From Credit Suisse, May 13, 2022:
If the current episode of monetary tightening were a scene from a movie, we’d be looking at something similar to the scene from Apocalypse Now, where a group of helicopters is approaching a small village on the beach with Wagner’s Ride of the Valkyries beaming from the speakers. Parallels between central banks and helicopters are not uncommon: Milton Friedman played with the theme (“helicopter drops of money”) and Chair Ben Bernanke earned a helicopter-themed moniker (“Helicopter Ben”). But then, consider...
...that helicopters are just vehicles. In helicopter analogies, it’s not the vehicle, but their payloads that matter, and payloads can be either money or volatility...
As we discussed in our “Volcker Moment” dispatch on February 16th (see here), there is a strong policy case for the Fed to inject volatility into markets in order to control domestic services inflation (and demand for labor more broadly) through asset prices – stocks, housing, and crypto assets too. Then on April 6th, Bill Dudley, the former president of the Federal Reserve Bank of New York, argued that for hikes to be effective, financial conditions have to tighten more – a lot more. But if the broader market expects rate hikes to undermine growth and force the Fed to cut rates in 2024, financial conditions mathematically won’t tighten on their own. If financial conditions don’t tighten on their own, “the Fed will have to shock markets to achieve the desired response”, that is, “it’ll have to inflict more losses on stock and bond investors than it has so far”. If that wasn’t clear enough, the former vice chair of the FOMC closed by saying: “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”. The message could not be clearer.
A former vice chair of the FOMC arguing that the Fed needs to shock markets is as close as we will ever get to a former Fed policymaker endorsing the need for a “Volcker Moment”. And it’s good to share a conviction with Bill Dudley – the last time we shared a strong conviction was when he asked me to visit him for an interview during the summer of 2008 to join the Markets Group of FRBNY in response to a brief note I sent him describing my concerns about the plumbing. It was a formative experience: sitting across a market legend, finishing each other’s half sentences about shared convictions about “skeletons in the closet”.
In today’s dispatch, we’ll explore five topics: first, the Fed call versus the Fed put; second, monetary heroes and anti-heroes; third, the Fed’s impossible trinity and what gives; fourth, the need to “invert” our thinking about recession risks; and fifth, the Fed’s options to inject more volatility to tighten financial conditions. Our aim today is to highlight the risk that we might be dealing with a Fed that won’t be intimidated by curve inversions and asset price corrections, but will be emboldened by them to do more – a Fed that pushes against a curve inversion by hiking more than what’s priced today to tighten financial conditions further, despite recession risks or perhaps even with a (covert) recession goal in mind in order to maintain price stability. To understand our thought process, and to understand the volatility you see on your screens – a volatility by design that is a desired outcome for the Fed – please consider the following observations.
First, as we argued here, the Fed is now in the business of writing a call option on risk assets – not just stocks, but housing and crypto as well. Whether we think of the FOMC’s target level for the stock market and financial conditions as a call option or still as a put option just with a lower strike price is semantics. The big question of course is that if the Fed is indeed writing a call option, what is the level that it targets? Does the Fed want to see the S&P give up only a part of its post-Covid gains or all of them? Or does the Fed want to wipe off some of the gains that accumulated before the pandemic? More on this later...
....MUCH MORE
