The New Vigilantes

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

The markets are all aflutter as the Federal Reserve (the “Fed”) plans to reduce and then eliminate their purchases of government securities which are supposed to follow their first increase in the Fed Funds rate in March. That is estimated to be a 25-basis point (maybe 50-basis point) rise. If you believe the latest estimates of the members of the Federal Open Market Committee (FOMC), by the end of 2024 the rate would be up to 2 1/8%. And their “longer-term” estimate is 2 1/2%.

All this is in connection with the switch by the Fed from their pipe-dream estimates of last year that the burst of inflation was “transitory”. Now, apparently, it is judged to be not. So, they are going to tame inflation by raising the Federal funds rate to 2+% and at the same time reduce the size of their $9T balance sheet by not reinvesting the maturing bonds that they hold. 

In a Goldilocks scenario, this should take care of the inflation threat by year’s end. All the while, economists see 10-year bond yields reaching 2.5% – 3%. With inflation still likely lingering about 4%, where are the bond market vigilantes of old, that forced interest rates high enough to choke off inflation (and in the process caused the two recessions of 1980 and 1982)? With inflation likely two times the level of the estimated Fed Funds rate, what mechanism will tame the inflation?

Well, ironically, oil prices reaching $100/barrel are likely to be the new “vigilantes”. With oil production being penalized by Western governments via taxation or regulation to limit oil drilling, and at the same time global economic growth is expanding as the Covid pandemic becomes endemic, oil prices could continue to rise toward $100/bbl. While there is nothing magic about that price level, it can do two things: 1) keep overall inflation rising above expectations, and more importantly, 2) depress economic growth enough to take the word “recession” out of the closet. That’s all the Fed will need (especially in an election year and their history of overdoing it) to “blink” and reverse course, especially if markets continue to be under pressure and politicians need to be re-elected.  

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