Stephen Miller
In what looks to have been a finely balanced decision, the US Federal Reserve’s (Fed) Federal Open Markets Committee (FOMC) opted to increase the policy rate target by 25 basis points (bps) to an upper limit of 5 per cent. At the same time, however, the Fed was careful to present an ongoing vigilance in its efforts to tame inflation. Other things equal that would suggest some likelihood of a future policy rate increase, subject to the return of some semblance of stability in the global financial system.
In its Summary of Economic Projections, the median “dot plot” projects a policy rate at 5.1 per cent by end-2023, unchanged from the 5.1 per cent projected in December. The end-2024 projection was revised upwards to 4.3 per cent from 4.1 per cent.
The decision to hike 25 bps (rather than 50bps) and the unchanged the “dot plot” probably reflects some tightening of credit conditions as a consequence of recent banking upheaval. Chair Powell revealed that the Committee had indeed discussed a pause in the rate cycle but the consensus for an increase was strong, with data showing “inflation pressures continue to run high.”
Powell added that the US banking system is sound and resilient. The clear implication is that the Fed sees inflation as a bigger growth threat than the upheaval in the banking sector.
Inflation as measured by the core private consumption expenditures (PCE) deflator was revised slightly upwards to 3.6 per cent by end-2023, from 3.5 per cent projected in December.
Gross domestic product (GDP) growth for 2023 was revised modestly down to 0.4 per cent from 0.5 per cent in December, while the unemployment rate was revised down to 4.5 per cent from 4.6 per cent.
Such projections are not inconsistent with a shallow recession. That said, markets have appeared to have been on a recession footing for much of the last 15 months despite incoming economic data frustrating the more dire prognostications of substantial dislocations to economic activity growth and employment and an attendant sharp decline in inflation.
The Fed’s retention of its “hawkish” disposition is indicated by references that suggest “inflation remains elevated” and “anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 per cent over time.” Chair Powell added in his press conference that he would focus on the words ‘may’ and ‘some’. He added that Fed officials don’t expect rate cuts this year, although markets persist in pricing such cuts even those bets have been tempered a little following the Fed’s decision.
The “hawkish” disposition and upwardly revised “dot plot” and inflation forecasts come after the release of consumer price index (CPI) inflation data revealing at best only grudging progress in the fight against inflation, while activity and labour market data are consistent with ongoing resilience in the US economy.
The annual core CPI inflation rate is at a still elevated 5.5 per cent.
More importantly any progress in vanquishing inflation is barely perceptible in recent measures of the ‘inflation pulse’.
The 3-month annualised core CPI was 5.2 per cent in February, up from 4.6 per cent in January and what was a 15-month low of 4.3 per cent in December. Similarly, the Cleveland Fed trimmed-mean measure rose to 6.3 per cent in February, up from 5.8 per cent in January and what was a 16-month low of 5.2 per cent in December.
The big question regarding future inflation has been over the trajectory of services inflation. Progress on that front is less than the Fed would have hoped to achieve. The 3-month annualised services inflation rose to 7.5 per cent in February from 7.2 per cent in January. The 12-month change in the closely watched services ex-shelter component fell marginally in February, but remains elevated at 6.9 per cent.
It was the “stickiness” in services inflation that has kept the FOMC its moderately a hawkish tack even in the face of recent banking upheaval.
The bond market, however, looks to be pricing a scenario that is located at one end of the risk spectrum.
At this stage I’d conjecture at least one more increment in the policy rate taking the upper limit to 5.25 per cent.
Further, in my view markets are too dismissive of the Fed “higher for longer” outlook.
Of course, recession remains the big question. In terms of commentary, recession talk was around for much of 2022, particularly in the second half of that year when the Fed embarked on four successive 75bp policy rate increments. As mentioned, the Fed’s GDP projection is not inconsistent with a shallow recession.
Thus far, the data has not validated that recession view, particularly given the labour market’s extraordinary resilience and even the latest Atlanta Fed GDP “nowcast” has first quarter GDP growing at a respectable 3.2 per cent after 2.7 per cent in Q4 2022 and 3.2 per cent in Q3 2022.
Of course, that was prior to the upheavals in the banking system that have dominated the financial headlines in the last couple of weeks. No doubt those events will involve a de-facto tightening of credit conditions. That has certainly tempered the Fed’s pre-existing policy rate path.
However, as former US Treasury Secretary Larry Summers commented last week, the slowing of credit is not nearly as much as the amount of Fed tightening that has now been removed from market pricing. He added that reacting too strongly to the banking situation by taking policy rate increases off the table would have matters worse as economic agents came to believe “that if the Fed was scared, they should be as well.” Furthermore, an apparent diminution in the Fed’s resolve to contain inflation may cause a surge in inflation expectations. That might mean that too rapid a turn in the Fed’s approach could “both raise inflation expectations and contract the economy.”
In that sense, last night’s 25bps increase in the policy rate, combined with a stated ongoing vigilance with respect to inflation strikes the appropriate balance. As mentioned, that it is not inconsistent with an end to the tightening cycle before the middle of the year.
However, that also implies some further upside to US (and global) bond yields.
Coming up: Bank of England to hike 25bps
As with the Fed, the Bank of England (the BoE) must weigh up the balance between stubborn inflation and upheaval in the global banking system.
However, partially reflecting some policy missteps earlier through 2022 the BoE (like the RBA) is not as well-placed as the Fed in terms of inflation. That was underscored overnight with the release of February inflation numbers that showed an acceleration of inflation well ahead of market expectations.
The CPI came in at 10.4 per cent in February from 10.1 per cent in January and against an expected 9.9 per cent. The core measure came in at 6.2 per cent from 5.8 per cent in January and well ahead of the market expectation around 5.7 per cent.
Like the Fed, the Bank of England will likely increase the policy rate by 25bps to 4.25 per cent, but the magnitude of the miss on inflation suggests that a 50bp increase might be on the table. It is likely, however, that the banking upheaval makes that a bridge too far.
Nevertheless, it seems clear that more policy rate hikes are likely than not, especially if the banking landscape settles.
Like the RBA the BoE has on occasion prevaricated in its commitment to the containment of inflation and like the RBA, and in part reflecting that prevarication, it faces an increasingly intractable inflation problem.