I’ll explain the Fed’s plans
The Fed appears determined to maintain sufficiently restrictive monetary and financial conditions until economic growth has fallen below its trend rate and unemployment has risen. Analysis by Stephen Dover, Head of Franklin Templeton Institute
In shipping, “last mile” refers to the final delivery point. In climbing, it refers to the most arduous part of the ascent to the summit. Regardless of the context, the last mile is the culmination of a noteworthy feat. In the context of fighting inflation, the “last mile” refers to achieving a central bank's inflation target in an effective and sustainable manner. For the Federal Reserve (Fed), which began tightening monetary policy in 2022, when inflation measured by the personal consumption expenditure index reached a peak of 5.8%, the last mile represents the challenge to bring the current rate of 3.7% up to the target of 2%.
As worthy as the goal may be, the last mile can come at a significant cost. Once you reach altitude, oxygen runs out and your muscles ache. In transportation, goods have to be transferred from larger trucks to smaller trucks, at considerable cost.
Does the same apply to monetary policy? Is the last mile really the most expensive part of the process of restoring price stability?
According to Fed Chairman Jerome Powell, the answer is most likely yes. If this is true, are the markets ready to face the difficulties that lie ahead? Based on current stock, bond and currency prices, the answer is probably negative.
The last mile seen by the Fed
Perhaps this year's biggest macroeconomic surprise has been how well the U.S. economy and job market have held up in the face of aggressive monetary tightening initiated by the Fed in early 2022. Despite ominous warnings from most economists, supported by classic “leading indicators” of recession – such as the inversion of the yield curve – the US economy has continued to thrive. If anything, growth has exceeded the trend level in the last two years. Job creation has outpaced labor force expansion, 1 pushing unemployment rates to their lowest levels in half a century.
The sustained growth and tensions on the labor market were accompanied by a decline in all inflation indicators (core, overall, consumer prices and wages). So why should the last mile, reaching the Fed's 2% inflation target, be painful?
This is an important question. Over the last year the Fed has consistently reiterated that a period of below-trend growth will be necessary to bring inflation back to target. In other words, the US central bank believes that for the disinflation process to reach the desired conclusion, some spare capacity must emerge in the economy and in particular in the labor market.
This idea is based on an apparent empirical regularity first described in a paper published in 1958 by New Zealand economist William Phillips. The “Phillips curve”, which takes its name from him, shows the presumed inverse relationship (trade-off) between inflation and the unemployment rate. In particular, when unemployment is very low inflation is high and rising; when unemployment is high, inflation generally decreases.
The fascination exerted by the Phillips curve on the Fed
Powell has clearly stated that achieving stably low inflation will likely require generating spare capacity in the economy. In a recent speech to the Economic Club of New York, the Fed Chairman emphasized that:
the data suggests that a sustainable return to our 2% inflation target will likely require a period of below-trend growth and further weakening of the labor market.
However, there are at least two curious aspects to this statement. First, there has been no statistically significant relationship between inflation and the unemployment rate in the United States over the past 65 years. This finding remains valid even when the time lag between unemployment and inflation is taken into account or when the gap between actual unemployment and its estimated equilibrium rate is used.
Second, as noted above, Powell's statement appears to ignore the fact that US measures of core and headline inflation, as well as wage inflation, have all fallen sharply over the past 12 months without a period of markedly lower growth to the trend, much less a significant increase in unemployment.
So why does the Fed insist that sustainably reaching its 2% inflation target will require below-trend growth and rising unemployment?
The Fed's reasoning is likely based on several factors.
- First, there is a widespread perception, to some extent supported by recently published data, that the decline in inflation is destined to slow down or even stop before reaching the 2% target. An element of particular concern in this regard is the persistent inflation of core services, excluding rents.
- Second, although wage inflation has slowed, its current pace of 4.4% (average hourly earnings) or 4.3% (based on the Employment Cost Index) is considered above the level compatible with a core inflation of 2%. For example, if trend productivity growth is 1% per year (a reasonable estimate), wage (and benefit) inflation would need to decline by an additional percentage point to ensure price stability.
- Third, the Phillips curve could highlight a trade-off between inflation and unemployment when the latter falls below 4.5%. This is represented in the diagram by the best fit curve. If so, the last mile of the disinflation process may require an increase in the unemployment rate from its current level (3.7%). In fact, using regression techniques to measure the trade-off between inflation and the unemployment rate when the latter is lower than 4.5%, we can see that for every 0.1% increase in the unemployment rate, the rate core inflation on an annual basis measured on the Consumer Price Index (CPI) decreased by 0.3%.
- Finally, the Fed appears to have greater aversion to losses associated with above-target inflation, rather than excessive unemployment. In part, this stems from fears for its own long-term credibility. A persistent overshoot of the inflation target could lead to a rise in long-term inflation expectations, which could be costly to counteract. The Fed's asymmetric loss aversion may also reflect the harsh criticism leveled at it in 2021, when it suggested inflation would be "transient." The US central bank wants to avoid another misstep on the communications front.
Implications for markets
In summary, the Fed appears determined to maintain sufficiently restrictive monetary and financial conditions until economic growth has fallen below its trend rate and unemployment has risen. Furthermore, if these results do not materialize soon, the Fed appears ready to raise rates further.
Are these results consistent with current market expectations?
As for US and global stocks, the Fed's base case appears to refute prevailing earnings expectations. Corporate analysts raised their S&P 500 earnings growth forecasts for 2024 to 11.9%. 3 If growth were below trend next year, earnings growth would likely be nearly flat at best . If the economy enters a recession, earnings could even decline.
Bond yields have fallen recently, but remain a full percentage point above levels at the start of the year, supported by growth surprises and significant Treasury issuance. If U.S. economic growth begins to falter in the coming quarters, bond yields could fall further.
Finally, the US dollar appreciated significantly in 2023, supported by the high level of US bond yields and wide interest rate differentials relative to other countries. If the Fed wins, these two sources of support will disappear, causing a weakening of the greenback in 2024.
In summary, investors risk underestimating the Fed's determination to orchestrate below-trend economic growth and rising unemployment to reach its inflation target. We are likely to have a harder recession than expected. As a result, US stock markets and the US dollar appear vulnerable. The US Treasury curve, from zero to five years, reflects excessive optimism regarding the Fed's easing; In our view, rate cuts will likely occur later and more gradually than the market is currently anticipating. We believe that the long end of the yield curve (10 years and beyond), which is more sensitive to long-term growth, inflation and the financial implications of prolonged Fed tightening, is better valued given the likely downward pressure on medium-term growth and inflation expectations that derive from the Fed's determination.
The last mile is often the hardest. We hope that this adage does not result in a period of severe economic hardship as a result of US monetary policy, but we also know that hope is not a strategy. Investors may need to prepare for a difficult final climb.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/fed-ultimo-miglio-inflazione/ on Sun, 10 Dec 2023 06:57:40 +0000.