Four Reasons Why The Federal Reserve Is Tightening Into A Recession

For the first time since the early 1980s, the Federal Reserve is tightening into a recession. The economy is slowing quickly, and leading economic indicators such as housing suggest that the economy may be heading towards a hard landing.

Given how quickly the economy is slowing, why is the Fed continuing to raise interest rates at such an aggressive rate? Given that interest rate policy tends to work with a twelve-to-eighteen-month lag, wouldn’t it make sense to see how the economy reacts to the interest rate hikes that have already been enacted?

An increasing number of investors are seeking answers to these questions.

Barry Sternlicht, Starwood Capital Group’s CEO, recently said that “the economy is braking hard” and that the Fed is incorrectly relying on lagging indicators such as the Consumer Price Index (CPI) rather than leading indicators such as the housing market. Jeremy Siegel, a renowned finance professor from Wharton School of the University of Pennsylvania, was harsher in his criticism, suggesting that Fed policymaking had become incoherent. Both Sternlicht and Siegel think the Fed is wrong for targeting wage growth as the source of inflation.

It appears that the Fed has started to bring down inflation. From their peaks earlier in the year, energy prices have been declining along with the prices of most other commodities. Housing prices and rents have started to decline. And the official CPI has started to decline from the peak level of 9% that it hit in July. Given these trends along with the weakness in certain other leading economic indicators, it seems like it would make sense for the Fed to ease the pressure.

However, the Fed has thus far kept the pressure on interest rates. Below are several theories that might explain what might be motivating Fed Chairman Jerome Powell’s aggressiveness regarding interest rate hikes.

Theory #1: The Fed may be Misguided

Powell may be simply misguided, as Sternlicht and Siegel suggest, and may be making a terrible policy mistake. He could be looking at the data incorrectly, and he may be placing excessive importance on the wrong indicators and not enough importance on indicators suggesting that inflation will continue heading down and there’s simply no need to be over-aggressive.

Theory #2: The Fed may be Fighting a War

The United States is in a proxy war with Russia over Ukraine, and the financial and economic components of the war are just as important as the military component. Just as the U.S. banking system has been weaponized in this war, so too has the Fed. Raising interest rates aggressively to create a deep global recession would reduce oil demand, bring down oil prices and potentially starve Russia of revenues. If this is the strategy, it is starting to have an impact, but oil prices are still at a level where Russia can produce energy profitably and use those profits to prosecute its war in Ukraine. In the short run, the geopolitical goals of the United States are more important than the economic goals of the United States, which means that the Fed may need to continue to tighten monetary policy.

Theory #3: The Fed may be Serving the Banks

The Fed is a private entity owned by various U.S. banks. The Fed’s low-interest rate policy which it has been pursuing for many years has been wonderful for the price of assets, but it has been terrible for bank profits. The Fed is using inflation, which recently reached a 40-year high, as a reason to finally normalize interest rate policy and keep it there for the sake of the profitability of the U.S. banking system.

Theory #4: Powell may be Protecting his Legacy

Like many politicians, Powell wants history to view his tenure fondly. It may be that he wants to be thought of as this generation’s Paul Volcker, not this generation’s Arthur Burns. Paul Volcker was the Fed Chairman who hiked interest rates to double-digit levels in the early 1980s and created a deep recession, but he also succeeded in finally bringing down inflation. In contrast, Arthur Burns was the Fed Chairman in the 1970s who allowed wages to spiral out of control and was never able to contain inflation. Powell may be fixated on wages because it was the wage-price spiral that caused the persistence of the inflation that took place in the 1970s under Arthur Burns. In this set of circumstances, the Fed is raising interest rates to bring down the price of stocks which should lead to layoffs, a recession, higher unemployment, and ultimately less price pressure on wages.

Whatever the reason, it appears that Chairman Powell plans to continue hiking interest rates until something breaks. This week, we saw something break in the United Kingdom, where government bond yields spiked due to margin calls, which caused the Bank of England to reverse policy and buy bonds in order to bring down interest rates. If anything stops the Fed from its current course, it probably will be a similar situation in the Treasury market. After all, the only thing more important than containing inflation is making sure that the U.S. government is funded.

Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.