Good morning. Ethan is away this week, resting up for August, which I will skip altogether (Unhedged will appear just three times a week all month, with a special guest author writing one of those.) So you know who to blame for the below: robert.armstrong@ft.com. 

The market thinks the Fed has very good timing

It’s a solid bet that tomorrow the Fed will raise its policy rate by another three-quarters of a percentage point. The futures market puts the odds at a bit over 75 per cent, with the remaining probability space taken up by a full-point increase.

Some part of the reason for the confidence in 75 rather than 100 basis points may well be that the Fed does not seem to have leaked the bigger move to Nick Timiraos of the Wall Street Journal, as it almost certainly did last month. I’m not too worried about what this sort of leak does to Fed credibility or whatever. But this does raise two mildly interesting questions. One: is not leaking to Nick Timiraos now a form of forward guidance? Two: is the Fed looking for someone else to leak to? Someone with a truly global audience and a wry appreciation of the ironic nature of financial history? If so, my email is above.

The more important question, for investors and the Fed itself, is how the bank will respond as new data roll in the months to come — especially if those data follow the current trend, which has suggested that economic activity will soon slow and that inflation is already past its peak in key areas such as house prices and commodities.

As Unhedged has pointed out before, the hard question for Fed watchers is what the Fed will do when inflation is still very high, but clearly falling, and unemployment is still very low, but clearly rising. There is a good chance we’ll be in such a situation before very long, and speaking for myself I’m not at all sure how quickly the Fed will back off under those circumstances (a nice piece from Reuters yesterday argued the Fed internal consensus could crumble under such circumstances).

The market, by contrast, has lately taken the view that the Fed and other central banks will back off quickly, and start cutting rates by the middle of next year. This is visible in the recent decline in bond yields which, as Capital Economics’ Franziska Palmas notes, is quite a global phenomenon. Her chart of downward moves in yields and in expected policy rates over the last week:

Are markets right? Again, I don’t know. But I would note that while I hear a lot of people talking about the “Fed pivot” and the good that might mean for stock and bond prices, there is not a lot of talk that the Fed will pivot too late — the classic Fed mistake. One person who is talking about this grim possibility is Morgan Stanley’s Michael Wilson. Here he is in a note to clients yesterday (which landed, by the way, before the bad news from Walmart):

We remain sceptical that the Fed can reverse the negative trends for demand that are now well established . . . the demand destructive nature of high inflation that is presenting itself today . . . will not easily disappear even if inflation declines sharply because prices are already out of reach in areas of the economy that are critical for the cycle to extend — i.e. housing, autos, food, gasoline and other necessities. Remember, lower inflation does not mean negative price changes for many of these items and to the extent deflation does return via discounting to drive demand, rest assured that will not be good for profit margins and/or earnings revisions.

It is painfully obvious but bears repeating: if the Fed pivots when we are already sliding into a deep recession, stocks will fall.

Bad news from Walmart

Making sense of the economy has been tricky lately because of the contrast between the message from financial markets and from measures of business and consumer sentiment (absolutely bad!) and measures of current activity (fine, thanks!). That changed a bit Monday when Walmart cut its profit forecast again. From the press release:

[same-store] sales for Walmart US, excluding fuel, are expected to be about 6% for the second quarter. This is higher than previously expected with a heavier mix of food and consumables, which is negatively affecting gross margin rate. Food inflation is double digits and higher than at the end of Q1. This is affecting customers’ ability to spend on general merchandise categories and requiring more markdowns to move through the inventory, particularly apparel.

The company expects operating profit to be down 10 to 12 per cent for the full year. This is not surprising, but is important all the same. It is the first unambiguous indication from a major US consumer business that — today, right now — all is not well among Americans in the middle and lower part of the income spectrum (barring perhaps AT&T saying last week that customers were taking longer to pay their bills). We are entering a new phase of the economic cycle.

The credit channel, redux

Last week, as I was writing a piece about how quantitative easing influences bank lending — in response to a post from Benn Steil and Benjamin Della Rocca — I admitted to Ethan that I was worried about getting the technical points correct. Ethan, who is not generally a smartass, said I did not need to worry, because only about five people would read such a hopelessly nerdy piece.

Ethan was wrong. Tons of comments and replies came in. A bunch responded that the answer to the question posed in the title ( “Did QE cause inflation?”) was obviously yes. I should have been clearer. My view is that QE contributes to inflation, but I disagree with Steil and Della Roca about why and how much.

To boil down our disagreement to a gross simplification: Steil and Della Roca think that QE creates bank reserves, and this additional liquidity encourages banks to lend, with direct inflationary consequences.

I think that reserve levels don’t matter much to bank lending decisions. The Fed no longer imposes a reserve requirement on banks. Banks are required to maintain a certain amount of high-quality liquid assets such as (but not only) reserves at the Fed, but they can borrow liquidity as needed. The decision to lend is about loan demand and the cost of liquidity. Reserve levels don’t tell you much about lending — as you can see by the fact that reserves and lending do not track one another.

Steil and Della Rocca have responded to me, arguing that lending and reserves do track, once you adjust for other stuff that absorbs reserves, such as the Fed’s reverse repo program and shifts in size of the Treasury’s general account. They provide this chart of adjusted reserves (black line with yellow highlighting):

They also give this account of the impact of QE on lending:

Abundant liquidity drove down interbank lending costs, sent asset prices soaring, improved borrowers’ creditworthiness, and spurred the chase for yield. By December 2021, bank lending reached its fastest monthly growth rate since 2012 (save for the anomalous first two months of the pandemic). 

I agree with this neat summary of how QE spurs credit creation: it increases liquidity in the entire financial system (not just bank balance sheets), stimulating risk appetites and asset values, with immediate consequences for borrowers’ apparent creditworthiness and desire to borrow. But I still don’t understand what bank reserve levels have to do with this, except that QE, all else equal, increases both reserves and total system liquidity.

Steil and Della Rocca think that “that the gap between central-bank bond holdings and bank reserves is a fairly reliable indicator of where inflation is headed, and that an undesired upturn in the gap is a signal that QE may have outlived its purpose”. Undoubtedly, that gap grew and inflation blossomed. We just disagree about how the causal relationship works.

(If you want the full text of their response, email me and I’ll send it along.)

One good read

Hooray for the Economist for putting the abject failures of ESG investing on its cover this week.