Welcome to Inflation IV – What Is a Hawkish Pause? Data Dependant Guidance?

Summary 

• The Fed’s ‘hawkish pause’ strikes me as confusing. If they plan to hike again, why wait? Or if they think they can stay on hold, doesn’t that bring dovishness into the picture? 

• Also, taking a ‘data dependent’ position makes pricing bond prices and related interest rates difficult as the Fed is not anchoring expectations as this stance is devoid signals on strategy.  
• All this, in my view, increases the probability of a hard landing. 

Market Implications 

• I think the hawkish delay has increased the possibility of further tightening in the future. 

• It is easier to for central banks to cut rates than raise them. 
• The market for US Treasuries has continued the selloff we had witnessed from earlier this year. I expect further disinversion over the next two quarters.  

Introduction 

The Federal Reserve held the Fed funds rate at 5.75% at the September meeting. Many analysts and the board called it a hawkish pause, and the Fed remains data dependent. I still wonder about the meaning of these two terms that to me seem like oxymorons for a central bank. I will examine each before returning to the US monetary situation. By pausing, the Fed has made a hard landing more probable.  

Hawkish Pause: The Fed paused rate hikes in September but signaled clearly that they will raise them at the next meeting in November. I find this very confusing. If they will hike in November, why not now?  

Perhaps they want to see if the conditions are right to stay on hold, but that brings a dovish side to the hawkish pause. Moreover, Chairman Powell has referred repeatedly to the experience of the 1970s where the Fed relaxed monetary policy with the first sign of a decline in inflation only to have to raise rates massively in the next three years to combat a huge surge in prices. What we learned from that and a lot of experience of many central banks the world over is that cutting is easy but hiking is not.  

Accordingly, a truly hawkish stance would have hiked despite the risk of overshooting. If the Fed tightens too much, we will know soon enough and within time to undo the excess tightening. It would also ensure inflation is on a downward trajectory, helping reconstitute the Fed’s credibility that was harmed during the over easing period.  

Data Dependent Fed: Investors are forward-looking, and pricing assets today involves discounting the prices in the future. When speaking of the bond market and interest rates, investors must have a reasonable idea of future interest rates. And that depends on inflation. To pin down bond prices today, investors need strong conviction about future interest rates and inflation rates.  

The idea of inflation targeting is to have a credible rule that investors and citizens can use to formulate expectations about future inflation. If the central bank is credible, that is a relatively easy task as investors and citizens will take the Fed at its word. And even if the Fed misses the target, investors  need to believe that the Fed will act to return inflation to that target as fast as possible. 

If the Federal Reserve is data dependent, then anchoring expectations becomes that much more difficult especially since the Fed’s credibility was already harmed. The Fed needs to lay out a clear contingent strategy on how it will act given different data outcomes. If not, investors basically have one equation with two unknowns: today’s interest rates depend upon future interest rates, which depend on future inflation, and investors must formulate their own expectation with inferior guidance from the Fed.  

Lessons Learned and Not Learned From the 1970s 

Let us take a short trip back to the 1970s. Because of political pressure from more than one administration, the Fed ran loose monetary policy starting in the late 1960s (Chart 1). The Fed effectively financed the Vietnam War and The Great Society expansions in government spending by creating (base) money. Consequently, the inflation rate peaked just below 14% in November 1974.  

The Fed tightened money leading into the peak, as reflected by a brief increase in the nominal and real effective Fed Funds rate. Inflation fell to a low of 4.86%. The Fed, thinking that it had done its job, decided to lower the Fed Funds rate back down to below the inflation rate, with the real Fed Funds rate moving into negative territory.  

What followed the premature easing was a surge in inflation. Only when the Fed under Chair Paul Volker pushed the nominal Fed Funds rate enough for the real rate to turn positive in 1981 did inflation start to recede again. But the cost was an extremely hard landing, with the US economy slumping into recession in 1981-1983. 

The current situation seems less dramatic. Yet today’s inflation rates are near those of the late 1960s, and the recent peak of 9.1% is halfway between the high of 6.2% in 1970 and 12.2% in 1974. When the Fed started tightening in June 2022, Chair Powell referred extensively to the 1970s experience and has continued to reiterate this appeal when raising the Fed Funds rate until the current ‘hawkish pause.’  

This makes this current pause even more perplexing. If the Fed wants to avoid a repeat of the 1970s, it should have raised rates at the last meeting.  

Long and Variable Lags 

Back in July 2021, I asked how late is the Fed? The answer was at least 15 months late because they had not even started raising rates. I estimated these long and variable lags, if they had started tightening then, to be at least 15 months, but they would have had to go to a tight stance. Indicators show that the Fed is only recently turned marginally tight. 

Using ex post real interest rates (Chart 2), the Fed’s stance became tight only as of May 2023. Until then, the Fed was still loose. The hikes since 2022 rendered its stance less loose. That continued looseness also is subject to the same long and variable lags. Consequently, considerable looseness is built into the economy that will only dissipate over the next 10-12 months, becoming tight thereafter.  

The National Financial Conditions Indexes published by the Federal Reserve Bank of Chicago, on the other hand, still show financial conditions as loose (Chart 3). All this indicates that the Fed ‘pause’ is, at best, premature. 

Finally, we can consider a concept that analysts applied to emerging markets, especially Latin America, called monetary overhang (Chart 4). This looks at cumulative growth in the monetary base. In other words, it shows how any monetary base surge moves into price increases. At the high in 3Q 2021, the overhang peaked at 175% above the level in January 2020. Inflation has brought the overhang down to 135% in August 2023. That means we still have significant overhang that will likely translate into further price increases.  

Market Implications: The Bond Market Catches On  

The market for US Treasuries has continued the selloff from earlier this year, as I had expected and wrote about in March 2023. Moreover, the long end has sold off more than the mid part of the curve. We can see this in Chart 5 where the disinversion of the curve is evident. Although the curve has disinverted, it is still inverted. The market seems to have caught on, with investors capitulating on the long end of the curve. The huge (and larger than expected by the market) Treasury issuance to finance large budget deficits has made the selloff more acute. 

The market has already erroneously expected the Fed to stop hiking half-a-dozen times  only to run into inflation stubbornness and surprises. So, is this the (final) capitulation trade? And will the Fed stop raising rates?  

I think the hawkish delay has increased the probability further tightening and a hard landing. It is easier to cut rates than raise them. Guaranteeing inflation is headed for the target is crucial to the Fed’s current success. By continuing to raise, the Fed can achieve this. And if the Fed has overshot, they will probably know soon enough and prepare the market for future easing. But if the Fed must return to hiking rate quickly as happened in 1979, recession is almost a certainty.  

John H. Welch is currently Executive Director at the Brazilian American Chamber of commerce. He is also the Farrell Family Liberty Fellow in Economics at the King’s College in New York. At chamber, Dr. Welch coordinates a team of six colleagues in creating content driven events, including webinars, seminars, and the Person of the Year awards dinner. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)