Good Friday Morning! I want to thank everyone for the feedback they gave me on the cryptocurrency issue from last week. I’m glad you all enjoyed it. I enjoyed writing it. There are no real updates since what happened then. The Luna coin is nothing more than digital dust now, with virtually no hope of getting resurrected. No bailouts are coming for crypto.
In a way, that’s why I continue to be bullish long-term on blockchain and crypto as a whole. As recession looms, the downturn in crypto is burning away all the fake companies and should leave the better companies unharmed. The result should be a better sector — a16z had an intriguing read on the future of crypto and web3.
This week, we’re pivoting to a related topic: the stock markets and the Federal Reserve. I’m going to cover why I don’t believe the Federal Reserve has an idea of what it’s doing. Not because I know what to do, but because the Fed’s framework to examine the world is flawed. Links to follow.
Where you can find me this week
Please subscribe, rate, and review my podcast on iTunes, Spotify, or Google Play — the reviews help listeners, and readers like you find me in the algorithms. Make sure to sign up for the Conservative Institute’s daily newsletter and become a subscriber at The Dispatch, where I’m a contributor.
[05/16/2022] India’s wheat export ban sends world into food crisis – Conservative Institute
[05/20/2022] History roars back with coming food catastrophe – Conservative Institute
The Markets Meltdown and the Fed’s hard choices
There’s a hilarious scene in the Austin Powers movies where Mike Meyers is trying to perform a three-point turn with a laundry cart in a narrow hallway. He repeatedly backs up and drives forward while making no momentum, lodged between the walls. He got stuck between a rock and a hard place.
The Rational Root Twitter account made a funny meme of that clip where Fed Chair Jerome Powell backs back and forth between Recession and Inflation. It’s hard to imagine a better description of where things are right now in both the economy and markets. They keep trying to avoid both, but no one believes them.
The last few months have been brutal in the stock market indexes. I hinted at this last week when talking about the plunge we’re witnessing in cryptocurrencies. That’s the easy sector to liquidate first. We’re seeing a broader downturn as markets and investors price in rate hikes from the federal reserve and the odds of a recession.
The Wall Street Journal examined the broader S&P 500 and found the following:
The S&P 500 has tumbled 18.2% in 2022, or 17.7% when accounting for dividends and stock distributions. The stock market’s former darlings have fallen even farther. Netflix has declined 70%, and Facebook parent Meta Platforms Inc. and Nvidia are down 43% and 42%, respectively. The other five stocks have dropped between 23% and 36%.
“They’re taking a huge chunk out of the S&P return,” said Anne Wickland, portfolio manager at Easterly Investment Partners. “It’s really lopsided because of how many of those big names make up the top part of the S&P 500.”
In one sign of their influence, a version of the S&P 500 in which each stock is assigned an equal weighting is down just 13% in 2022.
The big names are taking the hardest hit. But there is a broad downtrend here too. The only thing preventing a bear market in the S&P 500 is companies exposed to the energy sector, which is booming right now thanks to oil prices.
Why is this crunch happening? Interest rates. Again, the WSJ:
The tech trade began to crumble late last year when it became clear that inflation wasn’t easing. Investors began to count on more-aggressive monetary tightening from the Federal Reserve, which has kicked off an ambitious campaign to raise interest rates. Higher rates are especially painful for growth stocks since their often-lofty valuations count on business expansion far into the future.
Just how high the Fed will raise rates is an open question—and an important one for investors trying to discern the path forward for big tech stocks and major indexes. If inflation takes too long to cool, central-bank officials could decide they need to lift rates higher than currently expected, a development likely to further punish the market’s weightiest stocks, and potentially tip the economy into a recession.
The trillion-dollar debate at the Federal Reserve, the White House, and markets is this: can the Fed tame inflation without causing a recession? Additionally, can the Fed slow inflation down enough that they can resume normal policy-making?
I have to keep reminding myself that the Federal Reserve has only conducted two rate hikes. TWO. With only two hikes, we’ve seen cryptocurrencies puke up their value, growth stocks in the Nasdaq plummet, and housing prices/mortgages (already high) skyrocket.
Two. Rate. Hikes.
However, the point this entire debate is missing is the political angle. Everyone likes talking about how the Federal Reserve is politically independent. That’s never been correct in the history of that institution. It’s an inherently political institution, subject to all the pressures of any place.
That was abundantly clear to me when Biden gave a “big speech” before the latest inflation numbers from BLS. Here’s Biden one day before the CPI numbers:
President Joe Biden said that the Federal Reserve has primary responsibility for fighting inflation, placing the burden for his party’s top political problem with the central bank after a report Wednesday showed continuing price spikes.
Biden called inflation “unacceptably high” and said that “bringing it down is my top economic priority” in a statement following a Labor Department report that showed the consumer price index climbed faster than economists had expected in April.
But he said that action to lower prices “starts with the Federal Reserve, which plays a primary role in fighting inflation in our country.” While the president has noted the Fed’s role for some time, the statement put more emphasis on the central bank.
My read on this speech is that Biden and the White House are pressuring the Fed to tackle inflation. You have to ask, “how far does the White House want this to go?”
And if that’s the first question, the second question is assuredly this: does either the Federal Reserve or the White House know what they’re doing?
The answer to the second question is simple: No. The Fed does not know what they’re doing. And because the answer to that is “No,” that means how both camps have defined the first question, “how far to go,” is crucial. If you don’t know what you’re doing, how far you take these random guesses is haphazard for everyone else involved.
