Crisis-Weary Fed Has 9%-Tall Mountain Left To Climb: Quant

Jerome Powell is a victim of circumstance, a golfer who “can’t putt,” a professional fall guy, a “dangerous man” and any number of other things, depending on who you ask and what year it is.

One thing Powell isn’t, is comfortable. His tenure as Fed Chair belongs in the dictionary next to the entry for “fraught.”

Recall that on his very first day in the big seat, the VIX ETN complex imploded. It’s been one crisis after another since then (figure below).

Powell has endured a trade war, unceasing personal attacks from a sitting US president, a pandemic, a one-month economic depression, three bear markets and the highest inflation since the Volcker era.

There’s no rest for the weary. In all likelihood, Powell will be able to add a second recession to the list of unfortunate events associated with his tenure as Chair by the end of this year.

In any other circumstances, a decelerating US economy would be met with a countercyclical policy lean from the Fed. This time, though, they’re inclined to tighten policy into a burgeoning slowdown. It’s either that, or risk being remembered for presiding over a ruinous inflation spiral.

Last week, Thomas Barkin tacitly suggested central banks may not deserve all the credit they get for keeping inflation anchored over the past several decades. “I’m concerned that our success in managing inflation over the last twenty years was partially enabled — it was good policy but it was also tailwinds which were disinflationary,” he mused, while chatting with reporters at an event in Richmond.

That exemplifies Powell’s bad luck. He’s Fed Chair at a time when myriad structural disinflationary forces that most economists believed would last forever, were dislodged by a once-in-a-century public health crisis. In 2020, Powell witnessed what may be remembered as the beginning of the end for globalization. Then, in 2022, he was forced to confront a shift towards economic fragmentation and regionalization brought on by Russia’s invasion of Ukraine and attendant sanctions, which severed Moscow’s ties to the global financial system.

Barkin’s structural, disinflationary “enablers” (including and especially globalization) were what allowed policymakers to undershoot previous easing efforts in subsequent tightening campaigns, leading to an ever-lower ratio of tightening to easing. SocGen quant Solomon Tadesse captures that dynamic in an “MTE ratio” (figure on the left, below). A ratio below 1.0 means (by definition) that policy trends easier over time.

That ratio hasn’t been above 1.0 since the early 80s. An MTE below 1.0 represents a friendly, “good cop” Fed, which is growth-conscious while tightening. Growth-conscious tightening is, by nature, protective of risk assets.

In 2022, market participants are compelled to ponder the prospect of a Fed which, bereft of the structural, disinflationary enablers which made growth-conscious tightening possible, pivots to what Tadesse called “inflation-containment tightening.”

He noted that the average MTE prior to the era defined by Barkin’s “enablers” was roughly 1.5x. “Such aggressive monetary tightening with a focus solely on inflation containment, even at the cost of inducing recession… would require overall monetary tightening of about 11.6%,” Tadesse said.

That’s the total required. When you incorporate tightening already delivered from the lows in the shadow rate, a return to inflation-containment mode requires an additional 9.25% worth of tightening across rate hikes and balance sheet runoff. The figure on the right (above) illustrates the point.

“The policy rate could go up by as much as 4.5%, with the remainder coming from QT,” Tadesse went on to say, noting that if one assumes every $100 billion of QT equates to 12bps of tightening, this iteration of QT would come to around $3.9 trillion, or “roughly equivalent to the net growth in the Fed’s balance sheet during the pandemic.”

I’ll say it again: There’s no rest for the weary.