Fed monetary policy through the looking glass

September 3, 2021

12:19 am

  • In the United States, last week was one in which the ‘big men’ were doing the talking. In Washington, President Biden was repeatedly lifted, tortoise-like, from the straw-filled box in the White House’s airing cupboard in which he is normally kept and placed before the world’s media to try to spin the government out of the political, diplomatic, and humanitarian debacle that has been the final stage of the US withdrawal from Afghanistan.

  • On the other side of town, unable to attend the Jackson Hole economic symposium in person due to the pandemic and thus forced to communicate via video link, Fed Chair Jay Powell held the financial world in thrall with a long-awaited speech which many market participants have assumed would mark a definitive announcement about the tapering of the Fed’s quantitative easing (QE) programme. Both men have an extremely difficult job on their hands, and their respective fates are more intertwined than perhaps people and markets acknowledge.

  • Focusing on the Fed, the run up to Mr Powell’s speech has been characterised by a frenzy of press coverage from the more hawkish regional Fed Presidents. Pole position goes to Dallas Fed President Robert Kaplan who, in the space of a week, went from dovish (due to the Covid delta variant) to hawkish (due to inflation), advocating a rapid tapering process to be completed by next year.

  • The graph below (as of 25th August 2021) acts a reminder of the unbelievable speed at which the Fed’s balance sheet has grown over the past 18 months, and should also act as a salutary reminder of the real reason for the extraordinary rally in equities and other risky assets over the same period of time. Correlation is of course not causality, but equity outperformance and Fed money printing have at the very least been suspiciously coincident.

Source: Bloomberg as at 31 August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • Financial markets have born witness to a lot more Fed ‘hawkishness’ than ‘dovishness’ in the past month or so, at least when Chairman Powell isn’t speaking. There are a number of reasons for this. Given how dovish Mr Powell has been of late, the doves at the Fed have an advocate and therefore don’t need to speak up. The Fed is ostensibly divided (as well it might be when ‘hawkishness’ in 2021 means talking tough on tapering when inflation is over 5% and GDP will rise by over 6% in the year – no hawks are advocating immediate rate hikes for example), so perhaps the hawks are making sure they have their voices heard.


  • While AOC and the rest of the squad have come out urging President Biden to ditch Mr Powell (‘AOC, Tlaib, Pressley call on Biden to dump Powell as Fed chair’, Politico, 30/08/2021), Powell has received the public support of Treasury Secretary Janet Yellen with respect to his re-election for a second term as Fed Chairman, and this is what matters in this Alice in Wonderland style game of croquet. While it may not appear like an overt revolution in government, the monetary necessities of quantitative easing resulting from the fiscal largesse in response to the 2020 pandemic have effectively subordinated the central banks in the US and elsewhere to the needs of government. Fed hawks may simply be mouthing off knowing full well it’s the government calling all the shots these days.


  • If the Treasury supports Powell, then what Powell says (and does) is infinitely more important than what anyone else at the Fed says (or does). While deputy Fed Chair Richard Clarida was recently talking tough on rate hikes in 2023 during a speech before the Peterson Institute (4th August 2021), one has to remember that his term finishes in January 2022 and therefore anything he says now about events in 2023 is entirely irrelevant. Unfortunately, headline-chasing algorithms have yet to acquire this level of sophistication.


  • What did the Mad Hatter Mr Powell actually say during his J-Hole speech? Not a lot new, and it was certainly dovish in tone. There was some analysis of how inflation was limited in its scope (he picked second-hand cars, not lumber this time, to illustrate his point). There was a brief history lesson on central bank policy in the 1950s and of inflation expectations in the 1970s, as well as a comment that ‘substantial progress’ had been made on inflation, if not yet on employment.


  • It’s fair to say that not much came out of the rabbit hole. The market had been anticipating a taper announcement, and the fact that Mr Powell didn’t go there was taken as dovish, with the usual consequences: equities up, gold up, dollar down. The graph below shows the DXY dollar index, and the moment Mr Powell began to speak is obvious. The dollar has been in no-man’s land for much of 2021. A break in the DXY below 89 would likely mark a period of extended weakness.

Source: Bloomberg as at 31 August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • The reason that so many regional Fed chairman are apparently so hawkish all of a sudden is obvious – the Fed has been completely wrong about the transitory nature of inflation. Inflation is a rate of change measure, and the deflationary period of April-June 2020 has now passed out of the period of comparison for yearly inflation and thus the ‘base effects’ argument which has sustained the Fed’s transitory narrative is no longer applicable. Pandemic-related supply-chain issues are still being felt, and it is quite possible that the effect of the massive money printing of 2020 is still being felt in terms of monetary inflation even if the rate of increase of M2 money has itself declined from its 2020 peak.

