How is FED spinning its plates?

FED is trying to keep the economy growing, inflation from surging, asset prices from imploding and international financial asset prices from cratering.

And just as physically trying to keep four plates spinning at the same time is tough, so the Fed may struggle to stop one, or even all, from crashing.

The first of these, economic growth, is at risk from the Omicron variant of coronavirus. So far, the US government seems to have a more relaxed attitude towards this threat than many others, particularly in Europe. In the past, we’ve seen the Covid threat spread first from Europe and then the US. This chain might have been broken and the US authorities could be right to eschew new restrictions, but the Fed must be aware that there is the risk of a material slowing in growth and provision monetary policy accordingly.

If growth were the only consideration the Fed would probably not be doing what it is doing at this stage as the bank is still some distance from its employment objective. But growth is clearly not the only consideration. Instead, more focus is rightly being given to rising inflation as reflected in the increased inflation forecasts from the Fed at yesterday’s meeting and the tone of Powell’s post-meeting press conference. Policy needs to be tightened to ensure Covid-related inflationary pressure does not become ingrained in the economy. But the Fed needs to do this without precipitating a slide back towards recession given the growth risks that we have already mentioned. This is where the third ‘plate’ comes into its own because, Fed tightening is only likely to push the economy back into recession if it initiates a rout in risk assets.

With house prices and stocks rising sharply, and increasingly large swathes of household wealth wrapped up in financial assets, particularly stocks, it would not take too much Fed tightening to tip prices back down and create hugely adverse wealth effects throughout the economy. In other words, the Fed needs to take the punch-bowl away but, if possible, in a manner that does not cause asset prices to crater. The same applies to the international economy and financial markets given that the Fed clearly has a uniquely important role in international finance by virtue of the dollar’s dominance in areas such as trade invoicing, international lending, reserve holding and more. One wrong step here and international assets could crater with an adverse spill-back to the US economy as the dollar’s likely surge hampers trade and lowers the value of the US’s international assets.

Yesterday’s FOMC meeting was another opportunity for the Fed to show how it plans to keep all these plates spinning and, which ones it seems most concerned about. In lifting the number of rate hikes anticipated next year to three (the FOMC was split between none and one last time), the Fed is clearly showing it wants to be ahead of the inflation curve. Next year’s PCE forecast was ‘only’ lifted by four tenths to 2.6% from 2.2% and hence the three hikes anticipated does give the market a sense that the Fed wants to be ahead of the inflation curve – and ahead of the market.

However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said in still signalling that rate lift-off will be dependent on the Fed achieving its employment goals the Bank is trying to give the impression that it is not abandoning economic growth and employment just to bring inflation back into line. In short, it is trying to keep both the growth and inflation containment plates spinning. There is some increased risks to the asset price and international plate spinning success should investors fear that the Fed is moving towards slamming on the monetary brakes. The doubling of the taper, to USD30bn per month may rescue this situation as it is no more than the market had anticipated. This being said, there is still a rough 50-bps gap between where the FOMC median forecast comes out for the end of 2024 and the (lower) rate implied by fed funds futures. “We think the market will have to catch up and that process could weigh on confidence in riskier assets”, Mr. Steve Barrow stressed.