The Fed: Fed is no longer worried about every market hiccup, economist Lavorgna says

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Reuters

Federal Reserve Chairman Jerome Powell and his colleagues have penciled in five rate hikes by the end of next year.

Perhaps lulled into a sense of complacency by a Federal Reserve that previously had seemed to attend to the market’s every hiccup, investors seem unprepared for a central bank that now thinks more hawkish medicine is in order, a veteran Fed watcher said Tuesday.

“People don’t seem to realize the Fed does not have investors’ backs,” said Joe Lavorgna, chief economist for the Americas for French investment firm Natixis.

Lavorgna has spent 20 years following the Fed for Deutsche Bank Securities and other Wall Street firms after starting his career at the New York Fed.

Responding on Twitter to a Bloomberg article saying the Fed would continue to press ahead with a campaign of steady interest-rate hikes despite turmoil in Turkey, Lavorgna, in a tweet, said this would be a “mistake.”

In a phone interview, Lavorgna explained the mistake was the “trajectory the Fed laid out in June” for five more quarter-point rate hikes by the end of 2019.

Read: Fed signals another hike coming soon

“We’re at the stage where good news becomes bad news with the Fed trying to take liquidity out of the market, he said.

So any upbeat economic developments, like a decline in the unemployment rate, is likely to encourage the Fed to keep raising interest rates and may embolden them to do even more, he said.

The bottom line is the Fed has the wrong diagnosis, Lavorgna said.

The central bank mistakenly believes that low unemployment is the ultimate cause of inflation.

“It’s not,” he said.

Economists actually know very little about what generates inflation, he added. Famed economist Milton Friedman’s maxim that inflation is ultimately created by money is “effectively useless” because money is impossible to measure, he said.

As a result, the Fed has looked to other indicators, like spare capacity, to try to guess what causes inflation.

“Low unemployment has caused inflation some times, but a lot of times it hasn’t,” he said.

At the moment, the Fed has penciled in two more quarter-point rate hikes this year and three more in 2019. The market only has priced in only three moves over the same time span.

If the Fed follows through with its stated path, the result would be a stronger dollar and wider credit spreads. Ultimately this will result in lower stock prices.

The yield curve, the closely watched difference between short-term and long-term bond yields, would continue to flatten and ultimately invert, he said.

Some regional Fed presidents have signaled they are worried about policy that resulted in an inverted yield curve, which has been a fairly reliable predictor of recessions.

See: Yield curve will become part of Fed’s ‘reaction function’ once it inverts

Other Fed officials worry the economy will run into financial stability concerns if interest rates stay low.

The right thing for the Fed to do would be to “back away more” from QE, by picking up the pace of shrinking the balance sheet, he said. The Fed is slowly letting some of the securities on its balance sheet run off. After a year of steady and slow increases, the Fed will allow $50 billion of securities to be run off its balance sheet every month.

There have been various reports that suggest the Fed is considering slowing the roll-off next year.

Read: Wall Street doubts recent Fed pledge to keep balance-sheet reduction plan

“That would be a mistake in my view,” Lavorgna said.

Greg Robb is a senior reporter for MarketWatch in Washington. Follow him on Twitter @grobb2000.

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