A rock and a hard place
Will the Federal Reserve pivot from its fight against inflation?
Published March 24 2023
Bottom Line
At its policy-setting meeting on Wednesday, the Federal Reserve orchestrated its ninth consecutive interest rate hike in its ongoing battle to reverse the worst inflation in the U.S. economy in more than 40 years. That quarter-point hike brought the fed funds rate to a target range of 4.75% to 5.00%, its highest level since September 2007.
Amid the financial-market turmoil that has arisen over the past three weeks, however, the Fed finds itself in a very delicate position. Does the central bank continue to execute its plan to hike rates at its next meeting on May 3—and perhaps beyond—to bring the fed funds rate to a level above still-elevated inflation before pausing, as it’s done in every rate-hiking cycle for the past half century? Or does it pivot to an easier monetary policy soon—as the market believes—to help quell the growing concerns of possible banking-industry contagion?
Inflation still too high Nominal retail CPI inflation spiked from 1.4% y/y in January 2021 to a 41-year high of 9.1% in June 2022, but it has since fallen to 6.0% in February 2023. Core CPI (which excludes food and energy prices) declined from a 40-year high of 6.6% last September to 5.5% in February. The Personal Consumption Expenditures (PCE) index similarly declined from a 41-year peak of 7.0% last June on a nominal y/y basis to 5.4% in January, and February is expected to decline further to 5.1%. The core PCE, which is the Fed’s preferred measure of inflation, has declined from a 39-year peak of 5.4% in February 2022 to 4.7% in January 2023. February is expected to remain unchanged at 4.7%, while the Fed’s target for this metric is at 2.0%. Inflation clearly peaked last year and is starting to recede, but it’s sticky and persistent, suggesting that the Fed’s continued hawkishness on Wednesday was the right decision.
SEP update: slower growth, higher unemployment & lower inflation The Fed published the quarterly update of its Summary of Economic Projections (SEP) on Wednesday, in which it forecast that core PCE inflation would fall to 3.6% by the end of this year, to 2.6% by the end of 2024, and to 2.1% by the end of 2025. By the Fed’s own projections, then, it may be nearly three years before it has successfully slayed the inflation dragon.
The Fed also reduced its forecast for real GDP from 0.5% to 0.4% in 2023 and from 1.6% to 1.2% in 2024. Its forecast for the unemployment rate (currently at 3.6% in February 2023) is for an increase to 4.5% in 2023 and to 4.6% in 2024. The central bank is expecting to execute another quarter-point rate hike on May 3, at which point it expects to pause into 2024. The Fed expects to change course and cut interest rates three times next year, probably in the back half. So, in the Fed’s mind, the Phillips’ Curve trade-off between inflation and unemployment appears to be alive and well.
Financial markets disagree Investors, however, believe that the Fed’s expected May 3 hike will be its last, followed immediately by six consecutive rate cuts into next year. Fed Chair Jay Powell attempted to throw cold water on this idea during his post-meeting press conference, suggesting that the Fed may continue hiking interest rates on June 14 and beyond, if strong economic data persists, and that the Fed has no plans to cut interest rates before next year at the earliest. But the financial markets clearly do not believe him.
Bank lending is slowing Part of the problem is that banks have begun to tighten lending standards for households and businesses and reduce lending, which could slow economic growth. Chair Powell conceded that tightening financial conditions could have the same impact as another quarter-point rate hike—or possibly more—from the Fed. So, under the circumstances, if the Fed has perhaps one or two more rate hikes up its sleeve in coming months, does it fully appreciate that reduced bank lending could achieve the same tightening effect, potentially making Wednesday’s hike its last?
Fear of recession Benchmark 10-year Treasury yields have enjoyed a powerful flight-to-safety rally, falling from 4.09% on March 2 to 3.37% today. Two-year Treasuries plunged from 5.08% on March 8 to of 3.73% this week. So, the important 2/10 yield-curve inversion, historically a reliable recession indicator, has shrunk dramatically from more than 100 basis points three weeks ago to only 35 basis points today. The S&P 500 has declined by about 4% over the past three weeks, extending the equity market’s decline since it’s overbought peak at 4,195 on February 2 to about 7%. Given growing concerns about inflation, Fed policy, shrinking corporate profits, the risk of a bank-industry contagion and the debt-ceiling stalemate, we continue to believe that stocks could retest their mid-October low at about 3,500 in coming quarters.
Yellen flip-flops Another concern for investors is the seeming inconsistency in messaging regarding government policy on how to best handle the current situation. Treasury Secretary Janet Yellen experienced her own “hold my beer” moment during her testimony before the Senate Banking committee on Wednesday. During his FOMC presser, Powell said that the government could guarantee deposits above the FDIC’s $250,000 insurance limit if necessary to stem a banking crisis, as they did with Silicon Valley Bank. But at the same time in her Senate meeting, Yellen said that Treasury was not considering such action. The next day, however, in her testimony before the House Financial Services committee on the same topic, Yellen reversed herself and said that she would consider guaranteeing all deposits. So, which is it, and how should investors model this potential moral hazard? Has the Fed, Treasury, the FDIC and the White House actually met to craft a coordinated plan?
Not our Bear Stearns moment We do not believe that the forced closures of Silicon Valley and Signature banks, as well as the shotgun marriage between Credit Suisse and UBS in Switzerland, are reminiscent of the global financial crisis during 2008. Rather, we believe that these were company-specific one-offs, marked by poor management decisions and the absence of adequate risk controls. As a result, we believe that the equity market is hyperventilating and overreacting. The Fed was correct, in our view, to continue to fight the good fight against inflation rather than abruptly pivot to rate cuts due to the financial markets’ perception of a growing banking crisis. The Fed should continue to execute its vigilant plan to stuff the inflation genie back in its bottle, rather than succumb to the financial market’s siren call.