“Totally confused” Fed to send rates to both zero and infinity?

After 10 successive increases in the Federal Funds Rate, the FOMC paused (or perhaps skipped) rate hikes in its June meeting.

Jerome Powell has made it clear that the Federal Reserve is looking to hike rates in July and once more this year, with the most recent announcement simply acting as a breather for the economy.

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Powell’s key concern remains that inflation is sticky, particularly core CPI.

Monetary lags and how they may play out in the economy are still a crucial unknown.

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But George Gammon, an investor and popular Youtuber, believes that economic actors are likely incorrect to expect tightening to continue.

In fact, he says,

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…you won’t believe what is going to happen next and I can assure you the markets are totally unprepared…(there is going to) be a massive drop in interest rates.

Why does Gammon think that the Fed won’t follow through on its own promises?

Well, let’s look at this chart.

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Speaking of the Fed’s track record, Gammon said,

…going into 2000, the Fed was in an interest rate hiking cycle…they hit the pause button just like they did today and you see what happens next? Did interest rates go up or did they go down? They went straight down.

He added,

…then they started another interest rate hiking cycle…into 2006-2007.  What did they do? They paused…Don’t you think that Alan Greenspan…(and) Ben Bernanke were saying the exact same thing that Jerome Powell is today? … We’re just pausing but don’t you worry. We’re going to keep hiking rates in just a few months.

Regarding the recent global health crisis, Gammon identifies a similar pattern, noting,

…it never ever works that way…Jerome Powell himself was increasing interest rates (until) a pause and you know exactly what happens next.

Changing factors

So, is Gammon right to expect that markets will be blindsided by a massive Fed U-turn?

He references a theme that has come up often in my earlier pieces on Invezz.

This is the idea that runaway inflation was to a considerable degree a result of prolonged cheap money policies, unprecedented fiscal stimulus, and the disruption in global supply chains.

The reluctance of the Fed and Treasury officials to abandon the ‘transitory’ theory pushed the CPI to four-decade highs.

Although inflation is still above target levels, crucially, it is down considerably from its high of 9.1% in June 2022.

As a result, the main driver of Fed policy over the last fifteen months should be considerably less potent.

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Failing data

Other than the CPI, there are a host of troubling indicators which indicate not only an oncoming recessionary slowdown but the potential for a depression-style stagnation.

Markets are simultaneously facing an inverted yield curve, the implosion in commercial real estate, and the sharp decline in house prices which is taking consumer purchasing power along with it.

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Not to leave out the banking system which saw three of the four largest implosions in US history earlier this year, Raghuram Rajan, former governor of the Reserve Bank of India noted,

…while the first phase of the banking problem is probably over, there is a slow-burning distress emerging in the banks as they find they have long-term loans made at low-interest rates and deposits are repricing to much higher interest rates, so their profitability, especially the small and medium sector is getting hurt…

Unemployment and energy

In an earlier piece, I argued that the strength of the labour market may be dangerously overstated.

This may have misled policymakers into overtightening, again introducing the risks of monetary lags.

Gammon points out,

What is Jerome Powell trying to do? He’s trying to decrease inflation by increasing the rate of unemployment.

If the improved nonfarm payrolls are disguising the fragility in the jobs market, unemployment metrics could suddenly spike well beyond expectations.

If so, many of the factors discussed above, are likely to deteriorate significantly.

On a broader international macroeconomic level, the reduction of 2 million barrels a day of oil production by OPEC+ and Saudi Arabia has not resulted in sustained bullish momentum for crude prices, signalling a global demand contraction.

Safe asset demand and depression

Jeff Snider of Eurodollar University expects that as the economy worsens, as it should do if rates stay elevated, there will be a rush to safe assets such as gold, cash, US treasuries and other cash equivalents.

Snider argued that in troubled times, economic actors want to de-risk, thus,

… (during the 1930s) …interest rates on safe investments went down because in the depression, demand for safety goes way up.

This is a pattern that appears to be re-emerging today.

This becomes visible when noting that since approximately October 2022, the Fed’s rate hikes have shown no impact on the 10-year rates.

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Prior to this, treasury yields were following the federal funds rate higher, as borrowing costs increased.

However, this has changed dramatically over the past seven to eight months with the 10-year yields declining by approximately 11 basis points YTD, while the policy rate corridor has risen from 4.25%-4.50% to 5.0% – 5.25%.

At the time of writing, gold was up 7.32% YTD.

This would suggest that demand for safe-haven assets has risen significantly indicating that the economy may be entering what Snider refers to as,

…depression economics.

Two-way interest rates

Drawing on Snider, Gammon notes that since the yield on safe assets is going lower and deflationary forces are gaining momentum,

…we should expect the Fed funds rate to go down as well. Let’s say they go all the way back to zero…because we have some sort of situation…crisis, depression, recession, Black Swan…

This is not an unthinkable scenario since this has happened in the past, during the great financial crisis and even very recently.

A loose and tight environment, together

If such a situation arises, rates may reach a situation where they are loose as well as tight at the same time.

Since rates would be technically low, big players in the banking sector would be paying out zero per cent interest and benefitting from easy policies.

Simultaneously, a hostile environment may be worsened by an unforeseen event, leading the shaky banking system to be unwilling to lend to ‘mom-and-pop’ enterprises or entrepreneurial ventures, pushing the effective borrowing rate of this category to infinity.

Credit contraction

Mainstream credit is already drying up for the average American with a LendingTree report from May 2023 finding that a mammoth 43% of Americans are looking to apply for a BNPL loan in the next six months.

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Most of these loans are being taken to tide over until paychecks become available, while unfortunately, a fifth of consumers report needing the funds to purchase essentials such as groceries.

A survey by the Fed of senior loan officers showed that conditions were already tightening in Q1.

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Interested readers can find more information on the survey here.

Without access to working capital, manufacturing and service delivery will begin to see a marked reduction next year, exacerbating the weakness in economic conditions.

Gammon adds,

Once they (stimulus programs) step back and do a lot less of what created the consumer price inflation, to begin with, you (will) see the natural forces of the economy kick in and that’s when we start to see the disinflation if not outright deflation…

For instance, the crucial M2 indicator has been contracting.

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“Totally confused” in the long term?

Mike Shedlock, a popular blogger, and well-respected voice on economics, wrote of the Fed’s latest announcement,

A dot plot of future expectations reveals total confusion.

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The pink shading represents the median forecast for the interest rate.

Shedlock argues that the outcome of several factors is still shrouded in mystery, including the US government’s push for clean energy, the 2024 elections, China-Taiwan tensions and increasing forces of deglobalization.

Thus, it should be no surprise that there is so much confusion among committee members.

He added,

Total confusion is an appropriate position. We would be in a much better position now if the Fed had more diversity of opinion on inflation, endless QE, and positions every member of the Fed agreed with, all of them wrong for years.

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