You are what your actual fed funds rate says you are

The writer is Managing Director and Chief Investment Officer of Richard Bernstein Advisors

Former NFL coach Bill Parcells once said, “You are what your record says you are.” A team’s coach may try to rationalize a losing record by pointing out good planning, unfortunate injuries, or small player mistakes, but the harsh reality is that a team with a losing record is mediocre.

The Federal Reserve claims to fight inflation, but before one proclaims the central bank “hawkish,” it seems appropriate to paraphrase Parcells: you are what your real fed funds rate says you are.

The real federal funds rate (ie the difference between the central bank’s target rate and inflation) has always been a reliable indicator of monetary policy. When the real federal funds rate is positive, interest rates are high enough to slow nominal growth. But when the real fed funds rate is negative, it suggests that the Fed is trying to fuel the economy.

Every US recession in the past 50 years has been preceded by a positive real fed funds rate. And the Fed correctly kept the real funds rate negative for most of the post-financial crisis period, as falling bank lending made deflation a bigger risk than inflation.

Despite inflation being at a 40-year high by virtually every measure, the real fed funds rate is now negative to a degree well above historical averages. Measured using the consumer price index, the real fed funds rate is negative 7.5% versus a 50-year average of 1%. The real funds rate was above 10% at the height of the inflation-fighting Volcker regime of the 1980s.

The US and global economies have changed dramatically in 40 years, and Volcker’s extraordinary monetary tightening may not be warranted today. But serious questions must be asked whether the current real federal funds rate will slow the economy, much less dampen inflation.

Some economists are defending the Fed’s timid actions by suggesting that inflation will ease once current supply chain bottlenecks ease. However, supply disruptions have been behind the worst episodes of inflation in the United States. The oil embargoes of 1973-74 and 1979 fostered a large-scale price and wage spiral.

It is important to note that the current supply disruptions have already lasted longer than the oil embargoes of 1973-74 and 1979 combined and that supply chains still remain blocked. It is remarkable how investors, and the Fed for that matter, downplay one of the most important economic events in US history.

Whether supply is limited or demand is too high, inflation simply reflects demand exceeding supply for an extended period of time. The lesson of the Fed Volcker was that the central bank has a limited ability to increase the supply of goods or labor, so the only way to thwart inflation is to raise interest rates enough. interest in destroying demand and causing a recession.

Despite history, the current Fed thinks it can stage a so-called “soft landing” – that is, inflation returning to more benign levels without a recession. The Fed’s optimism has sparked discussions about whether or not a recession will occur.

The current hard-landing versus soft-landing debate, however, seems to be a false dichotomy. A third outcome could be that the Fed does not act vigorously enough to force a cooling of the nominal economy and that inflation lasts longer than the current consensus.

The markets seem to be considering this third option. The three-month to 10-year yield curve is the steepest in seven years, with investors demanding more returns for holding longer-term debt. Such an emphasis during a tightening of monetary policy suggests that the Fed is losing, not gaining, its credibility in the fight against inflation.

The combination of a tepid Fed, significant inflation and investors’ general underweight to traditional inflation-friendly assets appear to present an investment opportunity.

Although investors have shifted somewhat to traditional hedges such as inflation-protected treasury bills and real estate investment trusts, investors remain significantly underweight the assets that benefit the most from inflation: energy, materials and industrial stocks, lower quality credits, commodities and commodity-related securities. countries, gold, and real assets such as forest land, farmland, and trusts that provide royalty income.

The Fed wants to be seen as a conscientious inflation fighter, but the extremely negative real fed funds rate indicates otherwise. Despite the jawbone of the Fed, they are what their actual fed funds rate indicates they are.

About Andrew Estofan

Check Also

The Eurozone experiences a 4% annual increase in labor costs in the second quarter of 2022; 4.4% jump in the EU

In the second quarter of 2022, hourly labor costs increased by 4.0% in the euro …