Since June, the market rallied on hopes of a “policy pivot” by the Federal Reserve. However, those hopes got dashed each time as Jerome Powell clarified that the “inflation fight” remained the primary focus. Mr. Powell made that point very clear following the latest FOMC announcement.
“The question of when to moderate the pace of increases is now much less important than the question of how high to raise rates and how long to keep monetary policy restrictive.”
Before the pandemic, the Fed’s storyline was to let inflation run hot rather than allow inflation to stay too low for too long. Such makes sense as inflation is easy to deal with by hiking rates and slowing the economy. Deflation is a far different story, as it becomes an entrenched psychological impact that becomes difficult to dislodge.
Today, Powell says the Fed’s concern is entrenched inflation which causes pain to the economy.
The reality is that inflation is not the problem. If the Fed did nothing, “high prices will cure high prices.” The real risk remains a “deflationary” spiral that depresses economic activity and prosperity. Deflation is a far more insidious problem than inflation longer term. Such is why, over the past decade, the Fed flooded the economy with liquidity and zero interest rates to boost economic activity. The chart below shows the periods inflation ran above or below the average inflation rate from 1982. Since the “Great Financial Crisis,” inflation has run consistently well below that average and even the Fed’s 2% target rate.
While monetary interventions and zero interest rates failed to generate organic growth above 2% annually, they increased asset prices, inflated asset bubbles, and expanded wealth inequality.
What is important to note is that since the turn of the century, the outcomes have not been positive each time the Federal Reserve has started an aggressive rate hiking campaign. Notably, the Fed is well aware of this but no longer fears creating economic havoc. As Powell recently stated,
“If we overtighten, we can support economic activity.”
In other words, for the bulls hoping for a “pivot,” Powell made it clear that a “policy pivot” is coming. It is only the function of time until it is evident that something breaks in the economy and bailouts are required.