Get used to the Powell Ratchet
The Federal Reserve's central dilemma in 2022 is this: Inflation is very high. Unemployment is very low. Yet monetary policy is currently set as if the reverse were true.
The big picture: If the Fed readjusts policy to fit economic conditions too rapidly, it could cause a recession and/or financial panic. So instead, they're applying a strategy you can think of as the Powell Ratchet.
- Chair Jerome Powell and his colleagues appear set to keep pushing toward tighter money, pausing along the way to make sure that they haven't overtightened and put the expansion at risk.
Why it matters: This means a different market environment from the last two economic cycles, with extreme uncertainty around how high rates will get and how long it will take to get there. That could fuel more volatility on Wall Street.
- More so than usual, the mystery is how long economic and market conditions will continue to allow them to carry out the policy ratchet.
That helps explain why there is such a wide range of forecasts among reputable Fed watchers right now. Barclays economists are forecasting three rate increases this year, vs. seven rate hikes projected by Bank of America.
What they're saying: "Every time the market gets comfortable with a new level of hawkishness, the Fed pushes it up a notch," said Tim Duy with SGH Macro. "They are turning up the heat gradually so they don't shock the markets."
- He believes the central bank is aiming to get the federal funds rate, now near zero, close to or even above the "neutral rate," which neither stimulates nor slows the economy. Fed leaders think it's around 2.5%.
- That would imply 9 or 10 rate increases, assuming each was a quarter percentage point, significantly more than markets are pricing in.
Between the lines: Comments from several Fed officials this week indicate that they are inclined to raise rates only 0.25% at a time, for now at least, which is consistent with the concept of the Powell Ratchet.
- The goal is to push rates steadily higher to the degree economic conditions allow, not to shock and awe. The whole point is to adjust the stance of monetary policy in ways that the system can absorb.
In Powell's news conference last week, he made several comments supporting the idea that this will be a different type of tightening cycle.
- "It isn't possible to sit here today and tell you with any confidence what the precise path will be," Powell said. "But as we work our way through this meeting by meeting, we are aware that this is a very different expansion… and I think those differences are likely to be reflected in the policy that we implement."
What would end the ratchet? Some possibilities:
- Inflation finally comes down to earth. If there is clear evidence inflation trends are abating and settling down toward the Fed's 2% target, so would the upward pressure on rates.
- The expansion sputters. If we see real-time measures of the economy turn negative in ways that don't look like an artifact of odd seasonal or pandemic-related quirks, Fed leaders would at a minimum slow their roll.
- Financial panic arrives. It would likely take more than a mere stock market correction to get the Fed's attention, but if credit markets start to seize up that's a different story.
The bottom line: So far, Powell has been able to ratchet rate expectations higher without much apparent damage. There is no guarantee that will last.