“Should inflation begin to soar, correcting it isn’t like flipping a light switch — it’s a dimmer.”
— Richard Fisher, using an analogy his mentor Paul Volcker used to describe managing inflation, September 21, 2022
As market participants expected, the Federal Reserve (Fed) raised the target fed funds rate by 0.75% to 3 ¾–4% on November 2. It was the Fed’s fourth consecutive 0.75% rate hike and the sixth overall increase to the fed funds rate this year.1 The Fed will almost certainly raise rates again at its final Federal Open Market Committee (FOMC) meeting of the year on December 14. The debate is whether the increase will be 0.50% or 0.75%. Despite investors swelling anxiety about the aggressive pace of Fed rate hikes, the monetary policy mistake isn’t tightening too much — it’s tightening too late.
The single biggest contributor to financial market volatility this year has been uncertainty regarding the Fed’s terminal rate. In December 2021, the Fed forecast that the fed funds rate would be 0.9% in 2022. On September 21, after increasing their prediction several times throughout the year, the Fed forecast that the fed funds rate would be 4.4% this year and 4.6% next year. Shockingly, those estimates may still be too low. That’s a huge miscalculation.
Investors learned in Finance 101 that the intrinsic value of any security — stock, bond, real estate — is the present value of the future cash flows discounted at the discount rate. The target fed funds rate is a proxy for the discount rate. Investors’ inability to accurately determine the discount rate has created enormous market volatility this year. In addition, as the discount rate increases the intrinsic value of the security decreases. The rapid increase in the discount rate this year has resulted in significant declines across virtually every asset class, from the most conservative to the most speculative. There have been very few places for investors to hide in 2022.
I recently had the privilege to discuss all of this and a whole lot more with the former President of the Federal Reserve Bank of Dallas, Richard Fisher, on a SPDR client webcast. I have been a big fan of Fisher’s for a long time. He’s brilliant and a genuinely nice guy. For example, transcripts from the May 2007 FOMC meeting reveal that he sounded the alarm on the housing crisis well before any of his Fed colleagues. And in 2013, he was an outspoken opponent of the third round of quantitative easing (QE3), describing it as “one step too far.”
Having served as president of the Federal Reserve Bank of Dallas from 2005 to 2015, Fisher’s insider knowledge of the inner workings of the Fed, thoughtful analysis and timely market insights make him a must listen to person for investors trying to navigate today’s complex capital markets. I learned so many things from him in our hour long webcast, but here are my five key takeaways from my conversation with Richard Fisher:
Chairman Powell will keep at it
Human behavior changes slowly
Quantitative tightening is tricky
US dollar strength may be here to stay
The Fed’s terminal rate is a real interest rate
Chairman Powell Will Keep at It
In preparing for the webcast, Fisher told me that back when they were both voting members of the FOMC, he used to sit right next to Jay Powell in the meetings. In 2013, he and Powell were vocal critics of QE3, warning then Chairman Ben Bernanke and other FOMC members of the potential harmful impacts from constantly expanding the Fed’s balance sheet. Fisher recalls Powell telling Bernanke and the Committee that at some point there would be a 20–30% correction and the Fed would just have to tough it out.
Market participants, including me, have remained skeptical about the Fed’s willingness to keep aggressively raising interest rates in the face of a bear market and potential recession, impatiently waiting for the inevitable Powell Pivot throughout the second half of the year. And, who could blame us? The Fed has generously bailed out investors for more than three decades. So, of course, I asked Fisher about Chairman Powell’s resolve to keep raising rates to defeat stubborn inflation.
Fisher responded by noting that Powell keeps a copy of Paul Volcker’s book, Keeping At It: The Quest for Sound Money and Government, on his desk. Fisher said Powell used the phrase “keep at it” twice in his short, pungent, tough speech from Jackson Hole at the end of August. Fisher described Powell as a friend and said without hesitation that Powell is resolute in stabilizing prices. He went on to say that Powell knows the way to go down in the history books is to slay the inflation dragon and he’s hell bent on doing it.
Fisher also suggested that Powell’s November 2021 reappointment as Fed Chairman has bolstered his confidence. He withstood constant public criticism from former President Trump. And he beat President Biden on Capitol Hill. Biden wanted to appoint Lael Brainard as Fed Chairman, but Powell received strong support from both Republicans and Democrats. Powell also has earned unanimous support from the FOMC, including from the three new Fed governors appointed by President Biden. Despite hiking rates by an aggressive 0.75% at each of the last three FOMC meetings, there hasn’t been a dissenting vote since the June 15 meeting.
