I am not an economist but my undergrad degree is in political science, and don’t think for a second that the job of Fed Chair isn’t as political (and psychological) as it is economic. I’d like to point out that neither Jerome Powell nor Christine Lagarde, the leaders of the Federal Reserve and European Central Bank respectively, have degrees in economics. However, they both hold advanced degrees in law (Powell’s undergrad degree is in political science). My point, I am not an economist and neither are the leaders of the world’s two most important central banks.
So why am I pointing this out? Right now the Fed is in a battle with Wall Street over credibility. Bloomberg Surveillance does an amazing job each morning of bringing together some of the leading minds on Wall Street, economics, and guests from the Federal Reserve. Their first two guests on April 4th, PGIM Fixed Income Co-CIO Gregory Peters and Renaissance Macro Research Head of US Economic Research Neil Dutta, did an amazing job explaining how Wall Street believes the Fed will lower rates despite the fact Powell is signaling rates will remain higher for longer.
So far it looks like Powell is following elements of Paul Volcker’s (former Fed Chair) approach to inflation. Powell is signaling rates will stay higher for longer to, in a sense, spook Wall Street. Robert Samuelson defines this in his book The Great Inflation and Its Aftermath, a book about the stagflationary period of the 1970s: The Fed must convince Wall Street and consumers that they will keep rates longer for higher and— even if things go south economically—rates will remain high, likely into 2025 according to Federal Reserve Bank of Cleveland President Loretta Mester. History, specifically the high inflationary period of the 1970s and early 80s, tells us that the most dangerous parts of stagflation were the deflationary periods. Inflation decreased several times through the 1970s only to rise again. The reason was that every time economic conditions sank, the Fed came to the rescue with lower rates only to see inflation crop back up again.
Volcker’s solution, once appointed to Fed Chair, was “shock therapy” which meant increasing rates so high as to convince Wall Street, businesses, and consumers across the country that there would be no relief even when economic pain came about. And there was pain. Spring 1982 saw bankruptcies reach 280 a day, the highest since World War II. The number of business failures peaked at 52,078 in 1984. Unemployment rose dramatically. President Reagan’s approval rating sank well below 50 percent. However, the result was a largely prosperous second half of the 80s.
The point I am getting across here is that to truly quash inflation, history tells us it will most likely be painful. If the Fed decides to stick to the 2 percent goal, rates will likely need to stay higher for longer. This means higher borrowing costs for business and consumers. If the Fed is serious, there will likely be no relief in terms of mortgage rates, car loans, and other consumer (and business) credit in the near future. What sort of pain this causes remains to be seen.
However, history is not a perfect guide to the future—only a reference point. There are some differences right now. The first being consumer savings. Consumers kept demand high in 2022, and it seems so far they are willing to spend in 2023—car sales proved very healthy for Q1 of this year. Are consumers’ savings strong enough to weather sustained inflation and tighter credit? The Fed hopes not. Another question that I feel isn’t being asked is about the tens of thousands of workers who have been laid off. Will they find new jobs? For the ones who do find new jobs, will these positions pay as much or more than their previous positions, or will these workers—wary of economic conditions—temper their spending?
Other variables include the rapid rise in interest rates. The rise already doomed Silicon Valley Bank, but there’s a question if there are more banks where depositors smell blood in the water. Or is the leverage somewhere else? In the Great Financial Crisis, it was the banks and insurance companies holding mortgage back securities. This economic cycle we have seen crashes in crypto and some poorly managed banks, but are there other places where we will see bigger collapses? Possibly in private credit, or maybe losses from venture capital? Lastly, how will the Fed respond to a potential collapse? If they follow Volcker, they ignore the economic pain if inflation remains above 2 percent.
The last two elements are inflation and the Fed itself. The Fed is signaling to markets that it will hold rates higher for longer to achieve 2 percent inflation. However, there is a chance the Fed pauses or reduces rates. If this is the case, inflation may shoot up again. An important element is the 2 percent target itself. Economist Mohamed El-Erian explains that the Fed may commit to a 2 percent inflation rate, yet in reality accept a 3-4 percent inflation rate. In this scenario, the Fed commits to 2 percent in word only; at the same time, inflation stays sticky at 3-4 percent and the Fed refrains from increasing rates to try to lower inflation. Therefore, inflation remains at higher than 2 percent, and some years later the Fed acknowledges that they accept 3-4 percent as their new target.
In sum, the future is still very unpredictable. However, the safe bet is that inflation and rates will remain higher for at least the next 12 months (though don’t be surprised if this last until 2025), meaning consumers should have ample cash available to ride out any financial storms. Lastly, now is not the time to make any big purchases with borrowed money if you can wait a year and a half to two years. If you can’t, buying immediately will likely be your best option.
Disclaimer: This is not professional and/or financial advice. This content is for informational purposes only. Before making any financial decisions you should do your own research, evaluate your financial situation, and/or consult a financial professional.