I don't like it when someone as consistently right (and bullish) since the pandemic bottom as Michael Darda starts sounding alarm bells about the economy.
And I don't mean the kind of alarm bells everyone else is sounding because the two-year/ten-year yield curve is close to inverting. That crowd thinks the Fed is tightening too quickly right now in a weak economy, which will trigger a recession. No, the real risk, Darda says, is the Fed is still so far behind the nominal demand boom that they will have to tighten so much in the future that it will trigger a recession.
He was asked over the weekend about the likelihood the Fed can deliver a so-called "soft landing" for markets and the economy as we enter this historic tightening cycle. And Darda (the chief economist and market strategist at MKM Partners) is getting less and less optimistic that they can. The reason? Despite all the "hawkishness" out of the central bank in recent weeks, the Fed is actually falling further behind the curve.
Take, for instance, the market's expected inflation rate over the next five years, the so-called "breakevens." You'd expect it to have fallen since the Fed's meeting last week, where members dramatically raised their number of planned rate hikes, and especially after Chair Powell earlier this week said we may well see a half-point rate hike at the next meeting, in early May. But no--after all of that, breakevens yesterday hit a fresh high of almost 3.6% (the data goes back to 2003).
That's a huge headache for the Fed. It means for all their efforts--and as pointed as Chair Powell's language has been lately--the market is completely shrugging it off, not seeing any meaningful dent in medium-term inflationary expectations. You also have the Fed's preferred yield curves (based off of three-month Treasury bills, not the two-year note) steepening, not flattening right now--a sign markets expect nominal growth to accelerate.
What does it all mean? To Darda, that "we are in an environment of excess money," with the Fed's policy rate well below the neutral rate (which would be roughly 2-2.5%) and expected to remain there for many more months. "Overall nominal demand will remain strong, and inflationary pressures will linger by moving from one set of prices ([pandemic-related] durable goods) to another (the stickier services sector, and wages)," he warns. That's why this is about so much more than the recent spike in oil prices--it's a monetary phenomenon, he argues, and one that the Fed needs to quickly correct.
"Soft landings happen when the central bank moves its policy rate in a gradual and predictable manner to mimic a neutral rate which keeps the economy on an even keel," Darda wrote last weekend. "Hard landings occur when the central bank falls massively behind the curve and then at some future point has to impose a restrictive stance to reduce inflation (which typically means recession)."
Greg Ip gave a similar warning in The Wall Street Journal yesterday. "The odds don't favor the Fed's soft landing," he wrote. Why? "The biggest contrast with prior soft landings [is] that in the past, the Fed only sought to keep inflation from going up--not to actually push it down." The last Fed chair who had to push inflation down was Paul Volcker, and doing so triggered the deep "double-dip" recession of the early 1980s.
So if the market is holding up, rates and breakevens are higher, and the Fed is risking a steep future downturn by not catching up to the "neutral" rate now--why not get a little more aggressive? If the market shrugged off Powell's half-point hike suggestion for their next meeting in May, why not make it a full point instead--or at least float the idea, and see how markets react.
It reminds me of what our Steve Liesman has said on air--is it that crazy to take out emergency stimulus as quickly as we added it back in the depths of the pandemic? It's like gasoline prices, but in reverse--the Fed tends to cut rates very quickly, but raise them very slowly. That may have worked out fine in the past, but the pandemic, and the massive, $5 trillion monetary response it unleashed, makes this a very different episode.
The worst that could happen if the Fed "jawboned" a bigger rate increase would be that markets freak out, which would tighten financial conditions. But that would actually help achieve their goal, if they're that far behind the curve, right now. And you can always quickly walk it back if need be. But you won't have that luxury in the future if you really have to tighten substantially. Powell sounds like he is as committed as Volcker was to achieving "price stability." Sooner or later, he may have to move as aggressively.
See you at 1 p.m!
Kelly
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