  • It is much easier to illustrate the supply-side issues in the world economy than it is the monetary ones because the former are considerably more tangible in nature than the latter. A series of Bloomberg articles in August have highlighted the various aspects of the problem. An article on the 25th August (‘The World Economy’s Supply Chain Problem Keeps Getting Worse’) discussed not only the supply disruptions, rising raw-material shortages and spiralling container-transportation costs, but also how China’s zero-covid policy resulting in port closures is exacerbating the problem.

  • Input costs are also rising. A Bloomberg article on the 26th August (‘World’s Largest Chip Maker to Raise Prices, Threatening Costlier Electronics’) explained how the world’s largest chip producer, Taiwan Semiconductor (ticker TMS.US), will shortly raise its prices by 10 to 20%. This will further disrupt downstream industries including the auto makers who are already being forced to shut factories due to parts and chip shortages.

The name shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

  • For consumers, food-price inflation is starting to bite and “Eat me’’ is replaced with ‘’Can you afford me?’’ Mike Tattersfield, CEO of Krispy Kremes (ticker DNUT.US) was quoted in a recent article saying that donut prices would stay around $1 (‘Krispy Kreme is raising prices in September because of inflation’, Yahoo Finance, 18/08/2021). Nonetheless, prices are going up. Mr Tattersfield acknowledged that although Krispy Kreme has pricing power and pricing discipline, his customers are extremely price sensitive, and this is what really matters.

  • Rising food prices have an immediate effect on consumers’ spending power and thus on their overall outlook. The UN Food and Agriculture Organization reported an annual 31% increase in food prices since July 2020 (‘Soaring Cost of Food is Forcing Families to Scrimp at the Dinner Table’, Bloomberg, 18/08/2021). While this is a global phenomenon, its effects can also be seen in the US where economic sentiment is rolling over. The graph below shows a sharp fall in the University of Michigan’s consumer confidence measure, back below the pandemic lows.

Source: Bloomberg as at 31 August 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • This is not good, especially if it is happening at the same time as inflation pressures are proving far less transitory than hoped. In fact, one might ask the question of whether rising costs are in fact the reason for falling consumer sentiment. Public dissatisfaction has always gone hand in hand with rising prices. The Arab Spring of 2010 followed a period of sharply rising food prices. Even the French revolution saw the timing of popular protest closely linked to fluctuations in the price of baguettes. This general trend of higher inflation and falling consumer confidence (which one assumes will eventually make itself felt in lower GDP growth) doesn’t make Chairman Powell or President Biden’s respective jobs any easier.


  • In the past week, the media has clearly dipped deeply into Wikipedia and we have been inundated with historical analogies to allow us to gauge the significance for President Biden of the Afghan withdrawal crisis. President Ford did ok in 1975 after Vietnam, President Carter less well after the Iran embassy siege in 1980. What about the Korean War? What about inflation following World War II.


  • Two rank generalisations will suffice here: first, that so long as the domestic economy is doing ok, then foreign policy failures may not prove fatal to US Presidents. Secondly, when push comes to shove, the US will put its domestic interests ahead of international ones, and if this means sacrificing the dollar to prop up the US economy, then the President will do it. This happened in 1933 when FDR devalued the dollar against gold and again in August 1971 when Nixon suspended the gold convertibility of the dollar which had been the cornerstone of the 1944 Bretton Woods agreement.


  • With mid-term elections in the fall of 2022, and with the foreign diplomatic sphere in flux, the importance of the US economy to Biden’s hopes of maintaining a Democrat majority in the house and therefore of continuing his spending plans have just become even more important. Given the mission-critical nature of the Fed’s involvement in monetising the US deficit and propping up the financial markets since March last year, Jay Powell’s fate is becoming increasingly entwined with that of the Biden administration, especially if Treasury Secretary Yellen’s recent advocacy of a second Powell term as Fed Chairman is taken at face value.


  • All of this adds to the significance of the timing and magnitude of the Fed’s QE taper. Let us not forget that all that is at stake here is cutting some stimulus – rate hikes are clearly out of the question, as even the Fed hawks have emphasised. This is at the same that July CPI inflation printed at 5.4%, July PPI came in at 7.8%, and even the miserly core PCE deflator, the Fed’s favoured inflation measure (and incidentally always the lowest) printed at 3.6% in July, a level not seen since the early 1990s. Falling consumer sentiment, stalling house prices and so on to the backdrop of multi decade-high inflation prints screams stagflation. Can Jay dig Joe out of this hole or will it be off with his head?


Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 2 September 2021.


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