Fed Watch: What Do You Do When A Hawk Remains Bullish?

St. Louis Fed chief James Bullard said last week that fears of a recession in the US are exaggerated, even as he continued to call for “front-loading” interest rate increases.

Bullard, who has been an outrider in calling for stiff rate hikes to cut off inflation, firmly believes that the US economy is in an expansion phase and talk of a downturn is misguided or premature.

At a UBS event in Zurich, Bullard said:

"Interest-rate increases will slow down the economy but will probably slow down to more of a trend pace of growth as opposed to going below trend. I don’t think this is a huge slowing. I think it is a moderate slowing in the economy."

In nearby Basel, the Bank for International Settlements (BIS), widely known as the central banks’ central bank, is not so optimistic. In its annual report, the BIS warned on Sunday that central bank rate hikes have to keep ahead of inflation if they are to be effective.

"Gradually raising policy rates at a pace that falls short of inflation increases means falling real interest rates. This is hard to reconcile with the need to keep inflation risks in check. Given the extent of the inflationary pressure unleashed over the past year, real policy rates will need to increase significantly in order to moderate demand."

For good measure, the BIS added: “A modest slowdown may not be enough.”

So, who’s right—bullish Bullard or bearish BIS? Is there room for both?

There’s a lot of Monday-morning quarterbacking going on as pundits second-guess Fed policymakers. It entails a lot of punishment for the only real Sunday quarterback—Fed Chairman Jerome Powell.

One investment analyst, Joachim Klement, headlined an opinion piece in MarketWatch with a blaring headline: “Jerome Powell is the worst Federal Reserve policy maker in my lifetime.”

Klement, a London-based analyst trained in mathematics, thinks Powell has been bullied by financial markets into pushing the panic button, like the “weak chairmen” of the late 1960s and early 1970s.

"A strong Fed would be able to explain this to the public and withstand market pressure to hike rates fast. Instead, under Powell, we once again have central banks that let the tail wag the dog and let outsiders dictate monetary policy. By succumbing to market expectations of fast rate hikes, the Fed will create the very recession that the bear market in equities already anticipates."

He wants the Fed to focus on core inflation rates, instead of headline rates driven by supply shocks in energy and food that interest-rate hikes can do little to influence.

Underlying the measured comments of Bullard and Klement is the belief that the Fed should have acted much sooner to head off inflation more than a year ago when it was taking off.

Even just looking at core inflation, there are price pressures from excessive demand that timely interest-rate hikes could have dampened.

Why didn’t Fed policymakers do that? Maybe historians can figure that out. In the meantime, we’ve stumbled into the supply shocks that have exacerbated underlying inflation.

Powell had to admit in congressional testimony last week that there is a “risk” that unemployment would rise as the Fed hikes rates while pointing out that joblessness is currently at “a historically low level.” There could indeed be a recession, he acknowledged.

Having gotten inflation wrong, Fed policymakers are now pivoting, Powell went on in his testimony.

"The main thing is we can't fail on this. We really have to get inflation down to 2%. We're going to want to see evidence that it really is coming down before we declare any kind of victory."

Having raised the federal funds rate by a stiff three-quarter percentage point earlier this month, the Fed is now expected to match that increase in July.

Too much, according to Klement; too little, according to the BIS?