Will the Federal Reserve Destroy the World in Two Weeks?

When people using different models come to the same conclusion as myself, I pay attention:

I'm overdue on updating the fed pivot indicator, and frankly it's showing we have arrived already

We are at the point where the fed would usually halt rate hikes and begin easing again

As they gear up for 75bp in a couple weeks, they would be knowingly blowing up the system pic.twitter.com/u20NsnvhNH

— TheHappyHawaiian (@ThHappyHawaiian) July 11, 2022

He's using debt financing for government. I look at it from the view of inverted yield curves and the breakout in the U.S. dollar versus the yen in particular. Here's the spread between the 10-year and 2-year yield. Back to the line where rate cuts begin.

Here's the same chart with the effective funds rate (DFF on FRED) inverted.

This makes me very nervous:

If I was in Powell's shoes, I'd be scared of hiking 75 bps and the market interpreting policy as hawkish. The markets are on a knife's edge. In 2018, the Fed reversed course and stopped a stock market decline. I'm not sure they can reverse a collapse in the yen if they knock that domino over. Crashes beget crashes:

Coming into 2022, the Fed was trapped because the market would crush stocks and bonds whether they hiked or not, therefore they had to hike. Now they are in a different trap. They have a new threat: deflationary collapse. 

If they hike too slowly and the CPI stays high, they may have to hike more later. My hunch is recession will kick in eventually and solve this risk. Still, if it is a risk, it is a manageable one. They could signal hawkishness in September if August gets too inflationary for their tastes, but my hunch is any bounce in speculation and commodities will burn out in a couple months at most. 

If instead they push global markets into a major crisis, they will have to backtrack on tightening at all. They also might have to do it within days, weeks at most. That will harden the idea that the Fed is trapped for good and can never hike rates or has no idea what it is doing, setting up a repeat of 2022's decline as soon as whatever animal spirits they stir up fade away.

My view: the Fed has a lot of leeway on what constitutes a pivot. Markets are now pricing in a 75 bps hike with the gamblers betting on a 100 bps hike. This looks like lunacy to me given developments in commodity and currency markets, plus incoming economic data. Odds of a 50 bps hike were at 50 percent a month ago (before the market priced in more hawkishness). Since then commodities have cratered, gold-copper screams deflation, U.S. dollar is breaking out again and Fed models show a recession and rapid disinflation. Everything is telling me 75 bps will be a coup de grâce for inflation and financial markets.

At this point, a 50 bps hike would both be economically excessive in my opinion, but also perhaps necessary given Fed guidance. It would cause a "dovish" reaction in markets. If the Fed plays the markets, then 50 bps looks like the right number. Or the Fed could deliver 75 bps as expected, but signal a far more dovish footing for September, perhaps even no hike being on the table if the "data warrants" with the Fed statement discussing the rapid cooling in various markets. Whatever they do, they are at high risk of overshooting on the hawkishness and should consider how they want to climb down. A slower pace of hikes is the obvious choice because it leaves open the possibility of more hikes.

At least one Fed official sees the risk. Esther George today (PDF): Tightening Monetary Policy in a Tight Economy

The main role of the Federal Reserve is bailing out the banking system, not controlling interest rates. It mostly follows the market, and it ignored the market screaming inflation in 2021. It waited too long to hike rates and the economy is doing the work of raising rates and killing inflation for them. It's no surprise that recession fears are here so soon because the Fed should have started hiking rates at least 15 months ago when inflation was obviously manifest and financial assets were still in a speculative frenzy.

It is rare to say, but here a Federal Reserve official gets it. The Fed can communicate hawkishness while dialing back the speed of hikes. See if market forces start taking inflation down for them. The 1970s were a mess because the Fed cut rates in the recessions. If the economy is going into recession and commodities continue selling off, rates are probably already too high. Inflation will come down on its own without any push from the Fed. 

Contra 2021 screaming inflation, markets are screaming caution and deflation here. Maybe it's a momentary fit of madness and will pass. The Fed can't afford to take that risk though. If the markets are right, they're saying something very large could break. Better to wait and see, then to be the impetus for triggering a global meltdown.