Honey I blew up the Tools

Heisenberg Macro

As I think about where the Fed is today, I can't help but remember this scene from Lethal Weapon. And no, before you think I'm yet another FinTwit doomsdayer who believes that Fed is going to blow up the economy - this isn't about that at all. Rates are still very low and monetary policy works with a long lag so odds of near-term economic crash are low (but will probably rise as time passes). This blowup reference is to something they have already done!

The Fed has made a dramatic pivot over the past 3 months or so (if I was cynical I'd say after Nov 22, 2021 when Biden reappointed Powell). The Fed for most of last year was convinced inflation was transitory and restoring the jobs lost due to the pandemic remained its primary goal. And over the past few months, we have even the most dovish members acting like born-again Volckerians. The google searches for Volcker have spiked in recent weeks (Fed speechwriters?). The pivot in the hawkish direction clearly seems like the call of duty for the Fed members and is justified to defend their credibility given the current level of policy relative to the inflation prints and tight labor markets. But in rushing to correct policy mistakes made in 2021 when they continued to expand balance sheet at historical pace even as a large fiscal response was enacted, they are making new ones that will potentially come to haunt them in the future.

The post-GFC period was characterized by central banks facing an existential crisis as the toolkit to counter deflationary risks seemed inadequate. Over the subsequent decade, central bank innovation kicked into overdrive to develop and enhance the toolkit to be able to provide policy accommodation even after rates had been cut to zero. And these were on full display post-Covid. But in the last few months, the Fed has systemically undermined most of this toolkit. Lets go in reverse chronological order of tools that are unlikely to be used again or have lost their effectiveness -

Flexible AIT - If they were to still follow this, it would mean having inflation below target (perhaps even at or below 0 depending on what look-back period you use for averaging) to compensate for current high inflation episode. Even Volcker probably wouldn't do that - and the current Fed members are mere mortals. This should probably be re-branded 'Failed AIT' - perhaps a good idea in concept but implemented at the absolutely wrong time.

YCC - The BOJ YCC was watched with great interest by central banks around the world. The RBA was the only one to deploy it in response to Covid. But the potential of gargantuan expansion of balance sheet to defend the rate peg and a disorderly violent reaction in the market during the exit process makes this highly unlikely to make its appearance at a central bank near you.

Open-ended QE - The appeal of open-ended QE was avoiding the cliff effect and negative signaling effect as the maturity of a fixed-size fixed-time QE approached. But what was the desirable feature of this program became an albatross around the Fed's neck this time around. In open-ended QE easing is a passive decision and stopping QE (taper) is an active decision. Scars from the taper tantrum of 2013 has conditioned central bankers into an elaborate routine to prepare markets for a taper. In my view, the next time around fixed size QE will sound more appealing than open-ended QE.

Forward guidance - In addition to balance sheet expansion, this has been the go-to tool for central bankers post-GFC. This tool relies heavily on markets trusting the central bank's commitment. This cycle has seen a Fed that has gone from projecting a single hike of 25bp in 2022 to six months later guiding towards a move that is 8 to 9 times that. While likely to be deployed again if they find themselves at the effective lower bound (ELB) again, the ability of Fed (and other central banks) to use forward guidance credibly will be severely challenged.

The ultra-hawkish pivot might be exactly what the Fed needs to do today but it comes at a cost. Perhaps this is the cycle in which Fed can get rates high enough that it ends the era of unconventional easing and easing will be accomplished by cutting rates alone. But in the event that it is not the case, the tools they so effectively used to lower rates across the curve, suppress term premium, lower volatility and reduce risk premium across equities and credit will no longer be as effective. That in my view is the cost of this pivot. If they do end up back at the ELB in the next easing cycle (which might commence with inflation at or above target given lags), it will be an environment with steeper curves, higher volatility and higher risk premium.