Emboldened by a strong personal resolve, clear mandate from the President and Congress and unified support from the FOMC, I expect that Chairman Powell and the Fed will keep at it until inflation is firmly defeated. Chairman Powell underscored that it was premature to pause interest rate hikes and that the Fed had a ways to go before winning its battle against inflation in his post-FOMC press conference on November 2.
Human Behavior Changes Slowly
If the Fed is committed to taming inflation, why did it wait so long before aggressively raising interest rates? I pressed Fisher on why the Fed held onto the transitory description of inflation so tightly and for so long. A vocal critic of the transitory narrative, he suggested that the Fed was waiting for the inflation horse to leave the barn before retiring the transitory moniker. He noted that the challenge to that approach is that changes in monetary policy impact the real economy with a 12 to 18 month lag. Now, the Fed must work twice as hard to put the inflation horse back in the barn — something Fisher said may take longer and hurt more than expected.
Fisher posited that the Fed may have been lulled to sleep by the prolonged pre-pandemic period of benign inflation. For the decade prior to the pandemic, US inflation averaged less than 2% per year. When presented with new and shifting information, human behavior adjusts slowly to the changing landscape. After decades of disinflation, the Fed was skeptical that the US economy could be entering a new inflationary regime. The pandemic aftershocks made interpreting the inflationary environment more challenging. That’s why it took so long for the Fed to abandon the transitory label.
Taking this logic one step further, the Fed isn’t the only one impacted by this human condition of behavior changing slowly. For more than three decades investors have become accustomed to falling interest rates, mild inflation and a benevolent Fed that swoops into save the day at the first sign of capital market tumult, the so called Fed Put. This explains why investors are pining for the good old pre-pandemic days, restlessly waiting for a Fed pivot that isn’t likely to come anytime soon.
If this is a new investment regime, the Fed isn’t the only one behind the curve — investors must also adjust to the shifting landscape. Perhaps one of the silver linings from this change in the investing environment is, as Fisher said, that the old rules of finance are back and investors are just going to have to get used to it.
S&P 500 Drawdown vs. Fed Funds Rate
Quantitative Tightening Is Tricky
There’s always been a strange divergence about Quantitative Tightening (QT) expectations. Investors have consistently expressed uneasiness regarding its potential harmful risks while many Fed officials have dismissed the process as boring, like watching paint dry. The nuances of QT have been a mystery for many outside the Fed. So I asked Fisher, which is it — risky or boring?
Fisher reminded us that if QE expands the Fed’s balance sheet to implement easy monetary policy and support the capital markets, then QT is simply the reverse of QE. He explained that the Fed’s balance sheet is expected to be reduced by roughly half a trillion dollars in 2023 and encouraged investors to review the Fed’s H.4.1 report — Factors Affecting Reserve Balances — every Thursday. The H.4.1 report reveals changes to the Fed’s balance sheet holdings over the past week and year.
As of November 2, the Fed held about $5.6 trillion of US Treasury securities. Fisher highlighted that plenty of Treasury securities held by the Fed will mature within one year.2 The Fed will simply allow those Treasury securities to mature and roll off the balance sheet — the equivalent of watching paint dry.
However, the Fed also held about $2.7 trillion in mortgage-backed securities (MBS) as of November 2 —nearly all of them with maturities of 10 years or more.3 In order for the Fed to meet the announced QT targets, Fisher said it will have to start selling MBS.
This is going to be interesting because the Fed has never sold securities from its balance sheet. The Fed typically buys a security and lets it mature at par. In addition, when the Fed suffers a loss, it’s called a deferred asset, not a loss it reports to Congress. Fisher expressed concern that MBS rates are rising partly because investors have concluded that it’s going to be a challenge for the Fed to reduce the MBS holdings by the target $35 billion each month without selling.
While there is strong investor demand for US Treasurys, there are not many current buyers of MBS, especially with the Fed potentially having to sell MBS to meet its stated QT targets. Fisher’s more granular knowledge of the nuances of QT suggests to me that while the decrease in the Fed’s holdings of Treasury securities may be boring, there could be some fireworks in the MBS market that could seep into other markets as the Fed struggles to meet its QT goals.
