The central bank may be one of the most powerful and influential institutions in the world, but that does not mean that the people who are at its helm know what they are doing.
Outside of the late Paul Volcker, the Fed has in recent decades played a reactionary role more than a leading role. It has worked to wait to see what the cycle spits out and then react accordingly. Each time the Fed's solution has been to print -- of course it knows no other way but to just print itself out of a problem. It has worked the last 12 years, so why not keep doing it?
That does make sense, but at some point, there is a very delicate balance between heightened debt and inflation. But when the balance goes, old theories may stop working. The billion, or rather trillion, dollar question is when will too much debt just be too much?
The answer is yet a mystery, as that day will come, especially as the Fed has not and will not be able to normalize its balance sheet. We are at close to $9 trillion, and just Wednesday the Fed announced it would start tapering its asset purchases by $15 billion per month starting in November. It has already announced another $15 billion for December, but then it left the "door open" for January, saying it could adjust when it saw fit. In Fed speak that means, it knows not how bad this current slowdown is nor how transitory the inflation is. The Fed would rather keep some options on the table than make a commitment now.
Even though it keeps saying that it has significant tools to address the inflation or economy if need be, that is not entirely true. The Fed's only alternative is to raise rates aggressively. We all know that that will not end in a good way. The Fed has changed the wording to say that "inflation is transitory for a lot longer." A very level play on words, as the Fed needs to keep the word "transitory" in its comments, because if it does not, the market might misinterpret it.
The Fed has acknowledged supply chain shocks and lasting effects, but in truth it does not know. It really just hopes that inflationary prices will start coming down as supply chain shortages ease slowly. Given the slowdown we are now witnessing in China through lower coal, gas, iron ore, steel, and flattening shipping freight rates, there is a chance that this "tightness" may be easing off a bit. If that is the case, then the Fed will have been proven right to have waited. Better to be lucky than smart as they say? The problem arises if growth slows too fast and inflation just does not budge. We all know what that means, stagflation, and its game over.
The message Wednesday was very mixed and caused the dollar to fall, gold and silver to rally along with oil, copper and stocks. Initially bonds fell and now they are back down again as yields move lower again. We are back to the drawing board and monitoring each data trend to try and see what the Fed might be pushed to do. One thing is clear the "reflationary" trade in the market has unwound for now as defensive/Bond proxies have bounced significantly over the past weeks. Time to go back to numbers.