If the current episode of monetary tightening were a scene from a movie, we’d be looking at something similar to the scene from Apocalypse Now, where a group of helicopters is approaching a small village on the beach with Wagner’s Ride of the Valkyries beaming from the speakers.
Parallels between central banks and helicopters are not uncommon: Milton Friedman played with the theme (“helicopter drops of money”) and Chair Ben Bernanke earned a helicopter-themed moniker (“Helicopter Ben”). But then, consider...
...that helicopters are just vehicles. In helicopter analogies, it’s not the vehicle, but their payloads that matter, and payloads can be either money or volatility...
As we discussed in our “Volcker Moment” dispatch on February 16th (see here), there is a strong policy case for the Fed to inject volatility into markets in order to control domestic services inflation (and demand for labor more broadly) through asset prices – stocks, housing, and crypto assets too.
Then on April 6th, Bill Dudley, the former president of the Federal Reserve Bank of New York, argued that for hikes to be effective, financial conditions have to tighten more – a lot more.
But if the broader market expects rate hikes to undermine growth and force the Fed to cut rates in 2024, financial conditions mathematically won’t tighten on their own.
If financial conditions don’t tighten on their own, “the Fed will have to shock markets to achieve the desired response”, that is, “it’ll have to inflict more losses on stock and bond investors than it has so far”.
If that wasn’t clear enough, the former vice chair of the FOMC closed by saying: “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”. The message could not be clearer.
A former vice chair of the FOMC arguing that the Fed needs to shock markets is as close as we will ever get to a former Fed policymaker endorsing the need for a “Volcker Moment”.
And it’s good to share a conviction with Bill Dudley – the last time we shared a strong conviction was when he asked me to visit him for an interview during the summer of 2008 to join the Markets Group of FRBNY in response to a brief note I sent him describing my concerns about the plumbing.
It was a formative experience: sitting across a market legend, finishing each other’s half sentences about shared convictions about “skeletons in the closet”.
In today’s dispatch, we’ll explore five topics: first, the Fed call versus the Fed put; second, monetary heroes and anti-heroes; third, the Fed’s impossible trinity and what gives; fourth, the need to “invert” our thinking about recession risks; and fifth, the Fed’s options to inject more volatility to tighten financial conditions.
Our aim today is to highlight the risk that we might be dealing with a Fed that won’t be intimidated by curve inversions and asset price corrections, but will be emboldened by them to do more – a Fed that pushes against a curve inversion by hiking more than what’s priced today to tighten financial conditions further, despite recession risks or perhaps even with a (covert) recession goal in mind in order to maintain price stability.
To understand our thought process, and to understand the volatility you see on your screens – a volatility by design that is a desired outcome for the Fed – please consider the following observations.
First, as we argued here, the Fed is now in the business of writing a call option on risk assets – not just stocks, but housing and crypto as well.
Whether we think of the FOMC’s target level for the stock market and financial conditions as a call option or still as a put option just with a lower strike price is semantics.
The big question of course is that if the Fed is indeed writing a call option, what is the level that it targets?
Does the Fed want to see the S&P give up only a part of its post-Covid gains or all of them?
Or does the Fed want to wipe off some of the gains that accumulated before the pandemic? More on this later...
Second, if one of Jay Powell’s professional heroes is the legendary Paul Volcker, it must be that one of his professional “anti-heroes” must be Ben Bernanke, at least in a cyclical sense.
Allow me to explain: the “art” of Quantitative Easing (QE) was forged under Bernanke’s stewardship, and the original aim of QE was to reflate in order to avoid deflation: reflating house prices, reflating stocks, and reflating the price level were the goals.
Asset price growth was a target and positive wealth effects were a target too to generate growth and jobs.
Looking back, QE was essentially monetary policy for the asset rich, with trickle-down benefits for the less wealthy.
We’ve had several rounds of QE, and during the most recent round, we combined QE with fiscal policy and the government implemented Friedman’s notion of “helicopter drops of money”.
