Bill Ackman, the founder of Pershing Square Capital Management is a well-known voice in the financial markets. In his recent tweets, Ackman took aim at Jerome Powell and the Federal Reserve for not acting decisively enough to curb sky-high inflation. He stressed that inflation was now out of control and worse, that the markets no longer had confidence in the Fed. In his view, the Fed must commit to a substantial increase in rates to bring price rises within the target range. He believes that the current policy is “setting us up for double-digit sustained inflation”, and is responsible for the bloodbath in equity markets. If the Fed seizes the moment, Ackman feels equities can recover well.
Widespread fears of runaway inflation have changed from keep-me-up-at-night horror stories to eye-watering prints of over 8%. Such a situation was scarcely imaginable for most even till last year. Ackman is correct to point out that the Fed’s misses since the Great Recession have gravely dented its credibility as the inflation fighter.
Despite the best efforts of the collective mind at the Federal Reserve, inflation was nigh unmovable for years, staying well below the oft-touted 2% target. As Noah Smith wrote, “economists don’t really have theories that can predict things like inflation or unemployment with any sort of reliability”.
Inflation is a hard problem, and the markets are wise to the fact that no one fully understands how to address it.
Of course, today, the challenge is very different. The issue is not too little but too much. High inflation in a sense is a better problem for policymakers, because the primary weapon of interest rates hikes re-discover their potency. However, as we shall see, there are caveats to this.
Firstly, the unprecedented turnaround in inflation was not due to the magic of zero-interest policies but a host of external factors – the unprecedented covid pandemic, subsequent lockdowns, the gargantuan injection of fiscal stimulus, and most recently, the outbreak of the Russia-Ukraine war.
The majority of these factors are well outside the control of the Federal Reserve.
More so than the failures of monetary policy from 2008 onwards, the Fed’s image has been irreparably tarnished by its insistence that inflationary pressures were ‘transitory’. The combination of ultra-loose economic policy, simmering tensions, and unwillingness to acknowledge the gathering clouds, thrust inflation from the high asset prices of Wall Street to supermarkets on Main Street.
This loss of credibility should theoretically render the Fed less effective, and dilute its ability to guide the narrative to the promised land of a low-inflation soft landing.
How much should rates be raised?
Interest rates are designed to work primarily through a demand channel. The thinking is that higher rates reduce demand, and reduced demand lowers inflation. In Q1, GDP contracted amid higher international oil prices which reverberated through the production chain; and a widening trade gap. Demand growth was robust but this may be somewhat illusory, occurring on the back of low unemployment, savings, and earlier fiscal injections.
Domestic supply chains in the United States are yet to fully recover after two years of public health restrictions, while global sea freight indexes have declined for the third month running. Crucial imports such as fertilizers are in short supply with the onset of the Ukraine-Russia war and subsequent sanctions. Gasoline prices in particular have surged to $4.6, hurting the average American.
Suffice it to say that much inflation is supply-driven, blunting the use of policy rates to bring the economy closer to the 2% level.
Even though the Fed has tried to present a brave face, as Ackman points out, 2-3% increases in the rates are unlikely to contain inflationary pressures and are not nearly high enough. Usually, one may expect that interest rates would need to be higher than inflation to be effective. In Paul Volcker’s era, rates were raised to a record 20% to restrain consumer prices that reached 13% year over year.
Specifically, Ackman says that the rates should immediately be raised to the neutral rate.
The neutral rate is a theoretical construct – the rate where growth is not restricted by being too high, nor a rate so low that inflation is beyond control. As Ackman argues, if the rates are neutral, inflation can be managed without causing a recession (or worse). The big problem with that assertion is that no one knows where the neutral rate lies, with James Bullard of the Federal Reserve calling it “The Phantom Menace”.
Unfortunately, no bag of Jedi mind tricks can help here, and the Fed is much more likely to either overshoot or be under the neutral level. Ackman’s tweets and the current rate hike hesitancy suggest that the Fed is destined to be well below this, and consequently, unable to restrain inflation.
The Wage-Price Spiral
In developed markets such as the United States, wages play a major role in inflation. Ackman points to the “wage-price spiral”. This is the idea that as unemployment falls, workers gain bargaining power and demand higher wages. As wages rise, companies find costs go up and employees have more money to spend. This combination leads to higher prices, pushing workers to ask for higher wages, perpetuating inflation. Today, Ackman sees this as a big concern, due to unemployment falling to a low level of 3.6%.
The wage-price spiral was central to the high inflation of the 1970s-80s. However, today, opinions vary if the US is really in such a situation. The biggest challenge to a wage-price spiral in the United States is the lack of labor power. In the 1970s, labor unions were very powerful entities that could secure higher wages through collective bargaining. This changed with the onset of globalization. The US suddenly had access to a much broader labor pool, and this naturally reduced wages. Outsourcing and the introduction of technologies such as industrial automation further weakened labor’s collective bargaining power. As a result, it is unclear if workers can demand higher wages to keep pace with inflation.
Even though companies have been raising nominal wages, they have not kept pace with inflation. Inflation-adjusted wages have actually fallen 3.6% in the past 12 months.
