The US Federal Reserve (Fed) has capitulated to the data and in my view, has opened the door to a slightly more realistic assessment of the inflation and policy outlook.
Fed Chair Jerome Powell this week took the podium in a very weak position. The Fed had badly mismanaged communication ahead of this week’s Federal Open Market Committee (FOMC) meeting: it had telegraphed a 50 basis point (bp) hike but at the last minute signaled the larger 75 bp hike it then delivered—and which had therefore been largely priced in by markets. Upside surprises on headline Consumer Price Index (CPI) and inflation expectations had badly shaken the credibility of FOMC forecasts and of the moderate policy tightening that had been foreshadowed in last month’s meeting.
The FOMC outcome was a timely reminder that economic data eventually rule the day. In my view, the post-meeting press conference delivered a clear warning that investors should be prepared for further hawkish surprises. Powell acknowledged that the recent rise in inflation expectations had played a key role in swinging the decision to a larger hike. He acknowledged that the very tight labor market adds to inflation pressures via robust wage growth. He noted that the Fed is ultimately responsible for headline CPI inflation, and that headline inflation drives inflation expectations. The clear message is that the Fed is now—belatedly—aware that both inflation expectations and wages are adding to inflation pressures and sees inflation risks as skewed to the upside.
The FOMC’s median expectations of the policy rate have shifted up sharply, to 3.4% by the end of this year and 3.8% by the end of 2023. The end-2022 expected rate is now 150 basis points higher than at the March meeting.
Powell repeatedly emphasized the high level of economic uncertainty, in particular the important role that supply shocks outside of the Fed’s control can continue to exert on prices, and stressed that the Fed’s policy response will be data-dependent.
In a reversal of Mark Antony’s famous line “I come to bury Caesar, not to praise him,” Powell praised forward guidance while de facto burying it. The Fed wants to be transparent to investors in order not to add further volatility to markets, but in this case being transparent means that future policy moves will depend on data on which the Fed has very little visibility. This is a quite a momentous change. For over 10 years, major central banks have held markets by the hand with stone-clad forward guidance while claiming policy would be data-dependent. The inherent inconsistency and unsustainability of this combination has now come to the fore. Markets will need to adjust to this new reality.
While it will respond to data, the Fed recognizes it is still quite far from a neutral policy stance, and will need several months of declining inflation to be reassured that price pressures are coming back under control.
It’s a much more sober and realistic Fed than we have seen in previous meetings. Some of the criticisms and misgivings I expressed in previous writings still apply: inflation could easily end the year at 6%-7%, so that a 3.4% fed funds rate would still be deeply negative in real terms. At face value, the Fed’s forecasts still assume that inflation will come down on its own even as monetary policy remains expansionary. But this press conference has now signaled that the Fed could tighten more if inflation remains stubbornly high. I still find the Fed’s neutral rate estimate of the “mid-2s” to be way too low, but Powell to me this week sounded somewhat less confident of how reliable that estimate is.
Powell felt the need to reassure markets that he does not expect a 75 bp hike to become the norm. That sounded out of step with much of the rest of his comments. Consensus seems to be moving toward expectations of another 75 bps in July followed by hikes of 50 bps, 25 bps and 25 bps in the remaining policy meetings of this year. But I would caution that if inflation, wage growth and inflation expectations remain robust, the Fed’s “dot plot” could shift higher yet again and the actual policy tightening be more severe. I, in fact, see a significant chance that this could indeed be the case.
Overall, I think the Fed has taken an important step in the right direction. Acknowledging that policy will be driven by a very uncertain data flow gives a clear warning that policy tightening might get significantly more pronounced. I expect that data over the coming months will indeed point to the need for a greater degree of tightening, and market prices will need to adjust. But the Fed’s new stance should buy it greater credibility and help limit market volatility along a very challenging disinflation path.
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