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Imagine I’m the Fed Chair, how do I see the current (Nov 2022) US economy?
GDP growth (production): modest growth
Labor market: tight, strong
CPI growth: high
CPI expectation: low
What do I want (my goal)?
Keep my job (as legendary investor Jim Rogers has pointed out in interviews) and my reputation. It means, I’ll need to achieve Fed mandates:
Max employment
2% CPI growth in the long run (it means short run higher than 2% is ok)
How do I execute?
I want to see a weakened economy:
GDP growth 0 or slightly < 0
Rate of change of unemployment falling to 0 (softening labor market)
CPI (core PCE) falling
CPI long term expectation low
I DON’T want to see: Economic crisis
Unemployment rate shoots up to 6% (historically high in recessions) due to widespread bankruptcies in a short period of time.
Financial systems break down: banks and financial institutions fail:
Credit seizure: bond prices crash (massive bond sell off, banks don’t lend each other)
What is my decision making framework?
When the economy is hot (high employment, high CPI growth), I want to reduce the CPI growth while not reducing employment too much. How can I do that? I will tighten the financial conditions by increasing interest rates. When the financial condition is tightened, I would expect demand (people want to consume) will fall (1). Why do people want to consume less? Consuming less means reduction in discretionary expenses: purchase stuff, dining at restaurants, go on holidays, take flights or cruises, buy cars, buy houses. People want to consume less because either they have less income or wealth.
People have less income because of loss of purchasing power (fast consumer price increase) or layoff.
People have less wealth because their net cash saving, investment portfolio and house prices fall.
Supply will also fall (2) when I tighten the financial condition. Banks will extend less loans to businesses so more businesses will fall. When businesses fail, supply will fall because production capacity of those bankrupt businesses are taken out of overall supply in the economy.
In the tightening financial condition, the rate of change of consumer prices will fall when the decrease of demand (1) outpaces the decrease of supply (2).
As I keep on tightening, there will be a point when there’s an economic crisis whereby there are huge bankruptcies and a lot of people lose jobs. That’s the hard landing and also my constraint in how much I can tighten.
My ideal case for me is to tighten enough to bring down CPI growth (core PCE) to 2% and no economic crisis.
The case of a weak economy and easing financial conditions is the opposite of tightening one.
What decision did I make at the Nov 2022 meeting?
Current rate: raise 0.75%
Why did I make that decision?
CPI growth is not near target 2% yet.
There’s still room to tighten the financial condition further.
Economy is not weakened enough.
No financial crisis yet: no collapse in credit market, no big crash in stock market.
What terminal rate, pace and length of rate hike do I expect?
Terminal rate: higher than previously thought, but getting close
Pace of rate hike: depends on data. I think we are near to slowing down.
Length of rate hike: depends on data
Stepping out of the Fed Chair and returning back to myself, what is the rate path that market is projecting? What would happen to asset prices?
Future FED rate probability by the market as of 3Nov22 (Ref: [4]):
14Dec22: 57% chance 0.5% to [4.25%-4.50%]; 43% chance 0.75% to [4.5%-4.75%]
1Feb23: 53% chance to [4.75%-5%], i.e. 0.5% increase
22Mar23: 48% chance to [5-5.25%], i.e. 0.25% increase
3May23: 39% chance no change in rate, remain at [5-5.25%] => done raising rates
With these scenarios, probably, the market expect asset prices to be:
Equities: have bottomed
Bonds: falling, will bottom in Feb/Mar 2023 when rates peak.
Commodities: falling, will bottom Mar 2023 when rates peak
Housing: falling, will bottom beginning of Q3.
References:
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