By Mike Dolan
LONDON (Reuters) – The Fed will loudly insist again on Wednesday that its inflation battle is not yet won – even as it slows the pace of interest rate rises to combat it.
And yet the deftly worded ‘Fedspeak’ will just be about reining in jumpy markets, already chomping at the bit about peak interest rates and ‘soft landings’ for the economy – ebullience that risks undermining the whole tightening policy prematurely.
Quietly, Fed policymakers will likely feel rather smug – and not a little relieved.
At the very least, the central bank looks to have rescued a dire scenario that saw runaway inflation at 40-year highs above 9% by the middle of last year following a series of global health and geopolitical shocks the Fed misjudged to begin it.
Now, after the fastest rate hiking cycle since the 1980s pummelled stock and bond prices and slowed the economy last year, it looks like the Fed’s got things back in some order.
Inflation is on the wane with annual consumer price rises falling for 6 months in a row even as the economy remains effectively at full employment despite more than 4 percentage points of interest rate rises in just 10 months.
Job done?
The Federal Reserve Act’s rather vague ‘dual mandate’ for policymakers actually contains three goals, with the third a function of its success in convincing investors it’s got the first two in the bag.
The Act states the Fed should conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
With no explicit numbers and plenty of leeway, the Fed itself has clarified over the years that its implicit ‘stable prices’ target is 2%, defined by the personal consumption expenditures (PCE) price basket.
The closely watched core rate of PCE inflation that strips out food and energy fell back to as low as 4.4% last month – the lowest in over a year and as low as 3.2% on a 3-month annualised basis.
In fact, the Dallas Fed’s so-called trimmed mean one-month annualised rate of inflation fell as low as 2.3% – a third of the rate seen at June’s peak and as near as makes no difference to any notional target.
And even though the Fed’s own forecasts from last month show core PCE inflation only falling 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.
On that basis, the average core PCE inflation rate since 2010 is exactly 2.0% – even after the recent scare and with the monthly rate ebbing again fast.
Graphic: Rates and inflation Rates and inflation https://www.reuters.com/graphics/USA-FED/INFLATION/gkvlgnaywpb/chart.png
Graphic: US money supply and inflation https://www.reuters.com/graphics/USA-FED/MONEY/zgvobrgaepd/chart_eikon.jpg
TRIPLE MANDATE, ‘TRIPLE BLUFF’
For all the myriad ifs and buts going forward, there’s a cogent case to say the target is at least in the frame.
And powerful annual base effects from ebbing energy prices – which affect not only wholesale and retail oil prices but also the likes of airfares or energy-intensive manufactures – have yet to roll through. Annual Brent crude prices that spiked after the Ukraine invasion last February are already negative to the tune of 7% in January.
As to full employment, there’s little doubt that Friday’s expected release of a 3.6% national jobless rate for January shows virtually no slack in the labour market.
The tightness of the jobs market, along with worker shortages and signs of re-emerging real wage increases, is probably the main reason the Fed will hang tough for a bit – rhetorically at least.
But even if the unemployment rate ticks up from here as the economy slows and the lagged effect of last year’s Fed hikes kick in, it’s unlikely to exceed estimates of ‘maximum’ employment that economists put roughly at 4.5-5.0%.
What’s more, with China and euro zone economic activity re-accelerating into the new year, the International Monetary Fund on Tuesday actually increased its U.S. economic growth forecast for 2023 to 1.4% – up 0.4 percentage point from its October estimate.
And then there’s the Fed’s slightly forgotten ‘third’ mandate – to ensure “moderate long-term interest rates”.
Last year certainly saw a brutal back-up in how markets priced benchmark Treasury borrowing rates as inflation raged and the Fed squeezed hard – it was the worst year in a very long record for Treasury investors.
But historically 10-year Treasury yields are not only 80 basis points below last year’s peaks, but some 2.5 percentage points below the average of the past 70 years.
At 1.25%, real 10-year yields – measured by market inflation expectations rather than prevailing inflation – are far above sub-zero post-pandemic troughs and are also some of the highest in over a decade.
But these too are ebbing and perhaps the best testament to Fed credibility contained in the bond market is that 2- and 10- year inflation expectations derived from inflation-protected securities are just a smidgen over 2% too.
So if the Fed’s homing in on all its targets, why is it still battling?
It’s mainly because banks and financial markets transmit the thrust of Fed monetary policy to the real economy – via loans, mortgages, credit card rates, bond and equity financing and much else.
And so the Fed will be loath allow that system to loosen up too much for fear it stokes credit and inflation again before the central bank can sound the all clear – even if the lagged impact on household debt service burdens from last year’s squeeze is going to kick in anyhow.
And hence the cat and mouse game between Fedspeak and market pricing – rather than a material change to investors’ assumption that the Fed is nearly done.
“It is a game of double and triple bluff, which usually ends up going round in circles,” said Hawksmoor Investment Management’s John Wood-Smith.
Graphic: Fed inflation projections https://www.reuters.com/graphics/FED-INFLATION/USFED-INFLATION/gdvzqyoeypw/graphic.jpg
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan, Twitter: @reutersMikeD; Editing by Andrea Ricci)
