Does the Fed’s policy work?
An in-depth analysis of the US central bank's monetary policy and its implications on growth and the labor market by Jeffrey Cleveland, Chief economist of Payden & Rygel.
The FOMC hiked rates again at its July meeting , bringing the Fed Funds range to 5.25-5.50%. Furthermore, Fed Chairman Jerome Powell kept the door open for possible further hikes as early as September if inflation does not ease. Many investors believe that the Fed is now over its rate-hiking cycle, while some critics argue that it has gone too far. Still others wonder if the Fed's run-up to the 2% inflation target is wrong. At Payden & Rygel we disagree with the critics and believe more rate hikes are on the way.
THE DEBATE ON THE TRANSMISSION OF THE FED'S RESTRICTIVE POLICY
As expected, at its July meeting that ended on the 26th afternoon, the FOMC raised its policy rate target to 5.25-5.50%, the highest Fed Funds rate in over 22 years. Fed Chairman Jerome Powell, speaking to reporters gathered after the decision, kept all the Fed's options open, as "the process of getting inflation back to 2% has a long way to go," so the Fed "will continue to make decisions meeting by meeting,” he said. Powell acknowledged that “it will take some time for the full extent of our monetary tightening to be felt,” but believes it is still too early to say with certainty that 5.25-5.50% will mark the peak in rates. In fact, the Fed Chairman said that the next two reports on jobs and the CPI, along with a lot of data on economic activity, will need to be examined before making a decision. A decision that could mean another hike in September or the maintenance of the current level. However, many bond investors are incredulous, as the bond market expects rate cuts starting early 2024, and no further rate hikes in 2023. The conventional wisdom, which believes the Fed's job is now done, is that inflation is progressing towards the 2% target and, therefore, there is no need to 'tighten too much'.
We acknowledge that the core CPI has indeed experienced impressive disinflation over the past year, peaking at 6.6% year-on-year in September 2022 and ending June with a reading of 4.8%. Even more impressive is the fact that “disinflation” occurred while the unemployment rate remained near cycle lows, a feat that many investors, commentators and economic historians thought was “impossible”. However, even at around 5%, inflation is well above the Fed's target. Also, other indicators of underlying inflation have not cooled as much as the core CPI. Core PCE, the Fed's preferred measure, has fallen just 0.6 percentage points, from 5.2% to 4.6%, over the past eight months.
On the other hand, critics argue that once the “lagged effects of monetary policy tightening” kick in, inflation will come down, suggesting that the Fed may have already gone too far in tightening monetary policy and that further rate hikes would make no sense at all. In our view, we are already seeing the effects of the Fed's tightening campaign and therefore should not expect the much-vaunted textbook “delays”. One example above all: mortgage rates. The latter soared in the spring of 2022, as the Fed began its tightening cycle by signaling that it would soon make several rate hikes. But once they reached their peak in the summer of 2022, mortgage rates have been hovering close to current levels for a year now, suggesting that the housing shock is behind us.
We are not the only ones to think so. Fed Governor Christopher Waller gave a speech shortly before the FOMC meeting titled "Why Policy Delays May Be Shorter Than You Think." In his speech, the governor underlined, in fact, “If we believe that most of the effects of last year's tightening have already passed through the economy, we cannot expect a further slowdown in demand and inflation from this tightening. In my view, this means that the tightening policy we have conducted this year has been appropriate and that further tightening will be needed to bring inflation back to our 2% target. Pausing rate hikes now, waiting for long and variable delays, could leave you standing on the platform waiting for a train that has already left the station.”
THE IMPORTANCE OF THE 2% TARGET
Other critics of Fed policy believe that the 2% inflation target is not a goal worth pursuing, especially if the cost of reaching the coveted 2% is a softer labor market. Why not choose 3% or 4%? Would that be such a bad choice?
Jerome Powell reiterated the Fed's commitment to 2% in his press conference on Wednesday July 26, saying the Fed "remains committed to returning inflation to our 2% target and keeping inflation expectations well anchored for the long term." term". Powell added: "Whatever the short-term social costs of keeping inflation in check (eg higher unemployment), the long-term social costs of not doing so are greater." Indeed, we believe that 2% inflation is much better than 4% for the average consumer and investor. And this is because inflation erodes the purchasing power of income. If inflation were to persist at 4%, the value of paychecks (or the purchasing power of the income generated by a bond portfolio) would halve in just 17 years, compared to 35 years at a rate of 2%. To compensate for the losses due to inflation, it would be necessary to get paid much more and create higher portfolio returns.
Oddly, bond investors rooting for the Fed to raise its inflation target seem willing to trade fewer rate hikes (and potentially better total bond returns) in the near term for a greater erosion of government power. buying, higher inflation expectations and, therefore, higher interest rates in the long run – a bad deal, in our view. Currently, market-implied inflation expectations, a key element in constructing long-term interest rates, hover around 2%. If the Fed were to settle for 3-4% inflation instead, inflation expectations and interest rates would have to adjust accordingly. It's worth noting that 2% is not an arbitrary target. In contrast, 2% is roughly the average annual rate of core PCE inflation over the period spanning the modern Fed, i.e. 1993 onwards, and including the inflation targeting regime. Period nicknamed “the Great Moderation” and characterized by fewer downturns in the economic cycle and better macroeconomic results.
Where is all this taking us? With the unemployment rate at the same level as when the Fed began its hike campaign last March (3.6%), growth which continues to hover around 2% in the first half of the year and inflation of well above the Fed's target, we believe the central bank is not done raising interest rates. We expect another 25 basis point rate hike in the fall, admitting it could come sooner based on economic data over the next eight weeks. And with the economy remaining solid after more than 500 basis points of rate hikes, it's premature to say that the Fed has gone too far. Financial conditions have eased in 2023. If inflation doesn't subside or accelerate again in the second half of the year, the Fed won't want to sit still, to quote Waller. Finally, it is unlikely to expect a change to the Fed's 2% target any time soon, nor would we want to see one.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/funziona-la-politica-della-fed/ on Sat, 05 Aug 2023 05:49:24 +0000.