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by Giza Capital Research

“Nobody panics when things go according to plan, even if the plan is horrifying.” – The Joker

Currently, market participants/watchers are focused on the Fed’s battle against inflation. Chair J-POW! has been trying to jawbone inflation and get ahead of inflation expectations by squeezing out demand with higher costs of capital, yet the interest rate markets are unusually sanguine, seemingly calling the Fed’s bluff.

Some “smart monies” are even betting that there will be massive deflation, inverting the Eurodollar futures curve market in the process; they are betting that Chair J-Pow will need to actually need to cut rates (!) because the Fed is in the process of causing a massive recession / debt crisis. It is not a low probability that the Fed will over-tighten and cause some sort of deflation.

But what if the Fed Fails? What if the rate hike punches of J-Pow! miss the jaw of inflation, and even with the Fed Funds Rate at 5.75% (on the upper-bound of our prediction) fail to bring inflation / inflation expectations down to 2% ?

As Dr. Nouriel Roubini (one of the few economists, who predicted the GFC of ’08-’09), astutely points out (in his interview with Bloomberg, below), the “grey swan” risk that investors are not accounting for is the tangible possibility that the Fed will actually fail in its fight with inflation.

We concur with Dr. Roubini’s analysis, but for a different reason. Back when Chair Volcker was fighting inflation, the CPI (as officially measured by the US government) was a decently accurate gauge of inflation in the real economy. Many economists/analysts, who study inflation, point out that today’s CPI measurement woefully underestimates the real rate of inflation in the economy, as the current statistic has been changed by adjusting for the basket of goods/services included, “hedonic adjustments,” and other factors.

For example, the economist John Williams at ShadowStats, measures inflation in the US, by using the same methodology that was used in the 1980s. According to that measure, inflation in the US is not at around 8.2%* (as of end of Sept. 2022)*, but over 15% (if measured using what Chair Volcker likely would have used as his measure of inflation). We tend to believe that 15+% is a much more accurate inflation number, because that is what people (on average) observe for many goods/services at retail prices.

“Official” CPI vs. “Volcker Era” CPI

It is highly probable that the Fed is underestimating the real inflation that is raging in the economy, since it uses the newly updated methods for measurement, which likely understates the actual rate of inflation. If J-Pow used Volcker’s inflation metrics, the Fed Funds Rate would have to be closer to* 15% to tame inflation. Yes, you read that correctly, 15% Fed Funds Rate; with the level of aggregate debt in the economy, 15% is almost impossible, as Dr. Roubini also points out in his interview (below).

But even that is not the real risk. When we say “What if the Fed Fails?” we are not talking about the failure to jawbone inflation (that is a possible scenario). We are talking about the other end of the story, when the Fed does “money printer go BRRRRRRRRR” and tries to restimulate the economy by supporting financial markets (i.e. cut rates to zero again and does QE Infinity 2.0) 

… what if the Fed *Gulp* Fails ?

The Black Swan Awaits

^Above is NOT investment or financial advice.

*Edited 11.10.2022