In the history of the Federal Reserve, the most revered chairmen are William McChesney Martin, Paul Volcker and Alan Greenspan. All gained their reputation by decisive monetary policy action at times when stock and bond markets did not want or expect them to act.
William McChesney Martin was 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 credited with ending the runaway inflation of the 1970s by pushing the U.S. economy into a double-dip recession.
The Fed just raised interest rates by 0.75 percentage points and that is being compared with the 1994 rate hike of the same magnitude under Alan Greenspan. But in 1994, the Fed hiked interest rates long before investors 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.
Meanwhile, the darkest period of the Fed was the late 1960s and early 1970s, when weak chairmen were influenced by politicians who asked them to cut interest rates to avoid a recession or who reacted to a supply shock like the oil crisis by hiking rates.
In my view, the Fed under Jerome Powell repeats these mistakes. Remember that until early January, the Fed was arguing for a moderate path of rate hikes that would top 2% in 2024 while the bond markets priced in a much faster pace to 2% at the end of 2022. At its January policy meeting, the Fed suddenly changed tack and raised its guidance in line with what markets had priced in.
In February, Russia invaded Ukraine – a 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. Today we know this was one of the biggest policy mistakes in the history of the Fed and the start of the stagflation of the 1970s.
Compare this to 1990 when the Greenspan-led Fed did… nothing. Yes, oil prices rose by 170% from August to November of that year and inflation was rising to the highest levels since the 1970s. Yet no rate hikes. Investors were panicking about inflation, but the Fed had learned its lesson from the 1970s.
Jerome Powell has done the opposite. Since the Russian invasion, the Fed’s monetary policy stance has become more hawkish and it has signaled faster rate hikes. At its June meeting, the Fed hiked even more aggressively than previously anticipated as markets threw a tantrum after surprise inflation data. Its “dot plot” used to signal policy expectations now shows the Fed Funds rate reaching 3.4% by the end of the year.
The charitable interpretation of the Fed’s actions is that its economists were just catching up with what the bond market already knew. In my view, this charitable interpretation misses the point. The Fed has been bullied by the market into more and more aggressive rate hikes in light of a large supply shock.
I estimate that about two-thirds of current inflation is 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: Look at underlying core inflation and the demand dynamics, not the headline inflation.
Clearly, there is a strong labor market and strong demand that justifies rate hikes. 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.
A strong Fed would be able to explain this to the public and withstand market pressure to hike rates fast. Instead, under Powell we once again have central banks that let the tail wag the dog and let outsiders dictate monetary policy.
The result 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. By succumbing to market expectations of fast rate hikes, the Fed will create the very recession that the bear market in equities already anticipates.
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