The Fed will say loudly again on Wednesday that it has not yet won the war against inflation, even as it slows the rate at which it is raising interest rates to fight it.
Still, the carefully worded “Fedspeak” will only be used to calm markets that are already excited about peak interest rates and “soft landings” for the economy. This excitement risks undermining the whole policy of tightening too soon.
Fed policymakers will probably feel pretty good about themselves and a little bit relieved.
At the very least, it looks like the central bank has stopped a terrible thing from happening. By the middle of last year, the Fed had misjudged a series of global health and geopolitical shocks that led to a runaway inflation rate of over 9%.
Now, after the Fed’s stock and bond prices fell and the economy slowed down last year because of the fastest rate-hiking cycle since the 1980s, it seems like things are back in order.
The annual rise in consumer prices has been going down for six months in a row, and the economy is still at full employment even though interest rates have gone up by more than 4 percentage points in just 10 months.
Job done?
The Federal Reserve Act’s “dual mandate” for policymakers isn’t very clear, but it actually has three goals. The third goal depends on how well policymakers can convince investors that the first two goals are taken care of.
The Act says that the Fed’s monetary policy should “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Even though there are no specific numbers and the Fed has a lot of room to move, it has become clear over the years that its implicit “stable prices” target is 2%, as measured by the price basket for personal consumption expenditures (PCE).
The closely watched core rate of PCE inflation, which excludes food and energy, fell back to as low as 4.4% last month. This was the lowest it had been in over a year, and it was as low as 3.2% on a 3-month annualised basis.
In fact, the so-called trimmed mean one-month annualised rate of inflation from the Dallas Fed dropped as low as 2.3%, which is a third of the rate seen at its highest point in June and so close to any notional target that it doesn’t matter.
Even though the Fed’s own forecasts from last month show that core PCE inflation will only drop back below 3% to as low as 2.5% next year, its strategic policy shift before the pandemic was to focus on an “average inflation target” over time.
Based on this, the average core PCE inflation rate since 2010 is exactly 2%. This is true even after the recent scare and even though the monthly rate is now falling quickly again.
Rates and inflation in a graph Rates and inflation: http://www.reuters.com/graphics/USA-FED/INFLATION/gkvlgnaywpb/chart.png
US money supply and inflation chart: http://www.reuters.com/graphics/USA-FED/MONEY/zgvobrgaepd/chart.eikon.jpg
TRIPLE MANDATE, “TRIPLE BLUFF”
Even though there are a lot of ifs and buts, there is a good reason to say that the goal is at least in the picture.
And the big annual base effects of falling energy prices, which affect not only wholesale and retail oil prices but also things like airfares and products that use a lot of energy, haven’t happened yet. Brent crude prices went up after the Ukraine invasion in February last year, but they have already gone down by 7% since January.
There is little doubt that Friday’s expected release of a national unemployment rate of 3.6% for January will show that there is almost no slack in the job market.
The Fed will probably keep talking tough for a while because the job market is tight, there aren’t enough workers, and there are signs that real wage growth is coming back.
But even if the unemployment rate goes up from here as the economy slows and the effects of the Fed’s rate hikes from last year start to show, it’s not likely to go above what economists call “maximum” employment, which they put at about 4.5–5.0%.
Also, because economic activity in China and the euro zone is picking up again in the new year, the International Monetary Fund on Tuesday raised its estimate for U.S. economic growth in 2023 by 0.4 percentage points, to 1.4%. This is up from its estimate in October.
And then there’s the Fed’s “third” job, which is to make sure that “long-term interest rates are moderate.”
As inflation soared and the Fed tightened, benchmark Treasury borrowing rates went up by a lot last year. It was the worst year for Treasury investors in a very long time.
But 10-year Treasury yields are not only 80 basis points below last year’s highs, but they are also about 2.5 percentage points below the average of the past 70 years.
At 1.25 percent, real 10-year yields, which are based on market expectations of inflation rather than actual inflation, are much higher than the sub-zero lows after the pandemic and are among the highest in over a decade.
But these are also going down, and the fact that inflation expectations for the next two and ten years based on inflation-protected securities are just a little bit more than 2% may be the best proof of the Fed’s credibility in the bond market.
So, if the Fed is hitting all of its goals, why does it still fight?
The main reason is that banks and financial markets pass on the Fed’s monetary policy to the real economy through loans, mortgages, credit card rates, bond and equity financing, and a lot of other things.
So, the Fed won’t want to let that system loosen up too much for fear that it will fuel credit and inflation again before the central bank can give the all-clear signal. This is true even though the effects of last year’s squeeze on household debt service burdens will start to show up anyway.
So, Fedspeak and market prices play a game of “cat and mouse” instead of making investors change their minds about how close the Fed is to being done.
John Wood-Smith of Hawksmoor Investment Management said, “It’s a game of double and triple bluff that usually ends up going in circles.”
Fed predictions for inflation: https://www.reuters.com/graphics/FED-INFLATION/USFED-INFLATION/gdvzqyoeypw/graphic.jpg
These are the thoughts of the author, who writes a column for Reuters.
(Written by Mike Dolan, who tweets as @reutersMikeD; Andrea Ricci edited.)
