Former Fed Bank President Calls for Nuking Stocks

If Stocks Don’t Fall, the Fed Needs to Force Them

It’s hard to know how much the U.S. Federal Reserve will need to do to get inflation under control. But one thing is certain: To be effective, it’ll have to inflict more losses on stock and bond investors than it has so far.

Market participants’ heads are already spinning from the rapid change in the outlook for the Fed’s interest-rate policy. As recently as a year ago, they expected no rate increases in 2022. Now, they foresee the federal funds rate reaching about 2.5% by the end of this year and peaking at more than 3% in 2023.

Whether that proves right will depend on a number of hard-to-predict developments. How quickly will inflation come down? Where will it bottom out as the economy reopens, demand shifts from services to goods and supply-chain disruptions ease? What will happen in the labor market, where annual wage inflation is running at more than 5% and the unemployment rate is on track to reach its lowest level since the early 1950s within a few months? Will more people come off the sidelines, boosting the labor supply? Together with moderating inflation, this could allow the Fed to stop raising rates at a neutral level of about 2.5%. Or a tightening labor market and stubborn inflation could force the Fed to be a lot more aggressive.

....So far, the Fed’s removal of stimulus hasn’t had much effect on financial conditions. The S&P 500 index is down only about 4% from its peak in early January, and still up a lot from its pre-pandemic level. Similarly, the yield on the 10-year Treasury note stands at 2.5%, up just 0.75 percentage point from a year ago and still way below the inflation rate. This is happening because market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025 — but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely.

Translation: the Fed has lost credibility.

We should abolish the Federal Reserve or at least severely restrict its powers, but as an exercise in what is possible right now, the best move for the Fed is a shock hike in May. Take the funds rate up to 125 bps (a 100bps hike) or even all the way to 200bps. Reasoning is simple. 

If they're hiking into a recession as some claim, they front load the financial market hit. Stocks will quickly bottom as bulls are scared straight by the Fed's restored credibility. Inflation may also bottom as the commodity crowd gets rocked too. 

Conversely, if the inflation crowd (those who predict it, not those who want it) is right, this hike will only be a speed bump for inflation. In that case, the Fed will know before the end of the year and can hike much more quickly as would be needed in that scenario. 

The main downside to a shock hike is the Fed gets a little more blame than it is going to get anyway for the fallout. They'll clearly be the trigger for whatever sell-off ensures. 

On the plus side, with the CPI at 8 percent, they could justify hikes all the way up to 3 or 4 percent in May. They can browbeat bulls with that data point. They could even refer to Wall Street as mollycoddled 1-percenters if they grew a pair. 

And if they do crash the markets, inflation will certainly come down, and they will certainly point out the solved the problem with a 100 bps hike at a single meeting instead of some long drawn out 12 to 18 month affair. Better to rip the Band-Aid off than let a miasma of uncertainty hang over markets.