Stephen Miller
Federal Open Market Committee (FOMC) increases the policy rate by 25bps – Fed ‘dot plot’ now better aligned with aggressive market expectations. Quantitative tightening (QT) to be announced at a subsequent meeting
As was widely anticipated, the US The Federal Reserve’s (the Fed) FOMC announced overnight an increase in the policy rate by 25bps to 0.50 per cent. In so doing the Fed signalled via a revised ‘dot plot’ a more aggressive approach to policy rate increases than it had previously countenanced.
That revised schedule of policy rate increases, however, simply better aligns the Fed with prevailing market expectations of the pace of policy rate increases.
The newly issued Fed ‘dot plot’ revealed that at 12 of 16 officials see at least six policy rate increases this year. This compares with the December ‘dot plot’ where 12 officials saw just least three rate rises in that year.
The central tendency now has a policy rate of 1.9 per cent by end 2022 and 2.3 per cent by end 2023, compared with 0.9 per cent and 1.6 per cent back in December and just 0.3 per cent and 1.0 per cent back in September. That should not have been unexpected given that magnitude, persistence and momentum in inflation has consistently surprised the Fed, a circumstance only likely to be amplified by the sharp increase in commodity prices in the wake of the Russia / Ukraine conflict.
The FOMC also flagged a reduction in its balance sheet through QT, noting that it would reduce its holdings of Treasury securities and agency debt and agency mortgage-backed securities, although left the details for another meeting.
Having largely met the “maximum employment” mandate (albeit assisted by a low of labour force participation rate), it now appears that the Fed is focussing its guns on inflation.
The Fed, like the bond market, has been tardy in its appreciation of the new inflation realities and equivalently tardy in its withdrawal if stimulus.
The median projection from the Fed for its preferred core personal consumption expenditures (PCE) measure of inflation is now 4.1 per cent in 2022 and 2.6 per cent in 2023, up from the 2.7 per cent and 2.3 per cent forecast in December, and comes despite the sharply revised policy rate projection.
Fed projections for both real gross domestic product (GDP) and unemployment for end-2022 were 2.8 per cent and 3.5 per cent respectively (December forecasts were 4.0 per cent and 3.5 per cent).
Inflation momentum still strong
The greater Fed focus on inflation may be a case of better late than never.
Of course, that focus has been given greater impetus by the commodity price spike in the wake of the Russia / Ukraine conflict.
Inflation as measured by the February consumer price index (CPI) was at its highest level since 1982. Wage inflation is also on the march with wage growth now over 5 per cent and clear labour shortages emerging as evidenced by the existence of over 11 million job vacancies reported by the US Labor Department’s Job Openings and Labor Turnover (JOLT) survey. That should see even higher rates of wage increases.
The magnitude, persistence, and momentum in inflation remains challenging. US inflation was already showing stubborn persistence before the Russia / Ukraine conflict erupted.
Sophisticated measures of ‘underlying’ inflation, such as the Cleveland Federal Reserve median and trimmed-mean measures, show a smooth and undiminished acceleration in three-month annualised measures of the ‘inflation pulse’ from as far back as late 2020. Currently these measures are above 6 per cent (closer to 7 per cent in the case of the trimmed-mean measure).
Yet for much of 2021 the Fed maintained a narrative centred on ‘transitory’ price pressures.
However, it is now clear that it was not just energy and other commodity prices in the wake of the Russia / Ukraine conflict and supply chain blockages attendant on the pandemic that were behind the re-emergence of inflation.
Other factors were at work including the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (after the fall of the Berlin Wall and the ‘export’ of labour from large emerging market economies such as China and India) and baby boomer workforce participation. The latter is a factor, among others, behind the ‘Great Resignation’ phenomenon observed in the wake of the pandemic.
Also front and centre is the extended period of excessively accommodative monetary policy itself. Developed country central banks everywhere persisted with historically high levels of monetary accommodation even after it was clear that the economic dislocation wrought by the pandemic was not as great as initially feared.
Long dormant measures of inflation expectations – both survey based and market based – are on the rise. Inflation expectations have a habit of being self-fulfilling through its effect on wage and price setting behaviour. Companies feel more confident to increase prices because prices are going up everywhere while workers are naturally seeking higher wages, particularly in those areas of the economy where skill shortages are acute.
Adding to the mix is an increasing proclivity for governments to resort to protectionist policies and a renewed market-regulatory agenda in developed countries that, even if focussed on laudable objectives, inevitably add to price pressures.
Markets react to an inflation-fighting Fed
While the steepness of the policy rate path is possibly a little of a surprise, the overall ‘hawkish tilt’ should not be so surprising given the marked shift in the tone of Chairman of the Federal Reserve, Jerome Powell’s, commentary through 2022.
