Andrew Baume
Head of Fixed Income
Macro & Markets
16 Jun, 2022

The people of Hamelin realised they had a rat problem but didn’t like the cost of the solution. The Piper needed to be paid and a generation was lost. On Wednesday (early Thursday a.m. our time), Jay Powell the Chair of the Federal Reserve Open Market Committee (FOMC) did the only thing he could and raised Fed Funds by 75 basis points to a range of 1.5/1.75%. Markets are patting themselves on the back for pushing the Fed’s hand with the S&P rallying by 1.46% and the US 10 year bond dropping by a staggering 19bps to 3.28%.

By bending to the will of traders globally, Powell has reinforced that they will push the economy backwards to avoid inflationary spirals. He also committed to a hike next meeting in late July before a summer break pushes any further action to late September.

A decade of Central Bank and other governmental interference in markets left us a price to pay. Avoiding a 70s era snowballing of inflation with rates set too low has been made worse by the Russian adventure into Ukraine. Supply side shocks are bullying the Fed into reversing its emergency settings rapidly, trying to choke demand. The cost is going to be felt most by those without wealth and solid income. Poorer Americans are already drawing down heavily on their credit cards to meet day to day expenses and new home loan approvals are down.

The harsh reality is that a slowdown in the economy that is sharp enough to choke off demand and prevent widespread price rises can only lead to higher unemployment and lower asset prices. Powell himself said that if unemployment rose to 4% (3.6 now) but inflation was under control that would be a “great achievement.” The corollary is that this “demand destruction” can also destroy earnings margins. Markets reflected that the pain of unprecedented rate rises today means the future earnings will not be under as much pressure. 

This vigorous reversal of easy conditions may be met by fragility in economies who have had the liquidity drip from central banks for so long. Global Investment Banks are predicting recession by the middle of 2023 as the lack of demand plays out and a few saying it could hit by the end of 2022. But Equity markets have already visited the 80th percentile of the average recessionary drawdown. The relief rally today was all about the ingredients required to weaken the economy slow inflation being baked in and an inflationary crisis being avoided. Fedspeak as well as its actions are aimed at expectations as much if not more than actually imposing costs, and the rate hike was designed to calm the foamy sea.

A little inflation can be a good thing; borrowers find it easier to repay their debts, incomes rise and assets grow because revenues increase. Losing control is when inflation is dangerous. Monetary policy is a blunt tool that seeks to adjust the demand curve by forcing spending to be redirected to higher interest costs. Central Banks run a fine line between delivering a message that buyers should keep their hands in their pockets and avoiding companies repricing simply to cover higher financing burdens.

In the US most consumer finance is insensitive to the Fed Funds rate. Home loans are largely fixed rate in the US and the average US credit card interest rate was 16.17% in the first quarter of 2022, according to the Fed making the base rate a rounding error. Rate hikes largely affect the flow not the stock of consumer debt actual costs take some time to filter through. Most of the effect of rate changes in the US is indirect as companies pass on higher costs and shed workers. Without matching wage rises, demand is withdrawn from discretionary items and redirected to non-discretionary. The focus on oil is extreme because for most Americans oil and its derivative products like petrol are not at all discretionary, needed for both personal and goods transport as well as heating. By acting decisively overnight Americans will be in no doubt that further rises will be delivered if needed.

The Reserve Bank has a completely different dynamic. Because most loans are floating rate, rate decisions reprice the lion’s share of the stock of debt and not just the flow. Even fixed rate borrowers only have terms out to 5 years meaning they know their financing cost will go up sharply once the fixed period ends.

Given the fangs bared by Fed Chairman Powell this morning Governor Lowe of the RBA must be hoping that his frightening rhetoric about future rate hikes and 7% Australian inflation are enough to avoid the AUD being sold too heavily on interest rate differential grounds. He also knows that if the RBA does have to push interest rates to the levels the market has already priced in, the amount of housing stress will dwarf the effect in the USA and could push the economy much further than anyone would hope. Rates should not have to rise as far here as the US, but markets have already priced in similar moves.

There will be sighs of relief around the world that US traders welcomed this Fed action. Although they reiterated that 75bps moves would not be common the Board of Governors also changed their year end Fed Funds Forecast to a median of 3.4%, much higher than the prediction of 1.9% in March. Markets are already pricing in a Fed Funds rate of 3.5% by December, actually higher than today’s 10 Year rate.

So the piper will be paid, I close with a quote from Martin Wolf of the Financial Times: “I worked as an economist at the World Bank in the 1970s. What I remember most about that period was the pervasive uncertainty: we did not have any idea what would happen next. Many mistakes were made, some out of over-optimism and others out of panic.” The time to panic may have passed.

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