What’s the Fed Gotta Do to Catch a Break Around Here?

This week’s headline event was definitely the CPI report that came out yesterday. The expectations were for an inflation reading of 7.3%, with many hoping that the number would actually surprise to the downside. Instead, the number came in higher than expected at 7.5%. The major US stock market indices didn’t like that one bit. The S&P 500 fell over 1.7%, while the Nasdaq 100 dropped 2.2% on the day of the report.

News of the hotter than expected reading hit the bond market as well. Federal Funds rate now expects a full 0.5% increase at the next meeting in March. The last time the Fed raised rates by more than a quarter of a percent to start a rate hiking cycle was pre-1990. The reaction in the bond market was clearly responsive to remarks made later in the day by St Louis Fed Governor James Bullard, who called for a full percentage point hike by July and an earlier commencement of the balance sheet runoff scheduled for later this year. In combination, these two sentiments seem to illustrate the degree to which Fed governors are beginning to panic that inflation is getting out of hand.

The parabolic rising inflation is reminiscent of the late ‘70’s and early ‘80’s when it took dramatic rate hikes to crush runaway inflation. At that time the Fed had no other choice but to cause a double dip recession in order to reset the economy. Paul Volcker, the Fed Chair at the time, understood that killing inflation is like killing a zombie, you have to put a bullet in its head. Decades of accommodative Fed policy have currently created a financial system with a sense of entitlement. It remains to be seen if Chair Powell will have to react as strongly as his predecessor did, but if he is forced to respond with anywhere near the same fortitude you can bet that the market won’t be happy.

Year to date the S&P 500 is down 5.5%, which given the potential drama facing the economy and the Fed seems rather mild. Perhaps it has something to do with the fact that few market participants, having not been around for the last bout of inflation, have little idea what to expect. We have been conditioned to expect the Fed to promote higher asset prices. When the market begins to show the policy makers that it is uncomfortable the Fed typically eases its foot off the brake and adds more gas to the economy/market. The question hanging over the market’s head is are we in a different situation than we’ve been conditioned to respond? Can the Fed afford to be as loose as it has in the past?

That question really depends upon what the driving force behind the inflation is. If it is all supply chain problems, then perhaps we are only a matter of months away from that being eradicated. Moderate rate increases coupled with easing supply constraints could ease inflation. However, with no certainty that those constraints will ease soon the Fed is left to defend the US economy with the only tools at its disposal. Should the next few CPI readings come in as hot as the last we may see the bullet to the head response as the only one to take. Until then the market will be on edge, with potentially more downside pressure to come.

Thanks for reading,

Zach and Dave

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