Speaking at an event at the Atlantic Festival in Washington, Jerome Powell’s second public appearance of the week, the Fed chair took the opportunity to underscore just why he remains so complacent about the US economy, saying “it’s a remarkably positive set of economic circumstances,” and “there’s no reason to think it can’t continue for quite some time.”
Powell also praised the recent wage increases, saying some gains are welcome and noting that “the Phillips curve is not dead, just resting.”
The surprisingly confident Powell then put on the hawkish afterburners, and repeated what he said after the last week’s FOMC announcement, saying that “interest rates are still accommodative” because “rates have just now, in real terms, moved above zero.”
And here is the reason why the dollar is surging after hours: Powell said that not only are rates far away from the neutral rate of interest – or the interest rate that neither stimulates nor holds back the economy – but the Fed may go past neutral as the tightening process continues:
“interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral – – not that they’ll be restraining the economy. We may go past neutral. But we’re a long way from neutral at this point, probably.”
Why is this important?
Because as Stifel analyst Barry Bannister – who correctly predicted the February correction – wrote three weeks ago, contrary to Powell’s assessment, just two more rate hikes would put the central bank above the neutral rate. The Fed’s long-term projection of its policy rate has risen from 2.8% at the end of 2017 to 2.9% in June. The September rate hike followed Bannister’s note, so as of this moment just one more hike would be sufficient to push the fed funds rate beyond neutral.
What Bannister said next was ominous:
“Although some say the neutral rate is difficult to observe, stocks see the barrier quite clearly. A ‘maximum tolerable peak’ for the fed funds above the neutral rate has been associated with bear markets since the late-90s global-debt boom.”
As we noted further back in September, the Fed has a choice: it may not hike, which leads to the following dilemma: “cross the neutral rate in 2019 to forestall late cycle inflation or remain below neutral and foster speculative bubbles.”
When we last touched on this topic we said that “Fed Chair Powell has yet to tip his hand whether he leans more toward controlling inflation or avoiding the bursting of the biggest ever asset bubble.”
Well, as of Powell’s latest speech, the answer appears clear: Powell will push above, and perhaps far above, the neutral rate. And, as the following chart, every time this has happened, a bear market has inevitably followed.
This is bad news for Trump: not only has Powell hinted that he will keep hiking rates for the foreseeable future, but in doing so the Fed will be the catalyst the ultimately crashes the market, something we discussed earlier today when we laid out the conditions under which the Fed would keep hiking, and warned that every Fed tightening cycle ends with a crisis.
But don’t believe us, here is what Deutsche Bank’s macro strategist Alan Ruskin explained back in May:
- Every Fed tightening cycle creates a meaningful crisis somewhere, often external but usually with some domestic (US) fall out. Fed tightening can be likened to the monetary authorities shaking a tree with some overripe fruit. It is usually not totally obvious what will fall out, but that there is ‘fall out’ should be no surprise.
- Going back in history, the 2004-6 Fed tightening looked benign but the US housing collapse set off contagion and a near collapse of the global financial system dwarfing all post-war crises.
- The late 1990s Fed stop start tightening included the Asia crisis, LTCM and Russia collapse, and when tightening resumed, the pop of the equity bubble.
- The early 1993-4 tightening phase included bond market turmoil and the Mexican crisis.
- The late 1980s tightening ushered along the S&L crisis.
- Greenspan’s first fumbled tightening in 1987 helped trigger Black Monday, before the Fed eased and ‘the Greenspan put’ took off in earnest.
- The early 80s included the LDC/Latam debt crisis and Conti Illinois collapse.
And a post-script from Ruskin’s colleague at DB, Jim Reid:
A reminder that our note from last September suggested that financial crises have been a very regular feature of the post-Bretton Woods system (1971-) and that based on history we’d be stunned if we didn’t have another one in some form or another by around the end of this decade/turn of the next one.
The most likely catalyst was the “great unwind” of loose monetary policy/QE around the world at a time of still record debt levels.
We would stand by this and I suppose the newsflow and events this year so far makes me more confident of this even if we’re still unsure on the timing or the epicentre.
So for all those curious when the next crisis will finally strike, just ask Powell how much above neutral he plans to keep hiking, because every prior crash was ultimately manufactured by the Federal Reserve. This time won’t be different.
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