Asset price inflation on the back of traditional QE, and consumption growth on the back of fiscal QE (helicopter money), pushed the level of demand higher, and the pandemic and geopolitics have pushed the level of supply lower.
Something changed. Inflation got high. Some inflation is coming from abroad, but some is coming from home (services).
No one knows how to slow it down, but one thing is blatantly obvious: fiscal QE was too much and traditional QE is no longer appropriate.
If the origin of QE is to lean against deflation by generating asset price inflation (positive wealth effects), leaning against inflation must involve generating asset price deflation (negative wealth effects) – the core of Bill Dudley’s arguments.
If the great Paul Volcker is the cyclical hero, the great Ben Bernanke must be the cyclical “anti-hero”.
Elon Musk’s recent comments at the FT’s Future of the Auto summit sum up the situation well: when asked if his planned takeover of Twitter will end up hurting sales at Tesla, Musk said “right now, demand is exceeding production to a ridiculous degree”.
The message is quite clear: QE overstayed its welcome; we need a round of negative wealth effects; we need “shock therapy”; we need a “Volcker Moment”.
Third, a note on the Fed’s mandates. Since we first wrote about the need for a “Volcker Moment” one thing became quite clear from the Fed’s communications: the Fed has a singular mission, which is slaying inflation.
Central banking with a multitude of mandates is a bit like the life of a working parent: it is impossible to deliver 110% at work, 110% at home playing with Barbies or doing dishes, and 110% at the tennis court as well (if you are lucky to find the time to play). It’s an impossible trinity, but we are trying to do our best.
The same for the Fed: price stability, full employment, and financial stability are not possible to achieve all at the same time. Something has to give.
The Fed appears to have chosen price stability as the priority: it wants slower growth and higher unemployment; further, tighter financial conditions mean some financial instability by definition – nothing systemic, but turmoil still (see tech stocks and the crypto sell-off).
Fourth, the market is ripe with narratives about whether rate hikes and commodity price spikes will tip the U.S. into recession.
I find it puzzling that some argue that the reason why there won’t be a recession is because household and business balance sheets (and in the case of businesses, profits) are so strong. I think the opposite.
There can be a recession precisely because balance sheets are so strong, and if we follow the line of argument above, strong balance sheets mean the Fed needs to lean against the wind harder to shock demand lower.
If low rates, QE, and low volatility healed balance sheets, the opposite will hurt balance sheets – by design.
The negative wealth effect means pain for balance sheets. As Charlie Munger said: “Invert. Always invert”. Strong balance sheets are a “cyclical bad”, not a “cyclical good”. It means more discipline from the Fed.
More hikes and more volatility injected by the Fed – by design – until financial conditions tighten more and demand slows enough.
Fifth, how is the Fed going to inject volatility?
Back to the helicopter analogy, Wagner’s Ride of the Valkyries full blast, the Fed has two types of buttons to push to release its payloads of volatility: talking tough (a string of rate hikes, a string of 50 bps hikes, and maybe even 75 bps if things don’t cool down),
and shifting from passive QT to active QT, where the Fed controls the amount of duration each dollar of balance sheet shrinkage delivers into the market, as opposed to the refunding decisions of the Treasury.
In our “Volcker Moment” piece, we argued for the Fed to do the latter, but the former (verbal) strategy is working wonderfully for the moment. Yields and mortgage rates are higher, stocks are lower, but a comment from President Daly just crossed my screen:
*DALY: WANT TO SEE MORE TIGHTENING OF FINANCIAL CONDITIONS
So we are not quite there yet. As one astute market participant once told me: “volatility is the best policeman of risk assets”.
And volatility and illiquidity is everywhere: liquidity in Eurodollar futures is shockingly poor – “non-existent”, as one market participant put it.
Non-existent liquidity in Eurodollar futures is exacerbating moves in rates markets.
The market does not know what to price – have we priced in the peak for fed funds yet, or is the peak at 4% or 5%?