News over the Thanksgiving holiday of a new, fast-spreading Covid-19 virus variant gives newly reappointed Fed Chairman Jerome Powell, pictured, reasonable cover to demur on tightening.
Alex Wong/Getty Images
Now that Jerome Powell has been nominated to a second term as Federal Reserve chairman, markets think they know what they are getting. They might be mistaken.
In picking Powell, President Joe Biden gave investors what they wanted: a central-bank head they know, like, and believe they can count on to act as a type of mystical dove, at once leaving monetary policy ultraloose while maintaining price stability. But a reality check is in order.
There are two ways the next few years could play out economically, and neither involves both rock-bottom rates and back-to-target inflation. Investors are in for a reckoning in one direction or the other.
Under the less likely scenario, Powell’s second term will become Volcker 2.0, says Ed Yardeni, president of Yardeni Research. That’s a reference, of course, to former Fed Chairman Paul Volcker, who effectively hit the economy over the head with a two-by-four in the late 1970s and early 1980s as he raised interest rates to an unprecedented 20% to curb inflation. Yardeni pegs the odds of Powell channeling Volcker at 25%. It isn’t his base case, but he calls it a risk scenario that investors shouldn’t dismiss.
“They have created a mess they need to clean up,” Yardeni says of the Fed in reference to inflation, adding that the groundwork exists for the kind of wage-price spiral that would require much more aggressive policy action than the two to three rate increases investors expect next year.
Consider the recent contract ratified by the United Auto Workers and manufacturer Deere (ticker: DE), which includes a quarterly cost-of-living adjustment. The UAW/Deere contract affects only about 10,000 workers; the number of workers with COLAs peaked at about six million in 1975-76. But economists worry this throwback to the 1970s and 1980s reflects consumers’ difficulty in keeping up with inflation, and is a harbinger of the dreaded spiral that occurs when workers demand more pay to keep pace with rising prices, and prices in turn chase pay even higher.
The second scenario, more likely especially in light of renewed Covid concerns, suggests that investors are assuming too much policy action. For all of Powell’s talk of tools to deal with inflation, there is really only one: raising interest rates. Tightening monetary policy didn’t go so well the last time it was tried, before the pandemic. Powell quickly had to reverse the rate increases he’d initiated. And the Fed might be about to become even more dovish, as Governor Lael Brainard is installed as vice chair and as Biden fills three vacant seats on the seven-member policy-setting board.
Powell has repeatedly said the path of the economy and monetary policy depends on the path of the pandemic, which isn’t over. News over the Thanksgiving holiday of a new fast-spreading virus variant gives the Fed reasonable cover to demur on tightening.
There is a catch, however. If the Fed resists raising rates in 2022 by enough to douse inflation, Yardeni says officials will have to move the goal post. In that case, he expects Powell will raise interest rates no more than twice in the second half of 2022, and predicts the Fed will change its longstanding inflation target to 3% from 2%. Doing so would be more than semantics, with businesses, consumers, and investors all having to adjust to a new normal.
David Rosenberg, chief economist at Rosenberg Research & Associates, goes a step further. The longtime bear and ardent defender of the inflation-is-transitory argument also thinks interest rates won’t rise much, if at all, for a different reason. Rosenberg says the fragility of the U.S. economy is underappreciated. “The inflationistas who have been calling for inflation over the past decade are like dogs with a bone and they just won’t let go,” he says. “The risk runs the other way.”
Rosenberg rejects the growing consensus view that inflation has spread to stickier places, like rents, and is being underpinned by troublingly low workforce participation. His forecast? Zero rate increases next year and beyond.
“This may be the biggest bet against market pricing I’ve ever had on the books,” says Rosenberg, arguing that the supply response to booming demand, such as in new housing construction, is totally underestimated.
Moreover, the Fed might have tied its own hands, Rosenberg suggests, making the debate over inflation effectively moot. The U.S. economy is more sensitive than ever to asset prices, and, in his view, the stock market and the housing market are each about 15% overvalued. “If we get mean-reversion in equities and housing, which are where they are because of interest rates, you’re going to have some humdinger of an asset deflation,” he says.
He suspects the Fed won’t tolerate the carnage.
Several recent data points support Rosenberg’s view that the economy isn’t exactly on fire. Digging into the October retail sales report, one finds that about half of the better-than-expected increase was because of higher prices. Drop the seasonal adjustment that gets wacky around the holidays and first-time claims for unemployment insurance rose to a six-week high in the latest week, a very different headline than hitting the 1969 low for seasonally adjusted claims.
All of this makes it worth questioning the growing assumptions for relatively more hawkish Fed policy–not because it isn’t warranted, but because of the constraints policy makers face, whether they like it or not.
Corrections & Amplifications
An earlier version of this article said that Fed Chairman Paul Volcker raised interest rates to 20% in the late 1980s. Those hikes took place in the late 1970s and early 1980s.
Write to Lisa Beilfuss at lisa.beilfuss@barrons.com
