A Recession Is Not a Mistake

[5 minute read] Why the Federal Reserve wants a recession in its fight against inflation.

Over the past year, the Federal Reserve raised interest rates from 0% to almost 5%. This sudden and steep increase in the cost of money has cut off vast swathes of funding for many businesses and threatens to plunge the economy into a recession.

The Fed’s machinations and ultimate motive are crystal clear (raise interest rates to kill inflation) but the merits of its plan to achieve said motive is up for debate.

In fact, if you spend any time on mainstream financial media, you’d be inundated with a breadth of opinions on whether the Fed is doing the right thing or whether they’re going too far. The myriad of confident talking heads with their opposing opinions can be, to say the least, confusing.

This article lifts the veil on the Fed’s inflation-killing strategy.

Dual Mandate, Two Dragons

The Fed has two mandates: maximum employment and stable prices.

To achieve both mandates, it needs to fend off two proverbial dragons, the Recession Dragon and the Inflation Dragon.

As many of us know, the pandemic’s wanton money printing unleashed the Inflation Dragon that is currently rampaging through the economy. The Fed is intent on slaying this dragon and its weapon of choice is high interest rates.

This strategy sounds reasonable but critics are quick to point out that the Fed is possibly doing too much and if so, threatens to conjure the Recession Dragon from the corpse of Inflation.

Surely the Fed doesn’t want to make two mistakes in a row after underestimating the Inflation Dragon during the pandemic… right?

A Recession Is Not a Mistake

It’s becoming increasingly clear that the Fed doesn’t care if the economy plunges into a recession. In fact, the Fed appears to even prefer a recession as a way to kill the Inflation Dragon. The only thing that gives them pause is if the ensuing battle triggers another Lehman Brothers moment.

Here’s why.

The Inflation Dragon is much harder to kill than the Recession Dragon. Inflation has historically proven itself to be very sticky; people hate getting paid less or paring back their lifestyle. On the other hand, a recession can easily be reversed by flooding the economy with money… a task that the Fed and Congress have demonstrated remarkable aptitude for so far.

Inflation is much more damaging than a recession. For one, too much inflation can actually lead to a recession. As labor costs rise to keep up with inflation, companies start to be priced out of the labor market which raises unemployment. Another more important problem with inflation, unique to the United States, is that it could discourage the world from using the US Dollar. The US Dollar is the foremost global reserve currency and confidence in the Fed’s ability to manage domestic Dollar inflation is paramount to maintaining its premiere global status.

In fact, this is the first time the US Dollar has experienced significant inflation since the decade after the Petrodollar’s inception. It’s unclear how the world will react to prolonged runaway Dollar inflation but what’s certain is that the Fed has no desire to find out.

History remembers inflation and forgets recessions. Superficially, the legacy of Fed chair Jerome Powell is on the line. Historians and economists have shown that they don’t care about recessions as much as they do about inflation. In the late 1970s, Fed chair Arthur Burns appropriately raised interest rates to fight inflation but started cutting too early which triggered another bout of inflation. The next Fed chair, Paul Volcker, rapidly hiked interest rates again and kept them high for a long time. This plunged the economy into a major recession but also decisively killed inflation.

Burns is remembered as a failed Fed chair while Volcker is revered. Jerome Powell is a student of history and has paid homage to Volcker several times in his speeches over the last year. After making an uncomfortable but forgivable mistake of underestimating inflation during the pandemic, Powell definitely doesn’t want to be remembered as another Burns in this inflation fight.

So What?

While many people are expecting a Fed pivot to happen soon since leading inflation indicators are weakening, don’t bet on it.

The Fed wants a decisive kill on inflation and it won’t hesitate to use a recession as the killing blow.

As such, we think that high interest rates and quantitative tightening will stay for longer than the market expects, probably into mid-2024 (the bond market is pricing in rate cuts in the latter half of 2023). This will subject stocks to significant selling pressure that the stock market has definitely not priced in yet.

We expect stocks to fall further in 2023 when the market realizes the Fed isn’t bluffing. The bear market won’t moderate or reverse until late 2023 or early 2024.

What invalidates FinanceTLDR’s analysis?

The Fed is eyeing the labor market closely and an early Fed pivot will only be possible if the labor market softens considerably.

Even though the labor market is often a lagging indicator of inflation, it’s also the primary reason behind the stickiness of inflation through the infamous Wage-Price Spiral phenomenon. In the Fed’s eyes, inflation is only decisively killed when the labor market softens.

Isn’t the bond market right?

Some argue that the bond market is the true arbiter of interest rates and if it thinks the Fed will cut rates early, the Fed is likely to oblige. We vehemently disagree. The bond market drastically failed to predict high interest rates in late 2021 when inflation was already sky-high. Interest rates in the bond market barely rose until the Fed started raising its interest rate in March 2022.

As such, we believe that if the labor market continues to defy gravity this year, the Fed will keep rates high despite the rate cuts priced in by the bond market right now.

Average inflation targeting

In 2020, the Fed adopted a new inflation policy known as “average inflation targeting”. This strategy allows inflation to rise and fall such that it averages 2% over time. Given that inflation came in lower than 2% for several years in the past decade, this new policy gave the Fed leeway to print money and fight the pandemic-driven recession without worrying about inflation.

Using this strategy as a guide, the past 4 years’s actual average inflation is way above target (17.1% vs 8.2%). This suggests that the Fed needs several years of below-2%-inflation to compensate! The Fed is in no hurry to stimulate the economy.

Will the Fed raise its 2% inflation target?

Some evergreen stock market bulls hope that the Fed will raise its 2% inflation target in order to declare an early victory in the fight against inflation.

This is laughable.

As mentioned before, the Fed and the US Dollar’s international credibility is on the line and if the rest of the world sees the Fed moving goal posts to declare cheap wins, the Chinese Yuan becomes even more enticing as an alternative global reserve currency.

Don’t Take My Word For This

This is a great CNBC interview of Bank of America Securities global head of economic research, Ethan Harris, laying out exactly what the Fed’s mindset is. CNBC’s chief Fed reporter Steve Liesman also chimes in with useful insights.

In short, Harris, who correctly predicted 7 rate hikes in 2022 before anyone else, sees the Fed tightening financial conditions a lot more than what the market is pricing in right now.

A few select quotes from the interview:

Harris: [Fed officials] are trying desperately to convince the market that they are serious here… Markets don’t believe the Fed is serious about fighting inflation. I think the Fed will deliver more than the market’s expecting.

Harris: They’ve told us that they want a weak economy. I think that’s a friendly way of saying they want a recession.

Harris: [The Fed is] looking at parts of inflation that are going to be hard to get rid of. How do we stop all this labor cost pressure that’s driving service prices. That requires a much weaker economy and the economy just isn’t cooperating… So the fact that there are signals suggesting a recession is coming isn’t going to stop the Fed.

Liesman: [Fed officials] feel like the risk of higher inflation is one that outweighs… the risk of going too far and doing too much.

Liesman: This entire time of historic 75 basis point rate hikes, there has been a single dissent [from a Fed FOMC official] so there are no doves in the fox hole of inflation right here.