Investors Should Be Cautious Of A Policy Pivot: Volcker Showed Quick Policy Pivots Don't End Well
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Investors should be cautious of a policy pause or pivot as it might bring short-term gain at the expense of long-term pain. No one is better than Mr. Volcker at knowing that quick pivots or reversals in the fight against inflation don't end well. Mr. Volcker abandoned his inflation fight in early 1980 following the sharp plunge in the economy (at the time, it was the sharpest one-quarter drop in GDP in the post-war period) associated with the imposition of credit controls.
After lifting official rates by more than 1000 basis points over several months, Volcker dropped them equally fast, only to resume his inflation fight later in the year. Volcker eventually raised official rates to higher highs in the next two years, underscoring the critical point of inflation cycles; that they do not die quickly or easily.
Nowadays, there is nothing on the horizon that would trigger an economic decline equal to that of the 1980's drop. But that's not the critical point. Killing inflation cycles require a significant reset of economic and financial conditions following a fundamental tightening of monetary policy. The sharp two-day rally in equities this week based on the slightest hint of a policy pause shows investors' risk-taking appetite is alive and well. If that is still alive, so is the economy's growth and inflation appetite.
Yet, it is hard to deny that things are lining up for Fed Powell to pause at some point. For example, prices paid diffusion indices from the Institute of Supply Management for manufacturing and the service sector provides a snapshot of cost pressures. Both price measures fell to their lowest levels in roughly two years in September.
Yet, it is worth noting that diffusion indexes track the breadth of increases (or decreases) and do not distinguish the magnitude of change. So while cost pressures have subsided, they have not disappeared completely. Also, the service sector's price index at 68% remains elevated, which has to do with two things: services use fewer commodities than manufacturing, and labor is a more significant part of their cost. Since the inflation cycle is increasingly becoming a service sector phenomenon, rising labor costs remain the biggest wild card for the inflation cycle.
The number of job openings stood at 10 million in August, off 1.1 million from July, but still far above pre-pandemic levels. And, with 1.7 job openings for every unemployed worker, companies, especially in the service sector, will need to pay up to attract labor.
Tightness in the labor markets will not be an obstacle for Fed Powell to pause after the Fed follows through on hiking rates at the next two meetings, as suggested in the latest policymakers' projections. Yet, it does create the risk of a pickup of inflation and higher official rates later. That's because, without sufficient slack in the labor markets, companies would still face the same labor cost conditions as they do today, raising the prospect of an extended inflation cycle.
Inflation cycles are not linear, nor do they end in a day, week, or month. It takes time to stop and reverse. Policymakers say they must maintain restrictive policy rates for some time to kill inflation. Yet, will politics and investors let them?
Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.