On My Mind: Listen to the man

Federal Reserve (Fed) Chairman Jerome Powell delivered a very hawkish press conference after the Federal Open Market Committee (FOMC) raised interest rates by another 50 basis points (bps) in December; financial markets did not buy it.

Powell came into this press conference with two favorable inflation prints in his pocket: the headline Consumer Price Index (CPI) slowed to 7.1% in November from 7.7% in October and 8.2% in September. The November 0.1% month-on-month reading was especially encouraging. Powell noted the improvement, but his tone was very sober and pragmatic. To paraphrase:

• The Fed has already raised rates by 425 bps this year, moving policy into restrictive territory. It makes sense now to slow the pace of hikes to “feel its way” to the optimal peak rate.
• Inflation is moving in the right direction, which is encouraging, but…
• …getting closer to target will take a long time and more policy effort. Goods prices are correcting and housing inflation will slow as new, lower rental contracts feed into the index. But, Powell stressed that the bulk of inflation, that is non-housing core services inflation, is linked to still strong wage growth supported by a labor market which remains “substantially out of balance.” This, the Fed expects, will take a significant amount of time to cool off.
• Therefore, a strong majority of the FOMC now expects to have to bring the policy interest rate above 5%, and to have to hold it there for a substantial period, until they can feel sufficiently confident that inflation is coming down to target in a sustained manner.

This all makes perfect sense. It’s a very sensible policy approach, predicated on a very pragmatic read of economic trends. The problem is markets have a substantially more bullish view than the Fed. Powell is well aware of this—and that he contributed to this problem with some dovish-sounding statements in a recent speech at Brookings—and tried to push against it with an impressive barrage of hawkish points:

• The FOMC has repeatedly raised its estimate of the peak fed funds rate for the last several Summary of Economic Projections (SEP) revisions, and might do so again;
• Monetary policy is not yet restrictive enough;
• The historical record warns strongly against loosening policy prematurely; and Powell stressed that the Fed’s “dot plot” does not envision any rate cuts in 2023—against market expectations of 50 bps in rate cuts;
• The Fed has made less progress than it thought on inflation and is therefore ending 2022 with higher inflation than it anticipated;
• Core inflation is still running at 6%, three times the Fed’s target, and there is not much progress in getting the labor market to cool down and wage growth to slow.

In sum, Powell did all he reasonably could to sound hawkish. Financial markets were unimpressed; after the FOMC meeting, the 10-year US Treasury yield ended lower, the US dollar weakened and equities rallied.

I have noted in previous comments that the Fed has a credibility problem, given that over the past decade and a half it has conditioned markets to expect monetary policy to always support asset prices. Investors have been conditioned into a fear of missing out on a rally at any encouraging datapoint or soundbite. The December FOMC press conference confirmed just how serious the Fed’s credibility problem is.

It’s hard to fault the Fed’s current stance. The only way to overcome this credibility problem would probably be to go overboard on tightening—but that would imply risking a deep(er) recession, something that the Fed is understandably reluctant to do.

The obvious complication is that as financial markets express their total disbelief in the Fed’s rhetoric, they drive financial conditions looser. This will make it harder for the Fed to bring inflation back to target—which in turn makes it even more necessary for the Fed to do what it says it will do; that is, bring rates above 5% and keep them there for longer than the market expects.

To me, the Fed’s read of the economy and inflation outlook seem broadly right (though still optimistic on inflation): the economy remains resilient; there are only tentative signs of weakening in the labor market; and wage growth, core and “sticky” inflation measures are running persistently around 6%. Interest rates across the maturity spectrum are still below current inflation. Bringing inflation down to target will be a hard slog, and the risk of inflation getting entrenched at about 4%-5% is still real. Raising the policy rate above 5% and keeping it there for a while seems quite a realistic view of the kind of policy trajectory that can help achieve the inflation target. But investors no longer believe in a hawkish Fed.

Financial markets seem to have gone from “don’t fight the Fed” to “don’t believe the Fed.” This might turn out to be a self-defeating prophecy. It is most likely a recipe for a lot more volatility.