The Fed needs a new mandate

By David Nelson, CFA

The Fed cannot and will not deliver on the goals laid out by Fed Chair Jay Powell in his opening remarks at Jackson Hole. The long-term target of 2% inflation is not achievable. Monetary policy on its own isn’t enough to bring down inflation expectations and deliver on the Fed’s principal mandate, price stability.

Today’s inflation isn’t just too many dollars chasing goods and services. It’s also a supply challenge with the Energy complex ground zero in any inflation fight.

Even if you believed pushing rates higher for longer could do the job, you’d have to go well beyond any of the projections that are currently priced into the market.

The monetary playbook for the last half century has been for the Fed to hike rates at least approaching current inflation and often beyond.

We’re not even close! Even if you believed the next CPI was going to magically fall to 7%, consensus shows the terminal rate for Fed Funds is just 3.7% well below what history suggests.

Why? Because today markets understand full well that once rates start approaching 4 or heaven forbid 5% something will break. The economic fallout that would follow I think is well beyond what the Federal Reserve is willing to live with. (Current estimate for Q3 CPI is 8.3%)

Implied Overnight Rate & Number of Hikes/ Cuts as of Aug 26

Gross Federal Debt as a percentage of GDP is at the highest levels since World War II. Each tick higher in rates limits our ability to service that debt in a never-ending cycle of the United States morphing into a third world nation.

Gross Federal Debt as a Percent of GDP 1940 – 2021

Right now, key credit spreads are benign in part I believe an indication that the bond market isn’t fully buying into the Fed’s current message.

The Bloomberg U.S. Investment Grade Index spread is at 1.08. If we start approaching 1.5 the street is going to start to worry. The same for High Yield. If we start to live meaningfully above a 6% spread we have a problem. Nothing good happens when credit spreads start to blow out.

High Yield Spread

Forget about 2%. It’s too late. 

When it comes to monetary policy timing is everything and the Fed missed their opportunity to snuff out the fire quickly. If you wait till you can see it, inflation becomes embedded and now demands a team approach.

Unfortunately, the Fed’s teammate Washington is doing their best to wipe out whatever progress the Fed has made. President’s Biden’s student loan debt relief for a select group of Americans is politics masquerading as policy only adding to the inflation problem.

With the stroke of a pen the President wiped out the savings promised from the so-called Inflation Reduction Act that both Senator Sanders and the CBO said would do little to reduce inflation.

In the end it’s a wealth transfer that makes its way to colleges that have failed to deliver a reasonable return on investment. The excess ends up in your favorite college endowment i.e., Harvard with well over $50 Billion in assets.

We’re going to have to learn to live with higher inflation. The Fed will have to accept as its new mandate, reduce inflation to something livable and keep it from getting worse.