I’m taking my cues here from Ben Hunt over at Epsilon Theory. His piece NGMI explains an essential point (if you’re paywalled, read it here). The Federal Reserve got it front on “transitory” inflation. They got the entire inflation read wrong. Here’s Ben hitting one of those economists, Loretta Mester, and predictions she made off her “modal”:
Not “model” but “modal,” as in mean, median, and mode, as in run some econometric simulations and see whatever the most frequently observed outcome looks like. It is—and I mean this in all literal seriousness—the modern equivalent of cutting open a dozen rams and examining their entrails to see what the most typical pattern looks like.
Here’s what Loretta Mester saw in the entrails’ modal forecasts last year.
“I expect some higher inflation measures in the next couple of months but that is different from underlying inflation levels reaching 2%.” —Feb. 28, 2021
“I am unconcerned with inflation running away from us.” —April 5, 2021
“I’m not worried about inflation getting out of control.” —May 5, 2021
“The Fed needs inflation expectations and real inflation to rise.” —May 6, 2021
“I’d like to see inflation rise to 2% or higher.” —May 14, 2021
“By the end of the year, I expect inflation to be between 3.5% and 4%, with a drop in 2022.” —Aug. 27, 2021
“Inflation will be little more than 2% in the next years.” —Sept. 24, 2021
But wait, there’s more. It’s not just that Mester and the entirety of the Federal Reserve economic research team—more than FOUR HUNDRED PhD economists with a budget of literally hundreds of millions of dollars—got the 2021 transition to an embedded inflationary environment completely and utterly wrong, it’s also that Mester et al. got the prior embedded deflationary environment completely and utterly wrong.
My first CI column that touched on inflation is dated April 26, where I mused about inflation being real or a mirage. By May, I was convinced inflation was here to stay and laid out that reasoning and the political consequences. If a lawyer can get this right over economists, something is wrong because lawyers are dumb.
Ben Hunt explains that the way the Fed builds its predictions is completely flawed — which has been true for the better part of the last decade. The easy money of the Fed since the 2008 Great Recession has created more havoc than it solved. And now they have to solve a demon that won’t go away with easy money: inflation.
Sprinkle on top of wrong models/modals the political pressure of the White House to “take responsibility” and solve inflation, and you get the current predicament. The Fed doesn’t know when a recession could occur, they don’t know what it’ll take to kill inflation, and they’re not even sure they can succeed even if they guess the proper steps. All of this while political pressure is growing.
The same Fed that made all the predictions on why inflation was transitory, which got dutifully repeated by the White House, is the same Fed talking about soft and hard landings. Meanwhile, crypto is getting hammered, tech stocks are drying up, and the rest of the markets are getting beaten.
With that knowledge in hand, I’d like to highlight an interview I found interesting on CNBC this week. Stephen Roach is a former Fed economist and currently heads Morgan Stanley’s Asia group. He’s sounded the warning for stagflation since the start of the pandemic:
He warns the U.S. is on a dangerous path that leads to higher prices coupled with slower growth.
“This inflation problem is widespread, it’s persistent and likely to be protracted,” Roach told CNBC’s “Fast Money” on Thursday. “The markets are not even close to discounting the full extent of what’s going to be required to bring the demand side under control… That just underscores the deep hole [Fed chief] Jerome Powell is in right now.”
Roach, a Yale University senior fellow and former Federal Reserve economist, calls stagflation his base case and the peak inflation debate absurd.
“The demand side has really gotten away from the Fed,” he said. “The Fed has a massive amount of tightening to do.”
Roach expects inflation to stay above 5% through the end of the year. At the current pace of interest rate hikes, the Fed wouldn’t meet that level.
“50 basis points doesn’t cut it. And, by ruling out something larger than that he [Powell] just sends a signal that his hands are tied,” added Roach. “The markets are uncomfortable with that conclusion.”
In essence, take all the rate hikes by the Fed, and continue them for the rest of the year. On top of that, include that the Fed won’t touch inflation. In short, stagflation.
Two rate hikes in, and we’ve witnessed tremendous destruction of capital in growth sectors. We’re a few more supply chain issues away (see China) from inflation expanding (again). Sprinkle in new developments in the war in Ukraine and its recipe for uncertainty. All those things would exacerbate the decisions the Fed is making.
Plus, as I pointed out: the White House is a player here. How long does Biden want to ride out stagflation or rising interest rates to lower inflation? What does the Fed do if Biden gets weak knees and tells the Fed to loosen the money supply again to help out for the election? If they ease monetary policy, they likely push inflation back up.
Like I said at the outset, the Federal Reserve is Austin Powers trying to make a three-point turn in a hallway. They’re stuck sideways with few outs.
Something will eventually break. We’ll get a recession, or Biden will give up and try to avoid a recession. Politics will decide this maneuver. And unfortunately, they don’t know what they’re doing.
Links of the week
Biden’s Baby-Formula Farce – Noah Rothman, Commentary Magazine
He Was a World-Renowned Cancer Researcher. Now He’s Collecting Unemployment. Behind the fall of David Sabatini, ‘one of the greatest scientists’ of his generation. – Suzy Weiss, Common Sense with Bari Weiss
China Insists Party Elites Shed Overseas Assets, Eyeing Western Sanctions on Russia: An internal Communist Party directive bars senior officials from owning property abroad or stakes in overseas entities, whether directly or through spouses and children – WSJ
‘The Guilt Is Unbearable’: UST-Luna Investors Discuss the 99.99% Crypto Crash: It took less than a week for the third largest stablecoin and its ecosystem to become virtually worthless, wiping out countless traders’ savings. – Vice
Twitter Thread(s) of the week
Satire of the week
Disinformation Board Narrowly Outlasts CNN+ – Babylon Bee
Boomer’s iPhone Font Size Visible From Space – Babylon Bee
Thanks for reading!