Are markets right to doubt the Fed?

Last week a slew of Federal Reserve officials stuck to the script on the path for monetary policy this year, pushing back against market expectations for rate cuts in the second half of 2023.

In December, the FOMC set out a hawkish set of interest rate projections, with the median forecast showing a Fed Funds rate of 5.25% by the end of this year. However, projected rates from seven officials would end this year even higher than that, with two people calling for an upper bound of 5.75%. All the Fed officials who spoke publicly last week have made it clear that they still believe that rates will need to rise above 5%, in line with the 5.25% median forecast, although there are some differences of opinion starting to emerge about the pace of the increments going forward.

James Bullard, considered a hawk, has said he is open to another 50bp hike at the end-January meeting, as he would prefer to get to a “restrictive” zone as quickly as possible. However, several other policy makers have indicated that they would prefer to slow the pace of tightening to take into account new data as it emerges. 

The most recent economic data does indicate that the tighter monetary policy over the last nine months is starting to have the desired impact on the economy.  Inflation in December slowed to 6.5% y/y from a peak of 9.1% in June and declined outright on a m/m basis for the first time since May 2020. Much of the softening in price pressures was due to lower fuel prices. Core inflation, which strips out volatile food and energy prices, still rose 0.3% m/m. 

Looking ahead though, key contributors to services inflation such as housing and medical care services are expected to ease in the coming months, and provided there are no new supply shocks, energy and commodity price inflation will slow off last year’s high base. There is also evidence that supply-chain related price pressures are easing.

More broadly, demand does appear to be slowing in the US. Industrial and manufacturing data showed a decline in output and activity at the end of last year and consumer spending is also under pressure with retail sales falling 1.1% m/m in December. US banks reported in their Q4 earnings calls that more consumers are drawing down their savings and increasing their use of credit cards. The banks have increased their provisions as they expect economic conditions to worsen. 

With the economy evidently deteriorating and inflation likely to slow in the coming months, the question then is why Fed officials are still sounding so hawkish. The first thing to note is that while lower than it was a few months ago, inflation is still well above the Fed’s 2% target. Even if inflation falls to 3.0% as most analysts expect by the end of this year, that will be higher than many policy makers will be comfortable with.

The second issue is the strength of the US labour market and wage growth. Unemployment fell to its pre-pandemic low of 3.5% in December and average hourly earnings remain well above the 3% that the Fed says is consistent with 2% inflation.  For these reasons alone, officials are likely to stress that they need to remain vigilant, even as inflation slows, and that rates will likely need to rise further.

Perhaps the main reason for the hawkish jawboning by policymakers over the last week however, is that they don’t want financial conditions to ease too quickly.  The January equity rally and the two rate cuts already priced in for the second half of this year have contributed to some easing in financial conditions and if the trend continues, it could undermine the Fed’s efforts to rein in demand.

Officials are likely to keep pushing back against expectations of monetary policy easing until they are ready to deliver it. However, if the economic data continues to worsen, unemployment moves above 4% and inflation slows as expected, then the Fed will likely change its tune.      

This article was published in The National on 24 January.