in order to give beleagured banks some relief.
However, things are not quite as simple as they seem.
Despite the bad news afflicting banks at the moment, inflation is still very much a problem, with the Cleveland Federal Reserve’s InflationNow nowcast projecting February’s consumer price inflation number to come in at 6.21% year on year, with “core” inflation projected at 5.54%.
A consensus forecast by the economists of 10 major banks is somewhat more optimistic, putting headline consumer price inflation at 6%, down from 6.4% in January.
The annual inflation is expected to decline to 6.0% from 6.4% in January, while the Core CPI, which excludes volatile food and energy prices, is seen at 5.5% from 5.6%. On a monthly basis, the CPI is forecast at 0.4%, while the Core CPI is also expected at 0.4%.
While the trend is still down, consumer price inflation is nowhere near the Fed’s goal of 2%—and Jay Powell is determined not to move off that goal.
"We think it's really important that we do stick to a 2% inflation target and not consider changing it," Powell said in his semi-annual testimony to the U.S. Senate Banking Committee. The 2% inflation target "really anchors inflation" because "the modern belief is that people's expectations about inflation actually have a real effect on inflation. If you expect inflation to go up 5% then it will," he said.
However, Powell’s strategy for getting inflation down to 2% has been to push interest rates up, and last week’s banking news have sent rates plummeting.
According to Mortgage News Daily, the average rate for a 30-Year Mortgage dropped to 6.57%.
A 15-Year mortgage dropped to 6%.
Meanwhile, the 2-Year Treasury yield has crashed over a full percentage point.
The 10-Year Treasury yield dropped by a still jaw-dropping one-half of a percentage point.
Interest rates are moving in the opposite direction from where Powell needs them to go. Within the context of the Fed’s inflation-fighting strategy, this puts more pressure on the Fed to push rates back up again.
Nor is the Fed likely to ignore the much ballyhooed and ultimately fictional Employment Situation Summary from the BLS, which has pegged job growth in February at 311,000 jobs (it almost certainly was nowhere near that number).
While the BLS jobs numbers are questionable, the ADP National Employment Report asserts that 242,000 jobs were added in February, way wide of the BLS number but still a substantial amount of job growth.
If the Fed takes that data at face value, as has been the norm, it will continue to view the labor markets as tight and the economy as “robust”, even though the data tells a starkly different tale.
The seemingly “strong” economy only adds to the pressure on Powell to keep raising rates, despite the recent dumpster fire in the US banking system.
Complicating Powell’s problem even further is the negative impact last week’s news has had on the US Dollar.
The dollar index—a weighted index of tracking the US dollar against a basket of leading currencies—dropped throughout last week as the banking news got steadily worse.
Nor is there any bright spot to be found tracking the dollar against individual currencies. The dollar declined substantially against the yuan, the euro, and the pound sterling.
Whatever Powell does, that last week’s banking carnage pushed the dollar significantly lower against most if not all major currencies means, while fighting inflation and preserving the banking industry, he also needs to defend the dollar against those fresh vulnerabilities.
The perverse irony, of course, is that the Fed’s inflation fighting strategy has, ultimately, been a failure, as demonstrated by rising consumer price inflation as tracked by both the Consumer Price Index and the Personal Consumption Expenditures Price Index.
The reason Powell’s interest rate hikes have failed to quell inflation in equally simple: Raising the federal funds rate has an increasingly problematic correlation to market interest rates the higher rates move.
Thus, Powell’s preferred weapon, the federal funds rate, becomes increasingly ineffective the more he uses it.
Additionally, we should not forget the possibility articulated by Federal Reserve economist Julian di Giovanni that some 40% of current inflation is driven by factors other than consumer demand—which, if true, means that Powell’s campaign to crush demand within the US economy has potentially had all the impact it is able to have.
Even in the best case scenario, that Powell’s rate hikes have been impactful on inflation, there is a distinct probability that they have reached the limit of their effectiveness, which makes further rate hikes downright dangerous.
With just over a week before the FOMC meets to decide whether or not to raise rates again, last week’s banking cataclysms mean the official inflation data for February is likely to play an outsized role in determining what the Fed does next.
Should there be significant progress on consumer price inflation, the Fed might get a small breathing space where future interest rates are concerned.
However, should the BLS data show inflation returning, the Fed might feel it has no choice but to raise rates, regardless of the banking fallout. If the BLS data shows only incremental progress on inflation—which is what most economists are projecting—the Fed is likely to still feel significant pressure to hike rates yet again.
What the Fed is not likely to ever feel pressure to do is rethink its strategy on inflation. The Fed’s stance on inflation has always been one-dimensional: interest rates. That interest rate hikes are ultimately problematic for resolving significant levels of inflation, or that raising the federal funds rate is an increasingly ineffective way of managing interest rates more broadly, is something that the Fed simply will not even consider.
All of which means the BLS Consumer Price Index Summary for February very likely tells the tale on which mistake Jay Powell will make next on fighting inflation—and unless Powell finds a way to think outside the interest rate box, it is a certainty that whatever the Fed does next on inflation will be a mistake.
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A strategy that involves a 7 Trillion dollar Fed budget?