On February 1, the Federal Reserve raised interest rates another 25 basis points (0.25%), bringing the Federal funds rate between 4.5% to 4.75%. The hike was widely anticipated and already priced into the market. Fed Chairman Jerome Powell spoke about more “hikes” (plural) being needed at a slower pace to access the lag effects of previous tightening. Still, the market believes there will only be one more hike and a pivot. 88% of the market is predicting a pivot in 2023. Fed Chairman Jerome Powell again dismissed the idea during the press conference when asked about a possible pivot. “It’s going to take some time for disinflation to spread through the economy, and given our outlook, I just don’t see us cutting rates this year,” said Powell.
Powell has consistently presented the Fed position since the Jackson Hole conference in August, where Powell predicted economic pain. For whatever optimistic reason, the market repeatedly concludes he means something other than he says. The Fed often says the policy will be tight, and the market thinks it will pivot and become loose. The market has been speculating about a possible Fed pivot later this year.
Powell has been incredibly consistent in his statements about the path forward. Powell’s speech was almost verbatim to the last several FOMC press briefings. Watch the entire press conference here. Powell sounded like a broken record and repeated several familiar phrases, like "the full effect of our rapid tightening are [sic] yet to be felt [sic]. Still we have more work to do", "we anticipate that ongoing rate hikes will be appropriate to attain a monetary policy that is sufficiently restrictive to return inflation to 2% over time", "we will need to keep policy restrictive for quite some time," and “while recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path.” The phrases are a few examples of verbatim terms from previous press conferences.
At the Jackson Hole Conference, Chairman Powell explained that economic pain was coming. He spoke at length about the mistakes and successes of Chairman Volker in the 1970s and 1980s, bringing down inflation. Powell referenced how Chairman Volker could not tame inflation for years because Volker kept starting and stopping the interest rate hikes. Powell said it was only when Chairman Volker committed to raising rates as high as needed that he finally tamed the inflation. Volker raised rates to 20%. Volker's approach is the model Chairman Powell is following. Powell reaffirms it in every speech: "the historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done [sic]". He is referencing his explanation of Volker’s actions.
Three Reasons Why the Market is Wrong
At best, the market is wishful thinking. There are plenty of observable proofs like the stock, bond, housing, and crypto markets to think Powell is being straightforward. For years, it was almost impossible for bankers to do anything except make obscene amounts of money. The market became addicted to loose policy and easy money. During quantitative easing, the Fed flooded the system with cash and bought about $100 billion worth of bonds monthly. The markets want the gravy train to return, which requires the Fed to pivot. Here are three reasons things will get worse before they get better.
1. The labor market is out of balance.
Powell stated that the labor participation rate is almost identical to one year ago. On average, the market has added 247,000 new jobs monthly for the previous three months. However, in January, the U.S. added an astounding 517,000 jobs. The number of jobs is growing, but participation is not. The Fed wants to "tighten sufficiently" until the companies cannot afford to fill those vacancies. The laws of supply and demand will drive wages up to fill the vacancies. Higher wages create inflationary pressures in the cost of goods and services produced and available cash to be spent by higher-paid employees.
2. Baby Boomers are retiring faster than new workers are joining the workforce.
The young and old of a population do not contribute to GDP and create inflationary pressure. The working population is deflationary pressure. Baby Boomers were the largest segment of the workforce for decades and a natural counterbalance to inflationary pressure. However, things have changed. Instead of being a natural downward pressure on prices, Baby Boomers are now causing inflationary pressures in retirement. Every day, around 10,000 Baby Boomers turn 65, and 100% of Baby Boomers will be 65 by 2030.
As Baby Boomers retire, additional job vacancies will continue growing. The Baby Boomers will need to be replaced for companies to stay at current profitability. The job numbers will keep growing, but the companies won’t be growing. It is a double whammy, and raising interest rates will not affect the hole created by retiring Baby Boomers.
3. There is too much cash in the system.
1. Since the Dollar came off the gold standard, the number of existing Dollars went parabolic. However, in responding to the pandemic, the U.S. said, “Hey, World. Hold my beer and watch this.” Between 2020-2022, the U.S. printed more than $7 trillion, which is more than 25% of all Dollars ever created since the U.S. has been a country . The chart shows the existing Dollars since 1970. In 2020, the U.S. more than quadrupled the number of Dollars in existence. At every FOMC meeting, the Fed talks about reducing its balance sheet.
The little dip at the end is what he is talking about and how much it has removed from its balance sheet. The drop represents the bonds sold back into the banking system. The little downward movement is about $2.55T. Selling bonds to banks is called the reverse repo market. The market is still a long way down to shedding $7 trillion. To understand how this works, read this explainer article. Interest rates are going to be high for a long time. It is the only thing the Fed can do to try putting the pin back into the grenade.
The market thinks the Fed will pivot because they are having two different conversations. The market is talking about short-term profits, but Powell is speaking about the $20 trillion elephant in the room. "I would say our focus is not on short-term moves but on broader financial conditions. It is our judgment that we are not yet at a sufficiently restrictive policy stance, which is why we say we expect ongoing hikes [sic]." What broader financial conditions could he be referring to if it isn’t $20 trillion on the Fed’s balance sheet?
Take a long look at the M1 chart. The Fed has barely scratched the surface of getting inflation under control. Look at your portfolio performance in 2022. What will happen in 2023 if the Fed doesn’t pivot?
The average portfolio loss in 2022 was down around -16%. In contrast, gold did what it does best. It hedged against inflation and protected purchasing power. It was up 0.44% for the year. If you could go back to January 1, 2022, how much of your portfolio would you put into gold? If you think the Fed will continue to tighten policy in 2023 and more market losses are ahead, how much of your portfolio do you want to protect?
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