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Hello. Ethan is away this week, resting for August, which I’m going to skip completely (Unhedged will only appear three times a week all month, with a special guest author writing one.) So you know who to blame for the following: robert .firstname.lastname@example.org.
The market thinks the Fed has very good timing
It’s a solid bet that tomorrow the Fed will raise its key rate an additional three-quarters of a percentage point. The futures market puts the odds at just over 75%, with the remaining probability space occupied by a full point increase.
Part of the reason for the confidence in 75 rather than 100 basis points may well be that the Fed does not appear to have disclosed the larger move to Nick Timiraos of the Wall Street Journal, as it almost certainly did. last month. I’m not too worried about what this kind of leak does to the credibility of the Fed or anything. But this raises two slightly interesting questions. One is not leaked to Nick Timiraos now a form of forward orientation? Two: Is the Fed looking for someone else to talk to? Someone with a truly global following and a tongue-in-cheek appreciation of the ironic nature of financial history? If so, my email is above.
The more important question, for investors and the Fed itself, is how the bank will react as new data arrives in the coming months – especially if that data follows the current trend, which suggests that economic activity will soon slow down and that inflation is already past its peak in key areas such as property prices and commodities.
As Unhedged has pointed out before, the tough question for Fed watchers is what the Fed will do when inflation is still very high, but falling sharply, and unemployment is still very low, but falling. clear increase. Chances are that we will be in such a situation before very long, and for my part, I have no idea how quickly the Fed will back down under these circumstances (a nice article from Reuters yesterday argued that the internal consensus of the Fed could collapse under such circumstances).
The market, on the other hand, has recently estimated that the Fed and other central banks will back down quickly and start cutting rates by the middle of next year. This can be seen in the recent drop in bond yields which, as Franziska Palmas of Capital Economics notes, is a fairly global phenomenon. His chart of the downward moves in yields and key rates expected over the past week:
Are the markets right? Again, I don’t know. But I would note that while I hear a lot of people talking about the “Fed Pivot” and the good it could mean for stock and bond prices, there isn’t much discussion that the Fed will pivot too late – the classic Fed mistake. One person who talks about this grim possibility is Michael Wilson of Morgan Stanley. Here it is in a note to customers yesterday (which landed, by the way, before the bad news from Walmart):
We remain skeptical of the Fed’s ability to reverse the now entrenched negative demand trends . . . the demand-destroying nature of the high inflation that presents itself today. . . won’t go away easily even if inflation comes down sharply because prices are already out of reach in the sectors of the economy that are critical for the cycle to continue – i.e. housing, autos, food, gasoline and other necessities. Remember that lower inflation does not mean negative price changes for many of these items and to the extent that deflation returns through discounts to stimulate demand, rest assured this will not be good for profit margins and/or earnings revisions.
It’s painfully obvious but bears repeating: if the Fed pivots when we’re already sliding into a deep recession, stocks will fall.
Bad news from Walmart
Making sense of the economy has been tricky lately due to the contrast between the message from financial markets and measures of business and consumer sentiment (absolutely bad!) and measures of current activity (great, thank you !). That changed a bit on Monday when Walmart again cut its earnings forecast. Excerpt from the press release:
[same-store] Walmart US sales, excluding fuel, are expected to be around 6% for the second quarter. This figure is higher than expected with a heavier mix of food and consumables, which negatively affects the gross margin rate. Food inflation is in double digits and higher than at the end of the first quarter. This affects customers’ ability to spend in general merchandise categories and requires more markdowns to browse inventory, especially apparel.
The company expects operating profit to be down 10-12% for the full year. It’s not surprising, but it’s still important. This is the first unambiguous indication from a major American consumer corporation that – today, right now – all is not well among Americans in the middle and lower end of the income spectrum (unless can (maybe AT&T said last week that customers were taking longer to pay their bills). We are entering a new phase of the economic cycle.
The credit channel, redux
Last week, while writing an article about the influence of quantitative easing on bank lending – in response to a post from Benn Steil and Benjamin Della Rocca – I admitted to Ethan that I was afraid of correct technical points. Ethan, who isn’t usually smart, said I needn’t have worried because only about five people would read such a hopelessly cheesy article.
Ethan was wrong. Tons of comments and responses came in. One group responded that the answer to the question posed in the title (“Has QE caused inflation?”) was obviously yes. I should have been clearer. My view is that QE contributes to inflation, but I disagree with Steil and Della Roca on why and how much.
To sum up our disagreement to a gross oversimplification: Steil and Della Roca believe that QE creates bank reserves, and this extra liquidity induces banks to lend, with direct inflationary consequences.
I think reserve levels don’t matter much to banks’ lending decisions. The Fed no longer imposes reserve requirements on banks. Banks are required to keep a certain amount of high quality liquid assets such as (but not only) reserves with the Fed, but they can borrow cash if needed. The decision to lend depends on the loan demand and the cost of liquidity. Reserve levels don’t tell you much about loans – as you can see by the fact that reserves and loans don’t track each other.
Steil and Della Rocca wrote back to me, saying lending and reserves follow, once you adjust other things that eat up reserves, like the Fed’s reverse repo program and changes in the size of the general treasury account. They provide this table of adjusted reserves (black line highlighted in yellow):
They also report on the impact of QE on credit:
The abundance of liquidity has lowered the costs of interbank loans, boosted asset prices, improved the creditworthiness of borrowers and stimulated the search for yield. In December 2021, bank loans reached their fastest monthly growth rate since 2012 (excluding the first two abnormal months of the pandemic).
I agree with this clear summary of how QE stimulates credit creation: it increases liquidity throughout the financial system (not bank balance sheets alone), boosting risk appetite and asset values, with immediate consequences on the apparent creditworthiness of borrowers and their desire to borrow. But I still don’t understand what bank reserve levels have to do with it, except that QE, all things being equal, increases both reserves and the total liquidity of the system.
Steil and Della Rocca believe that “the gap between central bank bond holdings and bank reserves is a fairly reliable indicator of the direction inflation is heading, and that an undesirable rebound in the gap is a signal that QE may have exceeded its target. Undoubtedly, this gap widened and inflation flourished. We just disagree on how the causal relationship works.
(If you want the full text of their response, email me and I’ll send it to you.)
A good read
Hooray for The Economist for putting the abject failures of ESG investing on its cover this week.
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