MNI INTERVIEW: Hawkish Fed Risks Market Shock - Ex-Gov. Stein

The Federal Reserve's increasing hawkishness could trigger the kind of market turmoil that would undermine the economic expansion and force the central bank to reconsider its policy path, ex-Fed Board governor Jeremy Stein told MNI

Stein said he is surprised markets have remained fairly sanguine despite the Fed's pivot from penciling in just three rate hikes for 2022 in December to seeing seven for the year as of March – together with signaling the possibility of one or more 50-basis-point increases.

“Maybe the answer is you don’t try to over-rationalize it now – it’s like that famous quote, ‘if something can’t go on forever it won’t,’” he said in an interview. “At some point perhaps something will break but markets aren’t really predictable. I confess to being puzzled by it.”

Stein, a Board governor from 2012 to 2014, said the Fed’s efforts to engineer a soft landing will not be easy given the high starting point for inflation.

“They’ll do the best they can, but it may get to be quite tough,” he said. “The big unknown is even if you have some sense of inflation expectations, how much in the moment are they influencing price setting and wage-setting decisions? If that starts to happen, then things become more difficult.”

He contrasted the benign reaction to the Fed’s shift in tone by markets trading at high valuations to the taper tantrum which followed Ben Bernanke’s announcement in 2013 that the Fed would at some point reduce asset purchases.

“Bernanke was effectively clarifying how much bond buying there was going to be. But in fact, it was a modest policy change,” Stein said. “Here we're talking about a very significant policy change. If you had wanted to rationalize the level of the stock market I think your go-to would have been well, real interest rates are really low. Now they’re talking very explicitly about real interest rates having to go up.”

FLAT PHILLIPS CURVE

Fed officials are actively discussing whether it’s enough to get nominal interest rates higher or whether the real rate of interest – adjusted for inflation – will have to be substantially positive to contain inflation that jumped to 7.9% in the year to February and is expected to march yet higher as the war in Ukraine heats up commodity prices.

“There’s this implicit debate about levels versus changes – do you need to reach a certain level of real rates or will we get a fair amount of tightening out of raising by a certain amount?” Stein said.

Chair Powell recently seems to have come out on the side of getting the real rate positive, saying the Fed could if necessary “tighten beyond common measures of neutral and into a more restrictive stance” – an added hawkish signal on top of nods toward possible 50BP moves.

Stein said that key to how far the Fed can take monetary tightening without derailing credit or stock markets to an extent that hurts the economy will be the flatness or otherwise of the Phillips Curve, which plots the relationship between inflation and unemployment.

“If it’s very flat it means it takes a lot of pain to bring inflation down by a little,” he said, “Think about the global financial crisis – unemployment went to 10% and inflation fell by only a little – if that’s what you’re dealing with, that’s pretty ugly.

“If you think the Phillips curve is very flat, exogenous shocks to inflation are very hard to offset. When it was 1.7%, it was very hard to get it up to 2%. If it wants to be high, let’s say expectations dislodge, if it wants to be 5%, it’s going to be really hard to bring it back down.”