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Welcome back. One of the hard things about this job is that some days it feels it is all about the Federal Reserve. On days with Fed meetings, at least you can admit it.
Think I’m reading Fed’s actions all wrong? Email me: firstname.lastname@example.org
The Fed did a very good job
The job of the US central bank stinks right now. Inflation is above target, employment is below target and asset prices are very high. Whatever worries its officials have about setting the right monetary policy for optimising jobs and prices, precipitous stock, bond and real estate values represent a third nasty risk to the US economy.
If the Fed tightens policy soon because it is worried about inflation, policymakers risk cracking asset prices, which could kill the economic momentum. If they let inflation run because they care more about employment, they risk inflating an asset bubble certain to pop later, creating a recession in the style of 2001 or 2008. Not fun.
Coming into this week’s Federal Open Market Committee meeting, the financial markets expected the Fed to absolutely nail this balance — to bet on inflation subsiding, and to win. The expectation seems to be that interest rates will increase only in a long while and just a little bit, economic growth will remain healthy, asset prices will rise moderately and there will be peace in the kingdom, Amen.
A few indicators of the market’s confidence in the Fed’s precision and good fortune:
Stock indices, while they have been moving broadly sideways for two months, are moving sideways at their all-time highs in prices and near all-time highs in valuations;
Bond yields (an admittedly imperfect indicator) have not responded to hot inflation data;
The run-up in bank stocks, perhaps the companies most positively correlated with inflation and rising rates, has topped out;
Market-derived expectations for inflation from 2026-31 (the “five-year five-year”) seem to have stabilised at about 2.25 per cent in the past month or so. Fed data:
Market expectations for the timing and number of rates rises has been growing more dovish for a few months. A chart from Morgan Stanley:
The Vix, a measure of expected volatility derived from options markets, keeps on hitting post-pandemic lows:
A report from Mark Haefele of UBS Global Wealth Management a few weeks ago summed up the market sentiment perfectly:
“With the Fed handling any policy transition with care, we think global equities should continue to receive support in their next leg-up amid accelerating earnings and economic growth.”
Boy, that sounds nice.
To sustain those kinds of expectations, while at the same time maintaining their credibility by demonstrating that they take the inflation data seriously, Jay Powell and his merry band had to get the message just right. It looks like they did.
The language in yesterday’s statement was all but identical to the one from April, excepting a little verbiage about where we are with the virus. Policy, and the official outlook for future policy, are unchanged.
The dot plots, which show where individual FOMC members expect monetary policy to go, moved up for 2022 and 2023:
The significance of this is that the mean committee member’s expectation is for two rate increases in 2023, more than expected. The committee’s average core inflation expectations for this year also rose sharply, from 2 per cent to 3 per cent, which looked hawkish, too.
So has the Fed changed its stance? Is it leaning hawkish now? In his press conference after the two-day FOMC meeting, Powell said that the Fed was “talking about talking about” tapering its asset purchases, but emphatically not actually talking about it yet. And he played down the significance of the dots:
These are of course individual projections, they’re not a committee forecast, they’re not a plan, and we did not actually have a discussion of whether lift off is appropriate at any particular year. Because discussing lift off now would be highly premature, it wouldn’t make any sense . . . the dots are not a great forecaster of future rate moves and that’s because it’s so highly uncertain, there is no great forecaster of future rates, so [the] dots have to be taken with a big grain of salt.
This threads the needle. The dot plot and inflation expectation averages demonstrate that the committee members are not blind. They see the data and adjust their expectations. But the statement and Powell’s comments tell you that as a group they are sticking with their bet. Inflation looks transitory, and for the bit of the future that can be foreseen, monetary policy does not need to change.
Both pundits and the market responded with a bit of a wobble initially. The S&P 500 fell 1 per cent. Five-year Treasury yields hopped. Before the press conference, Aberdeen Standard economist James McCann summed up the mood:
This is not what the market expected. The Fed is now signalling that rates will need to rise sooner and faster, with their forecast suggesting two hikes in 2023. This change in stance jars a little with the Fed’s recent claims that the recent spike in inflation is temporary. If price volatility is temporary then there’s no obvious reason why they need to raise rates sooner than planned, especially with the labour market having disappointed of late.
But by the end of the day stocks, at least, had clawed back most of those losses. Tomorrow may bring a different consensus, but it seems to me the Fed did as well as it could have against high expectations and a difficult economic set up.
For what little it may be worth, my own guess is that the Fed will win its inflation bet, for the simple-minded reason that the price spikes I see are in things that one would expect to spike after a pandemic. Hence my argument about lumber prices yesterday (which to my amusement Powell more or less repeated on Wednesday). Lumber is theoretically linked to easy monetary and fiscal policy, by way of hot housing demand. But a closer look at lumber’s particular supply/demand issues shows how pandemic specific they are, and prices are rolling over now, as you would expect.
I am more worried about a growth disappointment than inflation, given what is priced into markets and the coming deceleration in fiscal stimulus and the money supply.
My confidence about these guesses? Low, and I hope the FOMC feels the same way. As Powell said yesterday: “Forecasters have a lot to be humble about; it’s a highly uncertain business.”
One good read
In The New Yorker, a review of a new book on the history of charts and graphs, with lots of good examples of how the right illustration can be the difference between seeing the truth and missing it.