As nominal wages climb but real wages fall, this may prompt exits from the job market resulting in the tight labor market being only a temporary phenomenon. If the job market happens to weaken, the Federal Reserve may be reluctant to raise rates as aggressively, since a major contributor to inflation would be absent.
Sustained rate hikes?
Although the Federal Reserve has certainly shown greater initiative to raise rates than what has been typical in recent years, it is uncertain how sustainable this may be. For instance, in 2019, the Fed was forced to reverse course on its policy normalization objectives. History suggests that any instance of imploding equities and burgeoning debt payments amid lowered growth projections could force a reversal from Powell and company.
In a bear market, with easy money drying up, inflated asset values, and a multitude of zombie companies, are likely to crumble. If stocks fall, this may cascade into the real economy and reduce employment, again possibly forcing a course adjustment.
Today, with GDP contracting and eight successive weeks of declining equities, raising rates would likely have catastrophic effects leading to rising debt burdens in a country fueled by credit-driven consumerism, precipitating a deep recession. This would be met by social upheaval and a popular backlash that may weaken the Fed’s resolve into U-turning.
The markets, now accustomed to free money, have little appetite for continuing rate hikes. With the interest rate cycle barely having begun, there are murmurs among financial players of a “Fed pause”, or an interval (so to speak) after September. As Ackman has tweeted, in recent times, the Fed communications themselves have suggested some officials believe that there may be scope to Pause.
Analysts at Brown Brothers Harriman wrote, “The views expressed in the minutes are about all they could say at the start of an aggressive tightening cycle where no one really knows how far rates have to go.” John Vail of Nikko Asset Management believes that the Fed will not go for a Pause because it will continue to attack inflation regardless of the source (supply and not demand-led). In addition, an interrupted rate hike cycle will likely ensure inflation stays for longer.
Although Ackman’s prescription would artificially destroy demand and likely stem inflation, the dose would not only have to be very high to be effective, but the medicine itself would be very difficult to keep taking.
Despite the pain involved, Ackman is right that if the Fed does not react or does not react fast enough, “the market will do the Fed’s job”. This is quite like exactly what will happen, as inflation will continue unabated, although pressures may be limited if a wage-price spiral does not materialize. Consumers will buckle down and businesses will be forced to cut back, leading to a crash in the stock market, wiping out savings and asset values, and finally resulting in a deep demand deficit.
Inflation Outlook
Some commentators argue that inflation may have peaked already. Even so, the inflation genie is out of the bottle and likely to persist. Supply disruptions and inflation expectations don’t reset instantly. To add to this, the Ukraine war still rages and the full effects of monkeypox are yet to be ascertained. In a worst-case scenario, Chinese measures over the weekend to end covid lockdowns may only prove temporary. Leading inflation indicators such as PPI are elevated at above 11%. Ackman is right to suggest that without swift action, prices will continue to climb and persist into the coming year.
Even if a fortuitous series of happenstances were to magically combine, this would likely not be sufficient to lower inflation to the 2% level.
As discussed earlier, monetary policy is not the only thing affecting inflation, but it is the only aspect that the Fed can exert control on.
In the US, inflation also occurs from structural problems such as a lack of modern transportation, poor infrastructure, costly healthcare, low productivity, and aging demographics. These can’t simply be alleviated by altering monetary policy, and will likely keep inflation sticky. Rates would have to be kept very high for a prolonged period, harboring major risks to the economy.
However, if interest rates are aggressively hiked, the ensuing recession will prevent crucial investments in these troubled sectors, contributing to inflation.
According to Dr. Komal Sri-Kumar, macroeconomic advisor and senior fellow at the Milken Institute, “The Fed is in an impossible situation”, and believes that higher rates would result in a 2008-style recession.
A Final Word
To meaningfully restrain inflation, the Fed will have to aggressively front-load interest rates as Ackman suggests. They may also have to rise above the level of inflation and would likely have a very limited impact in the low single digits.
However, high rates would cause significant pain to households, leading to demand destruction in an environment that is already showing signs of broader contraction. For May, the University of Michigan’s US Consumer Sentiment gauge fell from 65.2 to 58.4, reflecting economic fragility.
Dr. Komal Sri-Kumar believes that the opportunity for a softer landing has passed by in mid-2021. In his view, the Fed could have opted to raise target inflation to between 3%-3.5% and hiked rates accordingly. By delaying the process of normalization, he feels that the Fed “lost degrees of freedom”.
Mohamed El-Erian, Chief Economic Advisor at Allianz, agrees that the Fed has left it too late and “should have started hiking nine months ago to put the economy in a position for a so-called soft landing”. Worryingly, he added, “I think the Fed is going to have to decide between two policy mistakes: hit the brakes too hard and risk a recession or tap the brakes in a stop-go pattern … and risk having inflation well into 2023.”
The higher the rates climb; the greater harm would come to the economy. In such a situation, it is difficult to imagine equities performing well. Although Ackman expects at least real business stocks to rebound, this is far from guaranteed in a scenario where demand has collapsed.
Even though his views are clear, it may be difficult to implement Ackman’s ideas, or even agree upon how to deliver them. On the other hand, not delivering on this, could damage the Fed’s reputation further, while high inflation will continue to persist.
As it stands, the Fed is caught between a rock and a hard landing.
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