Risk assets have sold off. The SPY is now down 16.4% from its peak. Financial conditions have tightened more broadly. The 30-year fixed rate on prime US mortgages has increased from 2.9% to 5.3% per annum. The markets are continuing to price in Fed’s guidance. The Fed has set itself the goal of tightening financial conditions at least until inflation expectations are back on target and inflation itself is well on it’s way back to the target rate of 2% per annum. We’re very far from that world. Between here and there is a river of pain. The pain is magnified by the fact that it is at least partly in control of Putin. Russo-Western relations have devolved into a protracted competition in pain-tolerance, whose eventually winner — if there is one — is not clear as of writing.
Most observers have noticed the estimates of the damage that Western sanctions will do to Russia. Few have reckoned with the damage that Russia can do to the US in retaliation. In terms of regime security, Biden is more exposed to Putin than vice-versa. Putin can even make a play of trying to get Trump back into the White House. By simply prolonging the economic isolation of Russia and Ukraine from the world economy, Putin can attempt to ignite double-digit inflation in the West. The inflationary impulse from the Ukraine war has yet to be reflected in the cpi and pce prints. Since the last observations, a number of commodities have become priced for severe scarcity. Indeed, from the pricing in futures markets, we should expect double digit prints later this summer.
The Fed is caught in the place of a defender who must deliver on the deterrent threat simply to signal its commitment that it will deliver on future deterrent threats. So, they have to deliver the bitter medicine. The idea is to catch up rapidly with half-point hikes until you’re close to target.
Economists think of the game of chicken between the monetary authority and fiscal authority, whereby the monetary authority tries to impose discipline and the fiscal authority tries to get away with larger spending. Fiscal dominance is when the Fed backs off; monetary dominance is when it does not. There is also the idea of market dominance. This is the idea that, while market stress is of official concern to the Fed only if it threatens the stability US financial markets, market tantrums can somehow compel the Fed to bail investors out. Episodes when the Fed moved in to stabilize markets are seen as evidence of some kind of commitment from the Fed. There is no such commitment. The Fed has much bigger fish to fry that guarantee investor returns. Yes, the Fed will probably provide liquidity if markets go haywire. But the Fed is not targeting the wealth channel as an options trader. There is a fine line between market tantrums and financial crises, but it is clear to FOMC observers in real time.
If the markets scream and the Fed does not back off, it will reestablish its credibility as an inflation fighter. If it backs off in the face of market tantrums, the idea of market dominance will be vindicated. I believe the Fed will take the first option. But I am not certain of this wager. There is a risk that we have a fundamentally dovish Fed playacting as a hawk. There’s a definite policy risk that the Fed will come to believe that the risk-offs have gone far enough and act on that belief. In other words, there’s a risk is that the Fed may choose premature accommodation in the face of escalating sell-offs.
The Fed’s world now intersects with Putin’s well beyond the rouble’s exchange-rate against the dollar. It is close to the frontlines of the financial war. Putin is exposed to the Fed’s policy in a macrofinancial sense. But so is the Fed to Putin’s policy. Just by blocking the flow of neon from steel factories in the Donbas, Putin can perhaps double the prices of microchips. Global inflation has become directly coupled to the Russo-Western geopolitical confrontation.
I think we have yet to fully digest the Fed’s conundrum or the coupling of geopolitics and price stability. Zoltan Pozsar’s dispatches should be read in this light — not Bretton Woods III as the post-hegemonic future of the dollar world order — but as illuminating the blowback channel from geopolitics to commodities to price stability; and, no doubt, political stability — a point missing from Zoltan’s dispatches so far but which he conceded to me in person. He also clarified that RMB trading arrangements and other superstructures of Chinese hegemony will take time to articulate. We agree that what we’re watching is a process of destructuration rather than restructuration. What he insists upon, and I think he is correct to do so, is the centrality of commodities to the present moment.
We must expect an extended period of geopolitical tensions, food crises and global instability, price instability, and political instability in the United States. At the heart of this Russian doll of crises is the commodities shock, which doubles as the portfolio to hold for longonly investors as protection in Zoltan’s world. The bigger question, however, is whether the present ensemble of crises is productive or whether we are we falling further into the abyss.