Do Investors Think The Fed’s Hammer Works Like A Screwdriver?

Posted by Jeffrey J. Roach, PhD, Chief Economist

Friday, May 20, 2022

Our tools don’t really work on supply shocks.

The quote above was one of the most important statements Chair Jerome Powell made at the recent press conference after the Federal Open Market Committee (FOMC) decided to raise the federal funds rates and reduce the size of the Fed’s balance sheet. At the press conference, Chair Powell reminded the audience that monetary policy cannot directly impact supply imbalances but instead, is a tool to affect imbalances in the demand side of the economy. The Fed is equipped with blunt instruments – like a hammer – to address their dual mandates of price stability and full employment through various means. The Fed does not have a precision tool – like a screwdriver – to control supply chains. “Asking the Federal Reserve to fight supply chain problems is a misguided question,” explained Jeffrey Roach, Chief Economist at LPL Financial. “But, demand and supply are interrelated and there lies the Fed’s conundrum. The sooner the market comes to grip with this, the better for investor sentiment.”

A Business Cycle Like None Other

In previous business cycles, policy makers talk about sectors “overheating” from strong aggregate demand, driven by robust consumer spending. And as the economy starts to overheat, policy makers attempt to slow the economy by removing accommodative monetary policy through tightening financial conditions. What made this most recent business cycle different was the centrally planned nature of stopping and then abruptly re-starting economic activity. Given this unusual experience, the “overheating” mentioned above started almost immediately. The sudden onslaught of consumer demand created shortages in items like toilet paper, semiconductor chips, household appliances and used cars.

Supply Chain Kinks Are Inflationary

The St. Louis Federal Reserve tested the relationship between global supply chain disruptions and inflation.[1] They found supply bottlenecks created large inflationary pressures, especially in the technology equipment sector and automotive and parts sector. As we share in the LPL Chart of the Day, consumer price changes lagged 4 months are 72% correlated with the New York Fed’s Supply Chain Pressure Gauge.  Given the improvement in supply chains, inflation pressures should subside. And as inflation eases, the Fed will not likely need to increase rates above neutral. Our base case is the FOMC hikes rates by 50 basis points in June and then moves to 25 basis point increments, reaching 2.50% by the end of this year.

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