The Fed's Great Illusion

Tony Jacoby, CFA

In Christopher Nolan’s 2006 film “The Prestige,” Michael Caine’s character describes three parts of a magic act. The Pledge, where the magician shows you something ordinary; The Turn, where the magician takes that ordinary thing and does something extraordinary with it; and finally, The Prestige, where the magician takes the extraordinary and does something impossible with it. Think of a magician selecting an ordinary man from the audience (The Pledge), making him disappear (The Turn), and then reappearing him in the balcony behind the audience (The Prestige). A successful magician will orchestrate the illusion by convincing the audience that what they are seeing with their own eyes defies reality. The harder the magician pulls the rug out from under the audience’s reality, the bigger the round of applause at the “Ta-da.”

You may not realize it, but we’re all sitting front row to one of the greatest magic tricks in U.S. history: taming inflation without triggering the next recession.

The Pledge: The U.S. Economy

If the magician doesn’t convince the audience that the central object of the illusion is ordinary, then the trick falls apart. Of course, it usually isn’t…whether it’s a marked card or an audience member who’s in on the act. For this trick to work, it is critical that the audience believes the economy is firing on all cylinders. But we’ll come back to this later.

So, how is the U.S. economy abnormal and what is the audience being told to make them believe otherwise? Yes, the new jobs report for July was phenomenal relative to the prior four months and the unemployment rate is back down to pre-pandemic levels. So, what’s the catch?

Initial jobless claims (a weekly metric released by Bureau of Labor Statistics that tracks people applying for unemployment) have been steadily increasing since April (figure 1). This follows recent news about large company layoffs and hiring freezes¹. One can make the argument that, due to slack in the labor market as the economy was coming back online from the pandemic, jobs added versus jobs lost in the past several months had some breathing room before they began to catch up with one another. That said, recent Continuing Claims numbers (people still receiving unemployment compensation) appear to have bottomed out and have increased roughly 9.75% since May (figure 2).

Figure 1.

Figure 2.

The Turn: Rapid Interest Rate Increases

This is the part of the act where the magician attempts something daring and foolhardy—a feat so unbelievable that the audience gasps in collective anticipation and now fully commits itself to seeing how the illusion plays out. For the Fed, The Turn is tightening interest rates at a pace not seen in 40 years. The last time it raised the target rate an average of 0.50% per month over a four-month period was in the winter of 1982, the heart of the ’81-’82 recession, and since 1973, every time the target rate was raised this rapidly, the economy was either in a recession or would enter one within a year.

The notable outlier to this trend was when the Fed raised, lowered, and again raised the target rate by about 2% between January 1971 and June 1972 without triggering a recession. However, an argument could be made that the combined effects of Nixon “closing the gold window” in August 1971 and the subsequent Smithsonian Agreement in December 1971, both currency devaluation tactics to make American goods cheaper to foreign trade partners could have provided enough economic stimulus in the short term to offset the effects of the rate hikes.

The Prestige: A Soft Landing

The perception of destruction would just be destruction without restoring an object to its original form. After all, the main difference between a magician and a psychopath is that when they saw a man in half, the magician actually puts the man back together. The showstopper that the Fed is trying to pull off is known as a soft landing, a series of interest rate hikes that does NOT trigger a recessionary unemployment rate.

The reason that the term soft landing may sound foreign to most people is because it is incredibly rare. It has been argued that soft landings occurred in 1965, 1984, and 1994 but it should be noted that in each of those cases year-on-year price increases were below 5%, compared to 8.5% as of July 2022². Additionally, the 1984 and 1994 rate hikes, which increased the target rate by 2.50% and 2.25% respectively versus the current 2.25% year to date, occurred much more gradually. The most dramatic four-month average rate hike between the 1984 and 1994 periods was only .3125%, compared to .50% as mentioned earlier. Lastly, it should be noted that the target rate data used in this analysis does not extend as far back as 1965, but analysis of the Effective Funds Rate (an aggregate of actual borrowing transactions) indicates that the pace of rate hikes in 1965 was even more moderate than in 1984 or 1994.

Ta-Da?

“The art of a magician is not found in the simple deception, but in what surrounds it, the construction of a reality which supports the illusion.” - Jim Steinmeyer

It was noted earlier that for the Fed to continue to raise rates it is critical that the U.S. population believes the economy is firing on all cylinders. This is a consequence of the Federal Reserve’s dual mandate to promote maximum employment and price stability (keep inflation in check). By convincing the audience that there is nothing abnormal about the economy, it allays concerns of the inherent conflict between the two directives of the dual mandate. If the economy is officially in a recession or unemployment increases drastically, then the Fed loses its smoke screen behind which it can raise rates without alarming the population.

Magic is a little less fun when you know how the trick works, isn’t it?

Tony Jacoby, CFA is a portfolio manager at Shelton Capital Management

References

¹ Lu, Marcus. “Visualizing Major Layoffs at U.S. Corporations.” Visual Capitalist, August 9, 2022. https://www.visualcapitalist.com/major-layoffs-us-corporations-2022/.

² Labonte, Marc, and Lida R Weinstock. “Where Is the U.S. Economy Headed: Soft Landing, Hard Landing, or Stagflation?” Congressional Research Service, June 28, 2022. https://crsreports.congress.gov/product/pdf/IN/IN11963.

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