Fed: probably not but probably should – will that test the bond market’s patience?
Stephen Miller
The Federal Reserve’s policy rate setting Federal Open Market Committee (FOMC) meets next week.
At this point markets do not see much chance of a policy rate increase with market-based probability reckonings at some 15 per cent. That probability rises to some 75 per cent by the time the next Fed FOMC meeting concludes on December 9th.
I comprehend that probability based on what we’ve heard from various Fed spokespeople and Fed Chair Warsh, but I wonder if it might be more appropriate to again increase the policy rate at the October meeting.
Warsh has made much of his commitment to price stability and returning inflation (as measured by the core private consumption expenditures (PCE) price index) back to the 2 per cent target.
There is a danger that too great a delay in “living” that commitment to price stability dents the Fed’s credibility which would ultimately make the process of returning inflation to target that much more difficult.
Those credibility doubts might have played some role in the recent increase in bond yields. (Clearly a number of other factors were also important.)
In any case, inflation (core PCE) has not been close to the Fed target since March 2021. As we know that was a period when the world was emerging from the worst of the pandemic.
At the time the Fed (and most other developed country central banks) thought the post pandemic inflation surge “transitory”.
It wasn’t.
I fear that the Fed is in danger of repeating that mistake with the current oil price surge.
By the end of June oil prices were almost in touch with their pre-Iran conflict levels. Since that time, they are up almost 50 per cent!
Now the Fed can’t control the price of oil and nor should it seek to. But the lesson from the 1970s oil shock was that central banks should not accommodate such shocks. The big mistake that central banks made back then was a premature retreat from an inflation focus. By failing to adequately temper inflation expectations, central banks “let the inflation genie out of the bottle”. The end result was the painful, but necessarily harsh Volcker medicine of the late 1970s / early 1980s which saw overnight rates in the US (fleetingly) approach 20 per cent.
Of course, the current circumstance is not one that is quantitatively anywhere near on a par with 1970s. But there are elements that are redolent of that time, albeit on a substantially reduced scale.
The September PCE is released on October 29th. Unhelpfully that is a day after the Fed’s FOMC meeting concludes.
Given what we know about prices in September from the US CPI and PPI releases the core PCE is likely to accelerate a little to 3.1 per cent – still some way north of the target.
I think therefore that the Fed should probably increase the policy rate at next week’s meeting.
Fed Chair Warsh has stated that achieving both sides of a dual (inflation / labour market) mandate does not mean that monetary policy necessarily works at cross-purposes since high inflation itself is very harmful to economic prosperity and the labour market.
In that context, the best that the Fed can do to ensure maximum employment in the medium-term is to ensure a low and stable rate of inflation.
The widespread discontent with cost-of-living and its consequences are manifest across the developed world (think France or the US mid-terms).
To some extent this is the outcome of a propensity to “kick the inflation can down the road” as central bankers and governments avoided addressing inflation / cost-of-living issues in the interests of short-term political expediency.
In my view, that experience should tip the balance toward a further policy rate increase but I don’t think that the FOMC is at that point where it will raise the policy rate in October.
That may exercise the patience of the long end of an already skittish bond market as doubts emerge over just how much commitment the Fed has to price stability.
UK CPI (almost certainly) means a November rate increase
The UK September consumer price index was just troubling enough to ensure a policy rate increase when the Bank of England (BoE) meets on November 5th.
The inflation data were a tad higher than expected with the September headline and core annual rates at 3.5 per cent and 2.8 per cent respectively (compared with expectations of 3.4 per cent and 2.7 per cent respectively). Services inflation remains “sticky” at 3.7 per cent.
That the September employment and unemployment reports released earlier in the week indicated some resilience in the labour market eases the risk that some BoE Monetary Policy Committee members may harbour regarding the fallout from a rate hike on the labour market.
In some ways the Bank of England calculus is similar to that faced by the RBA.
Despite the more positive signs for the labour market in September, it seems the UK economy is in a state of cyclical fragility, and the UK also has somewhat of a structural inflation proclivity. In some ways, the inattention to structural elements has been more egregious than that attaching to Australia and in that context it is surprising that inflation has at the margin been better behaved. That may be attributable to a greater cyclical fragility.
In any case, inflation remains well north of the 2 per cent target and the September report reinforces a widely-held view that the BoE will increase the policy rate by 25 basis points to 4 per cent at the November meeting.
Such a move won’t surprise the markets.
By Stephen Miller, investment strategist
