Will US Fed walk the talk on the stimulus exit?

If the news that the Fed has an ambitious plan for monetary tightening hasn’t reached you yet, you must be in a dwindling minority. Blueprint for a massive monetary exit has been out for a while now. It will be on a scale that world had not witnessed any time in the past. It has been set on a double R i.e. rate hikes and reduction in balance sheet size. If you are like me and wondering, is there a third R so that we can make it a nice sounding acronym of triple R (of course, no connection with the blockbuster flick RRR), yes, there is one which the Fed would like to desperately avoid in this game of tightening, that is, Recession.  What keeps the Fed awake late night is this, how to execute the first two “R”s rigorously without having to deal with the third R? Or will the worry of third R push the Fed to abandon its tightening plans half way? Let us dive in. 

Looking at the genesis of this inflation battle, there is a lot of merit in what some of the experts are echoing on Fed being far behind the curve on its fight against inflation. Unfortunately, Fed had seriously under-estimated the risk of how far the inflation will go. Initially, Fed assumed inflation will be transitory and it will come under control once the lock-down is behind. That assumption went completely awry because of Ukraine conflict and renewed Omicron related lock-down in China. Now, Fed has to make up its lost time by going for a lot more aggressive steps on its tightening to shore up its inflation-fighting credentials. One should expect an aggressive tightening now with an accelerated interest rate hikes and balance sheet shrinking. Beyond the already discounted aggressive rate-hikes, on balance sheet shrinking, in July-Aug, they are likely to start with $25Bn per month and accelerate to $90Bn+ monthly unwinding from second half. The plan is to complete the full run-down by end of 2023. That is a massive 1.7tn dollars of liquidity reduction.

Given the scale of this exit, there will be repercussions both to the asset prices and to the consumer demand. It is not going to be easy for Fed to run the full course. On slightest of the excuses, it might slow down or even reverse its course. Even if the Fed wants to go the full course, the political establishment may not have the will to face the consequences. Looking at the past cycles, one can see the familiar pattern of shorter down-cycles and longer up-cycles. There is a reason why down-cycles are shorter. One doesn’t need to look beyond Fed’s PUT (unconditional back-stop from Fed whenever markets go through trouble) for finding the reason. No sooner than the demand starts contracting because of Fed’s medicine, political pressure starts building up on Fed for easing up to start another round of stimulus. This has been the playbook in the past cycles. It is unlikely to be different this time too, though long-term solution lies in allowing the patient to go through the full medication to completely purge the excesses. Fed has been postponing this D-day for long. What will make the Fed to go for the final kill is a known unknown and should be left for a discussion for another day. For now, it is unlikely that the Fed will go the Paul Volcker way of hard landing. For the uninitiated, Paul Volcker was the Fed Chair in 1979 who took the inflation battle head-on and managed to vanquish it, though not without putting the US economy into a painful recession.  

Turning to inflation now, there seems to be some cooling off on the whole-sale prices. Freight prices are down on easing container shortages (except for crude containers). Supply chain issues no longer hit the headlines. Chip and fertilizer prices are down. So is palm oil price. There is a sort of crash in metal and commodity prices, but for crude. These lower prices will impact the WPI very quickly and then   transmit to consumer prices with a lag effect. To that extent, the worst is probably behind for the inflation, unless we have new surprises in store.

In all likelihood, with the worst is behind on inflation, Fed is most likely to use the incremental softening in inflation as an excuse to go slow on tightening by becoming less hawkish down the line. There is a good chance that Fed might opt to go with this politically palatable path, thereby postponing the eventual hard-blow to sometime in future. Where does it take us? If history is any guidance, we will see more of a zig-zag movement in rate-hikes/tightening rather than a full-hearted Paul Volcker like playbook. This would mean soft-landing without hard exit from stimulus. For equity markets, that would mean a shorter down-cycle and faster rebound. Though this could be the most likely outcome, no one can be sure about anything in the short-term as things are so volatile and uncertain on the inflation front. Given this, the best way to navigate this uncertainty is through a disciplined process of investing and asset allocation.        

Happy Value Investing!!!

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