This week the Federal Reserve’s policy making body, the Federal Open Market Committee, delivered on Chairman Jay Powell’s promise in August that the Fed would continue to take aggressive action to restrain inflation, announcing a 0.75% increase in the Federal Funds rate. The out-sized increase is an unprecedented third consecutive 0.75% increase since June, a sharp departure from the FOMC’s historical practice of raising the policy rate in 0.25% increments. The Fed Funds rate, as it is called, is the overnight loan rate that banks charge one another for required reserve settlements. By buying short-term Treasury bills from the dealer network, or selling to them, the Fed’s Open Market Desk provides or withdraws liquidity from the interbank financial system, which ripples through the markets and impacts all short-term interest rates.
In uncharacteristically direct language, Chairman Powell in a speech in Jackson, Wyoming on August 26 sought to unequivocally crush market hopes that the Fed might be considering an early end to the tightening cycle currently underway. He left it open whether today’s increase would be 0.50% or 0.75% but he left no doubt about the Committee’s determination to purge inflation back to low levels around 2%, even if that necessitates a recession and rising unemployment. The Treasury bond market got the message and priced in implied Fed Funds rates that steadily rose over the last several weeks to 4.25% in December and 4.50% next March, up from 3.50% and 3.75% respectively, before Powell’s speech.
This increase, technically to a range of 3.00% to 3.25%, will result in trading more or less in the middle, around 3.13%; up from yesterday’s 2.33% average rate. Market expectations tilted toward a 0.75% increase in the weeks after the Jackson Hole speech, with a smidgen of possibility for a 0.50% increase, which would presumably have required a better inflation report than we saw last week. The Consumer Price Index (CPI) update for August last week was a mere 0.1% for the month, following a flat, or zero increase, reported for July. That’s an encouraging couple of months after trends averaging as high as 9.1% over the twelve months ending in June. Most of the weak inflation since June is attributable to falling gasoline prices, a good thing for sure; but the problem perceived in the markets is that the core inflation components, apart from food and energy prices, jumped unexpectedly by 0.6% in August. And the year-over-year increase fell less than expected, to 8.3% instead of 8.1% that the markets were hoping for.
And that seemingly minor disappointment in the expected year-over-year inflation rate aptly spotlights the essential challenge going forward. There are numerous indications that inflation is currently peaking, the deceleration in year-over-year CPI inflation from 9.1% to 8.3% in the last two months being Exhibit A. Chairman Powell often refers to a different inflation measure, the personal consumption expenditure deflator (PCED), which is more precisely calibrated to what consumers actually buy, as opposed to the fixed weight basket of goods represented by the CPI. The PCED has also dropped off marginally, from 6.8% Y/Y in June to 6.3% in July. The core PCED, excluding food and energy prices, retreated more significantly, from 5.3% Y/Y in February to 4.6% in July. Long-term market-based measures of expected future CPI inflation remained fairly stable during the inflation surge that started last year and have drifted back to pre-pandemic lows around 2% lately. A key market measure of expected CPI inflation over the next two years has declined dramatically since March, falling from nearly 5.0% to 2.3% this week.
With recessionary conditions spreading in the U.S. economy, globally as well, and the Fed tightening liquidity conditions, it is a reasonable expectation that the trend of decelerating inflation will continue in the months ahead. But the critical uncertainty is how fast inflation will retreat to the Fed’s objective of 2%. Our assessment is that the end-game should be coming into view by next spring. Inflation itself is currently disrupting consumer spending by diminishing the purchasing power of consumer incomes and forcing households to prioritize spending on essential goods and services, prominent among them food and energy. With inflation receding slowly, that pinch on consumer spending will continue for several more months. By spring the Fed will have raised the Fed Funds rate to a level that will constitute a stringent restraint on demand, the effects best exemplified by rising mortgage rates that are already suppressing the residential housing market. Our expectation is that the deceleration in inflation picks up steam in the spring and approaches the Fed’s 2% objective at a more rapid pace by summer.
The risk that the Fed will push too hard, overdoing its demand restraint tactics and drive the U.S. economy into a more severe recession than we currently expect is a significant reality. Our assessment is that liquidity conditions are already tighter than generally appreciated and that recessionary conditions are upon us, whether it turns out to be a mild recession or an episode of stagflation. The Fed’s stealth tightening program of portfolio roll-off, known as quantitative tightening, shrinking its asset portfolio by non-reinvestment of maturities, is contributing to diminished liquidity. With a moderate-to-severe recession spreading in Europe due to energy disruptions from the conflict in Ukraine, and China struggling to escape from COVID lockdowns, global demand is turning softer and will have a disinflationary impact on a number of commodities and consumer goods prices.
Our expectation at this point is that the probability the Fed will thread the needle fairly adroitly next spring, easing back on the tightening cycle as inflation rates gather downward momentum, is more likely than the less favorable scenario in which the Fed hits the brakes too hard.
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