Markets initially reacted sharply to the Fed announcement with bond yields up and yield curve flattening with more pronounced increases in front-end yields. Perhaps in a nod to the Fed’s renewed inflation-fighting credentials, ‘break-even’ inflation rates also fell, and equities gave up intra-day gains.
A number of those moves reversed after the press conference from Chairman Powell with equities closing strongly on the day as Chairman Powell pointed to what he saw as the reliance of the economy to policy rate increases.
In the final analysis, that reaction was a long way short of the “tantrum” of the scale that followed former Fed Chair Bernanke’s “taper” announcement back in the May 2013. The key difference this time around is that such a move had been mostly telegraphed by current Fed Chairman Powell in contrast to the “drive-by” announcement from the then Fed Chair Bernanke back in May 2013.
Australian labour force
The Australian February labour force data to be released today is likely to reflect an ongoing tightening in labour market conditions. Consensus expectations are for an increase in employment of circa 40,000 and a further one tenth decline in the unemployment rate to 4.1 per cent.
Since the inception of the monthly labour force series, the unemployment rate has only touched 4.0 per cent on two occasions (February and August 2008). A number only slightly better than consensus could therefore raise the stakes for the Reserve Bank of Australia (RBA).
While maintaining a disposition toward ‘patience’ when it comes to retreating from highly accommodative monetary policy settings, the RBA has implicitly at least admitted the ‘plausibility’ of a policy rate rise in 2022.
A strong labour market report that indicates an unemployment rate tracking lower at a faster pace than anticipated by the RBA may hasten a shift in its rhetoric to one focussed more on combatting inflation. In much the same way as the Fed overnight this may see the RBA move toward a stance more in line with that currently priced by markets.
Under its ‘outcomes-based forward guidance’ the RBA requires the satisfaction of a number of inflationary indicators which leave it confident that inflation is ‘sustainably’ within its 2-3 per cent target band.
Important among those indicators is that wages growth is ‘sustainably’ at 3 per cent. The latter involves an unemployment rate at around 4 per cent. Arguably, CPI Inflation, as defined by the ‘underlying’ measures upon which the RBA appears focussed, is already sustainably within that 2-3 per cent band and the unemployment objective might well be exceeded in today’s release.
While wages growth, as measured by the Wage Price Index (WPI), is at 2.4 per cent, a way short of where the RBA might wish to see it. That measure itself suffers from a methodological inertia that arguably belies the true state of the labour market. For example, the private sector WPI that includes bonuses showed annual growth of 3.0 per cent – the highest rate of annual increase in eight years.
Measures that include bonuses are likely to be more pro-cyclical and more indicative of inflation currents than measures that exclude them. Meanwhile, there is quite widespread anecdotal evidence of accelerating – some would say overdue – wage growth.
Australia’s relatively benign starting point for inflation may mean that the pressures faced by the RBA in withdrawing stimulus are not as urgent as may exist elsewhere. However, a number of central banks, including the Fed, look to be behind the curve when it comes to the withdrawal of monetary stimulus. In this context, recent comments from RBA Governor Philip Lowe that appear to create more flexibility for the RBA to respond to satisfaction of ‘outcomes’ are sensible.
Current RBA forecasts are located on the downside end of the inflation risk continuum and, as such, a policy rate rise around mid-year is still tenable. A clear acceleration in the March quarter WPI released on 18 May 18 (along with a notable acceleration in other measures of wages growth) would further enhance that prospect, particularly if it follows another upward surprise in the CPI to be released on 27 April 27.
Both of those outcomes are within the realm of the probable and an increase in the policy rate in June is therefore possible.
Bank of England (BoE)
The BoE also meets tonight. Markets are certainly expecting a further increase in the policy rate from 0.25 per cent to 0.75 per cent and, like the Fed, for the Bank to foreshadow that further increases are in store. There is, however, a view that the Bank may wish to douse current market expectations that the policy rate could be as high as 2 per cent by year-end. To deliver such a ‘dovish’ rate rise would constitute a policy misstep.
In the first instance such communication fails to acknowledge that the Bank “doesn’t know what it doesn’t know” and opens the possibility that it may have to walk back such ‘dovish’ sentiments at a later date. BoE communication has already proved a difficult beast to fathom. In the current circumstances, the maintenance of maximum flexibility is a more judicious path than one that seeks to unnecessarily influence market pricing. Indeed, that was the mistake that the RBA made toward the end of 2021.
In the second instance, as in other developed countries, CPI inflation is at multi-decade highs and shows little sign of abatement. In that context, to presage a ‘pause’ now would seem inadvisable and compound the risks of the inflation genie getting out of the bottle (if it is not already so!).
By Stephen Miller, investment strategist