Jay Powell has finally had his Road to Damascus moment. He’s catching up to where these pages were months ago. In the press conference following Wednesday’s FOMC announcement, he acknowledged inflation is a serious problem not to be dismissed.
He’s still dragging his feet on rate policy … the notion that rates can’t move until QE is over is a figment of Fed dogma. As we pointed out in Monetary Mythology, it’s based on an ad hoc assumption that QE is just an extension of rate policy out the curve.
This unfounded assumption has consequences. Real interest rates 5%-10% below zero is an economic emergency. But … and this is key … rates have started to move, just a bit, but every journey starts with a step. The Treasury market, not the fed funds target, is what really matters, and rates have already begun to creep up in the one-two year area of the yield curve.
It’s also just plain silly to keep any mortgage purchases going at all … never justified to begin with, they became redundant – worse, counterproductive – a year and a half ago. But at least now they’re being trimmed.
Sure, we could do better. I’d rather see movement first on rates and mortgages, but maybe be less aggressive on the Treasury taper, adjusting as needed to buffer unnecessary volatility. But at least the Fed is opening its eyes … as they say, the first step in solving a problem is admitting there is a problem.
What does it mean for financial markets? Fed tightening, or becoming less loose, typically leads to lower asset prices, or less pressure higher. But this comes at a time of extraordinarily high asset prices. The markets, bond and stock, are now in a similar position to Wile E Coyote after he’s run off the edge of a cliff and hasn’t yet looked down.
They could be correcting this hyperinflated state already, or they could stay that way for a while. Synthetic Systems says it could be as long at the second half of next year before they look down and realize there’s nothing below but a lot of thin air. Watch for the next update around the beginning of the new year.