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The Fed still thinks that inflation is only temporary

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Good morning. The Fed’s day turned out to be rather dull, mostly going as expected. But we still think that many observers are misinterpreting Federal Reserve policy and misinterpreting what the Open Market Committee is saying. It’s not that the Fed is being tactless; it’s that some are ignoring the literal meaning of its claims, which suggests that the “Powell pivot” as a tactical correction by the Fed is indeed still very dovish.

Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

‘Temporary’ in all but name

The most surprising part of the Fed’s quiet December meeting was the news – delivered in a notorious “dot plot” – that monetary policy committee members expected three hikes. interest rates next year, instead of twice the consensus is called.

Even this does not frighten anyone. In fact, the stock market was pleased with a happy one or two percent gain. Policy-sensitive yields on two-year Treasury notes were flat. Yields for 5-year and 10-year forwards are up a few basis points. The US central bank’s communications strategy seems to be working perfectly.

Some observers see the committee’s higher interest rate expectations, as well as a faster pace of asset purchases than expected, as signs the Fed has been forced to drastically change its approach. Here’s BlackRock’s Rick Rieder:

“However, we suggest, as we have been doing for months now, that this is what it looks like when the Fed is running behind the curve and needs to catch up with the rapidly changing events in practice. ”

One sell-side strategist thinks the rapid cuts show the Fed is investing in its “temporary” narrative:

“Inflation has clearly passed what could be considered a transient, and the Fed acknowledges that by accelerating the pace of reduction in asset purchases.”

Another strategist echoed the idea:

“The notion that higher inflation would be temporary has finally been dismissed by the Fed.”

It is true that the dot plot, the chart of central banks’ expectations for future rate hikes, clearly shows that the Fed has its eye on higher rates sooner. Here’s the plot from September onwards:

And here is the new plot:

But this is a tactic, not a strategy. As has been announced, the Fed acknowledges that short-term interest rates will need to rise slightly to protect against persistent inflation. That is evident in the dots 2022 and 2023. But the median forecast for the rate in 2024 is only marginally higher, from 1.75% to just over 2%. Longer running dots are preserved.

It is essentially a very clear fact that the committee considers, with great consensus, that a short cycle of rate hikes, as high as 2.5%, will ensure that inflation is temporary. The committee’s median forecast is for consumer spending inflation in 2022 to be 2.6%, and it is unanimously agreed that in 2023 it will be just above 2%.

That is, inflation above target will last about a year. Everyone let’s say together now: temporary! The Fed withdrew the word, but it still thinks the same way.

As we argued before, the bond market wholeheartedly agreed with the Fed’s attitude. Five-year inflation indexes, after trending downward this month, have floated near 2.7%. And the interest rate futures market is actually more dovish than the Fed: it thinks the rate hike cycle will fall below 2%.

The yield curve is flat zero, like some people argued, the wrong prediction was too late, the Fed’s over-tightening. It predicts that the US central bank can contain inflation easily.

As our friend and competitor John Authers at Bloomberg shown On Wednesday, both consumers and the majority of money managers agreed with the bond market that inflation would not last. The only market signal that could suggest the opposite is foresight tech stocks, which have seen a massive sell-off (although they did rise on Wednesday).

One explanation for this is that they are very sensitive to exchange rates and are anticipating long-term appreciation. However, another explanation is that they were trading at stupid prices and the stupidity has dwindled.

Even if the Fed achieves a 2% interest rate policy, that would constitute a very mild policy tightening, as Jim Caron of Morgan Stanley points out:

“The Fed signals a neutral policy move in 2024 with no tightening. . . The 2024 backed funds rate averaged 2.125% versus core PCE inflation at 2.125%. So [a] the real policy rate is 0% by 2024.”

Fed Chairman Jay Powell’s unwavering attitude to his rhetoric was evident in his press conference following the FOMC meeting on Wednesday, where he expressed grave concerns about the labor market. and participation rates in particular. This is not a man who sees the US economy stabilizing at strong post-pandemic levels.

The Fed’s forecast for real gross domestic product in 2024 and beyond is unattractive. It could even trend higher, given weak productivity growth and struggling demographics.

After inflation subsides, the new “new normal” will likely look a lot like the old “new normal,” which has worried people in the years leading up to the pandemic.

The Fed, the bond market, consumers and money managers can all be wrong that inflation is unlikely to last (we at Unhedged are not smart enough to predict inflation). But don’t be confused by the Fed’s change of terminology.

Everyone, from Powell down, is betting on the interim. If the bet loses, it will be very bad. (Wu and Armstrong)

A good read

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