Economist warns: Jerome Powell’s Federal Reserve is stuck in a self-destructive paradox

According to Torsten Sløk, chief economist at Apollo, the Bloomberg US Financial Conditions Index suggests that the supply and price of credit in the cash, bond and equity markets are significantly cheaper today than when the Fed began raising rates of interest in March 2022.

The reason for that is the change in course of the Federal Reserve in November, when its chairman, Jerome Powell, signaled that inflation had cooled sufficiently to stop rate of interest hikes and to think about a possible start of rate of interest cuts.

Wall Street interpreted these comments – incorrectly, because it turned out – to mean that an easing of rates of interest was imminent and that there could possibly be as many as six rate cuts in 2024. This triggered an enormous rally within the stock markets.

In a blog entry On Wednesday, Sløk estimated that the market capitalization of the S&P 500 stock index had increased by $9 trillion since then, comparing that to consumer spending of $19 trillion last yr.

“In other words, in just a few months, the private sector has experienced an unexpected gain equivalent to about 50 percent of last year’s consumer spending!” he wrote.

Meanwhile, the federal government has spent trillions of dollars on infrastructure, green energy initiatives and expanding semiconductor manufacturing capability.

As a result, the economy has remained strong as these fiscal stimulus measures proceed to spice up growth while easier financing conditions offset the Fed’s rate of interest hikes, Sløk noted.

In fact, the economy was so strong at the beginning of the yr that inflation numbers were above forecasts and showing signs of accelerating again, forcing Powell to warn that rates of interest could stay high “as long as necessary” because inflation gave the impression to be taking longer than expected to achieve the Fed’s 2% goal.

However, he later acknowledged that further rate hikes were unlikely and reiterated that the Fed’s next move – every time that could be – would likely be a rate cut.

And from Sløk’s perspective, this is precisely the error Powell is making.

“Looking ahead, with equity markets hitting new all-time highs and fiscal policy remaining supportive, markets should expect the economy to continue to gain momentum in the coming quarters,” he wrote. “You can call this the Fed’s rate-cutting reflexivity paradox: The more the Fed insists that the next rate cut will be a rate cut, the more financial conditions will loosen, making it harder for the Fed to cut rates.”

Certainly, GDP growth in the primary quarter slowed from the fourth quarter and was revised downwards from 1.6% to 1.3% on an annual basis. The latest report also showed that fiscal stimulus was having less of an impact.

However, consumers continued to spend heavily on services, and more moderen unemployment data showed that the labor market situation remained stable.

Meanwhile, minutes from the Fed’s last meeting showed that the economy’s resilience, with rates of interest at a 23-year high, had led some Fed officials to query whether all their tightening measures were putting enough pressure on growth. High rates of interest “may have less of an impact than in the past,” the minutes said.