The Fed stands firm; remains “patient”

Stephen Miller

As was largely anticipated the Fed’s Federal Open Market Committee (FOMC) decided to leave the policy rate target unchanged at 4.25-4.50 per cent when it met overnight. In its statement accompanying the decision the Fed downplayed the Q1 negative GDP print suggesting that idiosyncratic factors associated with a surge in imports accounted for that negative print and further that “recent indicators suggest that economic activity has continued to expand at a solid pace.” The statement added that the “unemployment rate has stabilised at a low level in recent months, and labor market conditions remain solid.” And further that “inflation remains somewhat elevated.”

Significantly, the Fed added that “uncertainty about the economic outlook has increased further” and that the Fed “is attentive to the risks to both sides of its dual mandate and judges that the risks of higher unemployment and higher inflation have risen.”  The decision to leave the policy rate unchanged suggests the Fed is worried that a “stagflation-lite” scenario is confronting the US economy.

In his press conference, Fed Chair Powell, while noting the uncertainties ahead, seemed to indicate that he thought the economy was still in good shape, noting strong private final sales despite the negative Q1 GDP print, and low and stable unemployment. In that context, he thought that meant that the Fed could be “patient” before contemplating cuts to the policy rate.

In some ways it appears that the Fed is concerned at repeating the mistakes of the 1970s “stagflation-heavy” environment where a premature easing of monetary policy, while inflation remained elevated, led to an extended period of economic dislocation, including high inflation, low growth and high unemployment. While the current period is some distance from the 1970s experience, the lesson nevertheless is that it is not best practice to accommodate supply shocks, even if they are expected to be transient. The notion of “transitory” inflation is that it doesn’t change wage and price setting behaviour. The current Fed is concerned that the “tariff shock” unleashed by the Trump Administration will lead to elevated inflation and expectations thereof, and it is that fact that has led the Fed to leave the policy rate unchanged at the overnight meeting, and the Fed Chair articulate “patience” in contemplating further policy rate cuts, even if there is some risk ahead of subdued growth and a shift upward in unemployment.

Even if it cannot influence supply levers in the economy (a point made by Chair Powell in his press conference), by failing to incorporate supply shocks associated with tariffs in its monetary policy framework, central banks can magnify and perpetuate the inflationary damage such shocks can inflict. Any delay in articulating a coherent and firm response to an inflation threat only heightens the risks down the track of a more damaging macroeconomic dislocation in terms of employment and activity.

The recent pandemic experience (as well as the 1970s experience) showed that “transitory” inflation elements can persist for longer than policymakers assume.  Further that experience will heighten the risk that inflation expectations reman elevated in the wake of price increases motivated by tariffs. Structural currents on inflation are also running in an adverse direction as price pressures are reinforced by the retreat of globalisation of goods markets as governments everywhere (including successive US Administrations) introduce protectionist measures (tariffs) under the specious guise of “industrial policy” and “national champions” or “national security”.

Immigration restrictions and the exit of baby-boomers from the workforce will also add to inflation pressures via higher wage growth, absent any offsetting productivity improvements. When Donald Trump became US President for a second time the prospects of a US recession in 2025 were small, but not non-trivial. Despite Chair Powell’s sanguinity regarding current conditions, some three months into Trump’s term, the risk of recession seems to me to be more likely than not. (Polymarket has the odds at a little above 50 per cent.) And were it to come to pass, the US authorities are less well-equipped to deal with a recession than they have been for some time.

In the past quiescent inflation has allowed the Fed to respond swiftly to downdrafts in growth. In the current environment, however, “sticky” inflation has robbed the Fed of the flexibility to quickly cut rates, a flexibilty that it enjoyed in the two decades or more leading up to the pandemic.  And with a budget deficit approaching 7 per cent of GDP fiscal policy is close to maxed out.  Financial markets appeared to be buoyed by Powell’s assertion that the economy is currently holding up relatively well despite uncertainty and the challenges ahead.  I fear that markets are overly complacent.

RBA to cut by 25 bps. Retain optionality for the future even if there are more cuts to come

 The March quarter consumer price index (CPI) was a good enough result for a 25 bp policy rate cut at the next RBA meeting on May 19-20, but that is about it. The trimmed-mean result at 2.7 per cent was bang on the RBA projection and recall RBA Governor, Michele Bullock, was at pains to quash any notion that the April rate cut was necessarily the start of a sequence of rate cuts at each successive RBA meeting. It may be but the Governor wants to give herself and the Board maximum optionality for future RBA Board meetings.

In that sense, expectations in some quarters for a 50bp policy rate cut seem “a bridge too far”. That said, the upending of the global trade system occasioned by the Trump Administration’s tariff agenda will more likely than not see a global recession by year-end.  That prospect, combined with perhaps some “over-achievement” on inflation relative to the current RBA projection, may mean that we do get successive policy rate reductions at future RBA Board meetings despite the understandable unwillingness of the Governor to pre-commit to such a path. 

Australia’s eschewal of retaliatory tariff measures may give the RBA a less complicated path to attacking the consequences of a global trade war.  The absence of retaliatory measures will mean a mitigation of the inflation part of the global “stagflation-lite” scenario, allowing the RBA to cut rates and, if need be, to cut aggressively to forestall the inevitable decline in economic growth. So, the RBA will almost definitely cut the policy rate in May. Further, given the prospect of the RBA “over-achieving” on inflation, combined with the likelihood of global recession, it could well be that the policy rate has a “2” handle by year-end. Just don’t expect the Governor to indicate that in her May press conference.

Bank of England to cut 25bps

As with the RBA, the Bank of England finds itself with a little more flexibility to respond to the upending of the global trade system occasioned by the Trump Administration’s tariff agenda given the UK government’s eschewal of retaliatory measures. This means that a 25bp reduction when the Bank of England meets tonight is an almost certainty. Moreover, there is a widespread expectation that the Bank will indicate that more rate cuts are coming. In one sense that is understandable given the prospect of a global recession this year, or at least anemic global growth. But in another sense, one wonders whether any precommitment on the part of the BoE is premature. 

Headline inflation, at 2.6 per cent, is well north of the 2 per cent target. Core inflation even more so at 3.4 per cent. Wages growth remains elevated at close to 6 per cent and with productivity challenges inflation may well prove “sticky”. Unemployment has been surprisingly resilient at 4.4 per cent. So, one wonders why the rush to precommitment.

Nevertheless, the view from the BoE seemed to be that with policy already “restrictive”, and activity conditions challenging and made especially more so by trade disruption, the outlook is such as to warrant sufficient confidence that inflation will return to target even with some easing in monetary policy. There is an argument that the inflation proclivities of the UK economy should mean only a very cautious withdrawal of “restrictive” monetary conditions.

Those proclivities include:

• Stronger worker resistance to real wage erosion. 
• Ongoing disruptions to external trading relations post-Brexit that have slowed supply chains and a lower degree of internal economic flexibility leading to productivity challenges.  
• Limited government effort toward supply-side enhancement.  

The latter two points were in large measure a consequence of the mismanagement of Brexit. The BoE was also complicit in the UK’s relatively poor inflation performance, early in the piece exhibiting not a small amount of prevarication in assuming a frontline role in fighting inflation.  And while the market’s sense of multiple cuts this calendar year is plausible – even likely – such an action may leave inflation (and expectations thereof) at an elevated level and the inflation target lacking credibility, with negative implications for future UK economic performance.