Source: Golden Ten Data
In an article issued on May 18, Guggenheim Partners, a global investment and financial advisory service, warned about the possible harm of excessive Fed rate hikes. The following is a compilation of the article content
If two trains are moving towards each other at different speeds, when will they collide?
The Federal Reserve applies the principles of this elementary school math problem in the execution of monetary policy. Against this backdrop, one train represents the aggressive tightening plan announced by the Federal Reserve, while the other represents the U.S. economy, which, while still strong, is showing some signs of cooling. Investors are wondering when a recession will hit.
The Fed has a dual mandate to ensure full employment and price stability. Historically, the Fed has changed the federal funds rate based on changes in unemployment and inflation (i.e. the second derivative of the price level). Simply adding up these changes (as opposed to unemployment signals) is a good indicator of changes in Fed policy. This relationship has been going on for decades so far.
But over the past year, there has been a stark divergence between the Fed’s monetary policy and the relationship between unemployment and inflation. Faced with a sharp drop in unemployment and a sharp acceleration in inflation, the Fed failed to move quickly. The reasons for the Fed’s sluggish action are mainly concerned with the impact of the epidemic and their previous wait and see whether inflation is temporary (the Fed also proposed an average inflation target of 2%).
The result is, as it now admits, that Fed monetary policy has fallen so far behind the curve of unemployment and inflation in the chart above that it has had to raise rates “quickly” by 50 basis points to keep inflation expectations in check, and protect your reputation.
But now inflation has decelerated and the rate of decline in unemployment is slowing. If the Fed followed the historical pattern in the chart above, the fed funds rate would now be around 2.5%, and the Fed could slowly reverse its decision to raise rates as the economy cools. That’s not the case. The Fed appears poised to raise rates to around 3.5% next year, when inflation will slow further and unemployment will largely level off. As the Fed continues to raise interest rates and time goes on, the impact of tighter monetary policy will grow.
Excessive rate hikes by the Fed will lead to the risk of financial accidents and recession before raising rates to 3.5%. This unsynchronized, tightening stance of monetary policy will slow the cyclical economy and lead to a recession as early as the second half of next year. Given this conflict between the Fed and a cooling economy, long-term interest rates are likely to be near their peaks.
As Scrooge asks in Charles Dickens’ A Christmas Carol: “Are these shadows of things to come, or shadows of things that might happen?” Only time will tell.
Scott Minerd, Guggenheim’s chief investment officer, pointed out earlier that don’t expect the Fed to protect you in a down market…
By the end of the year, our stock market is going to drop significantly because the Fed has made it clear that they don’t have a put on the stock.
Financial blog Zero Hedge pointed out that this Guggenheim concern echoes Societe Generale’s previous warning that the peak in federal funds will be just below 1.0% during this economic cycle, or before the Fed is forced to reverse, Less than 3 hikes left!
Editor/Corrine
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