Maturity Distribution Between Treasurys and Mortgage-Backed Securities
US Dollar Strength May Be Here to Stay
It’s been a difficult year for nearly all investments but the US dollar has been a standout, climbing roughly 15% year to date and trading at or near all-time highs versus the pound, euro, yen and yuan. A US dollar bull for over two years, Fisher emphasized his point by displaying the famous picture of Secretariat winning the Belmont Stakes by 31 lengths in 1973, likening the US dollar to the Triple Crown winner — light years ahead of the competition.
But will it last? Citing the incredibly strong demand from private non-US investors, Fisher noted that private purchases of US dollar denominated Treasurys were running at a $600 billion run rate, the most since 2012. He highlighted that the euro, the second largest alternative pool to the US dollar, is challenged by the growing threats to Europe from the Russia-Ukraine war. Given the current challenges in the UK, Europe, Japan and China, he asked, “Where do you want to put your capital? And, where can market participants put that capital to work in size?” Fisher concluded that the US dollar remains attractive even at these historically lofty levels.
Former US Treasury Secretary, John Connally famously said, “The dollar is our currency, but it is your problem.” Fisher acknowledged that US dollar strength may create challenges for the rest of the world, but it helps the US with deficit financing by suppressing rates, especially with the Fed shrinking its balance sheet. Despite all the handwringing about the potential risks from a strong US dollar, Fisher thinks we are fortunate to live in a country where everybody wants to invest their capital. And given today’s environment, he doesn’t see that changing anytime soon. US dollar strength may be here to stay.
US Treasury Federal Budget Deficit or Surplus, % of GDP
The Fed’s Terminal Rate Is a Real Interest Rate
Fisher was unequivocal that he believes that the Fed’s terminal rate is a real interest rate. Chairman Powell said the same exact thing on November 2 at his post-FOMC press conference, insisting, “We’ll want to get the policy rate to a level where it is, where the real interest rate is positive.” These may seem like ho-hum statements to you, but they are absolutely mind-blowing to me. For roughly the past 14 years, since the Global Financial Crisis (GFC), the Fed’s terminal rate has rarely been a real interest rate. There have been more sightings of Big Foot and the Loch Ness Monster during that period.
Even today, after the Fed has aggressively increased rates six times this year, the target fed funds rate is well below the rate of inflation. Point to breakeven rates all you want, they are fantasy. The US economy still has negative real interest rates, which means the Fed does have a ways to go — just like Chairman Powell has said.
Fisher acknowledged that he doesn’t know the Fed’s terminal rate. He described it as a numerator and denominator problem. Either rates have to go up or inflation has to come down. He reiterated the notion that managing inflation isn’t a light switch that you turn on and off; it’s a dimmer. Finally, he stressed that ultimately if the Fed’s long-run inflation target is about 2%, then a real interest rate would be incrementally higher than the target of 2%. But that’s a long-term goal and in order to produce a real interest rate in today’s inflationary environment, the Fed has to raise rates much higher.
Not surprisingly, Fisher said the direction of interest rates is higher. As a result, investors might expect some additional strain in the credit markets and continued volatility across many asset classes. He also expressed concerns that investments that were largely lifted by the benefit of zero interest rates may continue to struggle as rates drift higher.
10-Year Real Yields
It’s Never Too Late to Go Back to School
I really enjoyed chatting with Richard Fisher and learned so much from his insight into monetary policy. The clients I’ve talked with who attended the webcast have said the same. Thank you, Richard, for sharing your unique perspective — and I look forward to speaking again.
Given Powell’s personal resolve to defeat inflation, his strong support in Washington and a unified FOMC, it seems clear that a Powell Pivot won’t be coming any time soon. It’s also important to recognize that the Fed’s terminal rate is a real rate. And since a real rate is the goal, the Fed has a lot more work to do.
The same goes for investors who have to adjust to this shift in Fed policy. The old adage “Don’t fight the Fed” applies whether the central bank is easing or tightening. Despite the pain, there will be opportunities as the market transitions. And just as the Fed has committed to defeat inflation at all costs, investors need to evaluate these opportunities with renewed discipline.
1 Bloomberg Finance, L.P. as of November 7, 2022.
2 The H.4.1 report, November 2, 2022.
3 The H.4.1 report, November 2, 2022.
Inflation An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation — and avoid deflation — in order to keep the economy running smoothly.
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