The markets have lost respect for the Federal Reserve. Interest rate futures believe the Fed will not have the guts to keep interest rates high for long. The swaps published by Bloomberg foresee that the Fed will begin to lower rates in mid-2023 in the face of the looming recession. To put an end to these expectations, the Fed has to ‘overreact’, make exaggerated moves, implement the strategy of shock and awe (an ‘anti-Maradona’) to restore credibility and convince markets that the Fed is capable of to control inflation.
Stéphane Déo, head of market strategy at Ostrum, a manager of the Natixis Investment Managers group, exemplifies the dilemma facing the Fed, referring to a comment by former Bank of England Governor Mervyn King and his theory between the relationship between Maradona’s soccer and the predictability of monetary policy; the Fed could be forced to implement the strategy of shock and awe or (an anti-Maradona) to compensate for its initial lack of credibility. In his analysis, Ostrum’s head of strategy considers that Powell “faces” three rivals: Volcker, Los Mercados and Maradona.
The strategy of ‘shock and awe’ (in English, Shock and awe, technically known as Rapid Dominance) is a military doctrine based on the use of dominant maneuvers and spectacular displays of force to paralyze the adversary’s perception of a battlefield and destroy their will to fight. Going out overwhelmingly to scare off the enemy, in this case inflation.
In monetary policy it is supposed and sudden that they ‘scare’ the expectations of inflation and interest rates. The final result does not necessarily have to be higher interest rates, sometimes it would be worth advancing rate increases from the future to the present and for the markets to think that the terminal rate (the highest rate that the Fed intends to reach) it will be higher than it really will be.
Powell vs. Volcker
Why does Jerome Powell need to put this strategy into action? The Ostrum expert believes that one of the pitfalls that Powell seems to want to avoid is the 1970s sequence. Inflation rose sharply to 12.3% in December 1974, and the Fed reacted by raising rates in mid-1974. The result was a harsh recession in 1974-75 that brought inflation down to 5% just over a year later. The mistake was declaring victory. The Federal Reserve was confident and quickly lowered its reference rates to 5%,” says this expert.
Inflation was waiting for its moment, it was not yet due. “The subsequent recovery was accompanied by a rise in inflation. Once inflation was anchored, it took Volcker’s horse remedies, a decade of very positive real rates, for inflation to finally come down,” he explains.
Powell vs. the market
The markets, for now, anticipate that the Fed will be very aggressive this year but that it will turn around in the middle of next year. This is not a prolonged tightening of monetary policy, but rather a “stop and go” reminiscent of the 1970s.
Powell vs. Maradona
It is interesting to go back to Sir Mervyn King, the former Governor of the Bank of England. Sir Mervyn is known for his sense of humor. We owe him the quote: “There are three types of economists, those who know how to count and those who don’t”, or “a successful central banker is boring”. He also coined the Maradonian theory of monetary policy. It is about going back to Maradona’s goal against England in the World Cup: he crosses the entire field supposedly zigzagging the entire English defense.
“What is really striking is that Maradona ran almost in a straight line. How can you beat five players running in a straight line? The answer is that the English defenders reacted to what they expected of Maradona; if Maradona moved to the left or right” assured Sir Mervyn King in 2005″, explains this expert.
The analogy with monetary policy is that if markets expect rates to rise when inflation rises, their inflation expectations do not move and therefore the central bank does not need to raise rates. Now the opposite is happening, the markets do not quite believe the Fed.
The trajectory of monetary policy is as linear as that of Maradona. In other words, the more credible the central bank is, the less need it has to react to changes in inflation. That is the Fed’s dilemma right now. With markets not expecting to keep rates high next year, the Fed may be forced to do even more (anti-Maradona) to make up for the credibility deficit. Hence the importance of the current discourse. If effective, long-term rates should be higher than they are now, which, paradoxically, would be part of the Fed’s job and thus limit its need to raise rates (Fed Funds).”
Conclusion
“The mistake of prematurely easing in the 1970s seems to be very much on the Fed’s mind. This seems reasonable to us, but it would also imply that the rate cuts expected by the market for next year are surely too much. less probable than expected. This would also imply a steeper curve. Higher rates for longer, “says the Ostrum expert.
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