By Michael O’Neill
American farmers can rejoice. It may be a bumper year for crops if the volume of fertilizer spread during Fed Chair Jerome Powell’s post-FOMC press conference can be a guide.
It won’t be a bumper year for borrowers, though. Interest rates are going sharply higher after what was supposed to be “transient inflation” pitched a tent on Main Street USA.
On May 4, the FOMC raised the fed funds rate by 0.50% to 0.75%-1.0%. They also announced Treasury holdings would be reduced by $30.0 billion/month starting June 1. The move was expected, but equity traders reacted by driving the S&P 500 index up 2.24%.
Mr Powell opened the conference by saying, “I’d like to take this opportunity to speak directly to the American people.” Perhaps he is vying for the “central banker showing the most empathy to the great unwashed” award.
It is probably a good strategy. Soaring inflation affects every American, even the 1.0%, although for them, their housekeepers, personal shoppers, and chauffeurs may be far more attuned to price increases.
The Fed has two main functions: promoting maximum employment and stable prices. The US has achieved full employment. The unemployment rate was 3.6% in March and is expected to dip to 3.5% when the April data is released on May 6.
The Fed has missed the boat with inflation. The Fed struggled to achieve its 2.0% inflation target, and so to improve its odds for success, it changed the inflation measurement to be “an average of 2.0% over time.” That won’t happen in 2022, considering US CPI was 7.9% in January, 8.5% in February, and expected to be 8.5% in March.
So, the question is, Can the Fed crush inflation without driving the economy into a recession?
Short answer-Maybe, maybe not.
The American economy and other G-10 economies are awash in trillions upon trillions of government largess. The unprecedented volumes of fiscal stimulus dollars since 2020 helped drive US housing prices up 30% between Q1 2020 and Q1 2022. Wall Street printed money as the Nasdaq, Dow Jones Industrial Average, and S&P 500 index rose 52.9%, 32.5%, and 18.8% between Jan 2020 and May 4 2022.
Mr Powell said, “Inflation has obviously surprised to the upside over the past year, and further surprises could be in store. We therefore will need to be nimble in responding to incoming data and the evolving outlook.” He implied there would be at least two more 0.50% rate hikes at the next two meetings, saying “it anticipates that ongoing increases in the target range will be appropriate.”
Big deal. Fed funds were 1.5%-1.75% in January 2020 and that level is unlikely to dissuade borrowers, cool housing demand, choke the economy or put a dent in inflation.
Getting interest rates to the “neutral rate” won’t do much to reduce inflation, either.
Interest rates are going to rise substantially higher before inflation gets the message. How high is substantial? Fed funds ranged from a low of 2.90% in 1992 to 6.50% in 2000 before dropping to 1.25% in the two years after 911. They climbed to 5.25 in 2007. Five percent has a nice ring to it.
Fed funds rate-Historical chart
Commodity and equity markets liked what the Fed had to say with stocks rising, and Treasury yields falling. The US dollar retreated, and commodity prices rallied.
Those markets are trading like they believe the Fed will deftly manage an economic soft landing while driving inflation lower.
They are conveniently ignoring that a couple of catalysts for surging prices are beyond the Fed’s control.
The Russian invasion of Ukraine created a whole new layer of price shocks stemming from crude oil shortages and new supply chain disruption. If hostilities ended in the next week or month, would all be forgiven, and sanctions lifted?
China is another source of inflation risk. The Chinese economy is slowing. The Wall Street Journal reported that the latest Purchasing Manager Indexes showed factory orders and services activity contracted for the second straight month. Cement production is lower and smart phone production fell 18% y/y. The latest COVID outbreaks in major cities, and the government’s draconian measures to contain the virus will further disrupt supply chains.
Canada is not immune. The Bank of Canada faces the same challenges as the Fed, and that means, Canadian interest rates are going to rise sharply. Analysts forecast two 0.50% rate hikes in June and July.
The Canadian dollar will also get support from oil prices if a proposed EU ban on Russian crude and gas occurs, and drives oil prices toward $125.00/b. However, that support would evaporate if the higher oil prices sparked a broad risk-off plunge in stocks, particularly the S&P 500.
The above scenario suggests a USDCAD trading range of 1.2550-1.3050, with a bullish bias.
It may be a bumper year for crops, but the market reaction to the FOMC meeting is smelling rather ripe.