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As the Fed warns of impending turbulence, markets unbuckle their seatbelts

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August 15, 202216 minutes ago5 minutes read Join the conversation

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WASHINGTON – The Federal Reserve’s dovish message on inflation was quickly registered in US housing markets this summer as mortgage rates soared and home sales fell.

But that was the only prominent and expected adjustment in an economy that has seen the most aggressive change in US Federal Reserve policy in a generation with a relative shrug.

Share prices in the major indices have risen by more than 15% since June; Businesses added about half a million jobs in July; The premium that investors charge to hold the lowest-rated corporate bonds, an indicator of risk appetite in general, has declined and junk bond issuance is picking up after falling in July.

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For a central bank whose influence on the economy transcends financial markets, this was a testament to potential struggles ahead.

“The Fed is really waging a morale war right now… trying to prime markets for the idea that they have more wood to chop” in an attempt to stem an inflationary outburst unseen in 40 years, said Andrew Patterson, senior international economist at Vanguard. “The market reaction is a little premature.”

Since March, the Fed has carried out its sharpest interest rate hikes in decades. Its policy rate had been kept close to zero since March 2020 to combat the economic impact of the pandemic, but a price hike that started last year prompted the central bank to reverse course in a bid to keep inflation at its 2% target for the year .

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The first increase – a 25 basis point increase – was the standard increase for the last few years, but increased to half a percentage point in May and then to 75 basis points in June and July. With a range now set between 2.25% and 2.50%, the Federal Funds Rate is already hitting the peak seen in the last hiking cycle, which ended in mid-2019, and is reaching that point in seven months this time, down from 38 months.


All in all, it’s the most furious pace of tightening since the early 1980s.

But for over a month a Chicago Fed Index of 105 measures of credit, risk and leverage has been falling, the opposite of what one would expect in a world braced for surprises from central bank rate hikes and tighter credit conditions .

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Markets, which are pegged to the Fed’s interest rate, are now seeing a high of between 3.50% and 3.75%, with cuts beginning next July due to a possible recession or collapse in inflation.

Both assumptions are risky, as both economic data and Fed official language point to a protracted fight against inflation and an openness to allowing at least a modest recession along the way.

When investors take a downturn, even a slight one, as rate cuts, Fed officials don’t make that promise.

“Whether or not we’re technically in a recession doesn’t change my analysis,” Minneapolis Fed President Neel Kashkari said last week. “My focus is on the inflation data” and the need to keep raising rates until they choke, said Kashkari, who published an outspoken “I’m mistaken about inflation” essay in May.

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Recent weeks have delivered the first upside surprises in inflation after more than a year in which Fed officials watched prices rise with a persistence that caught them flat-footed.

But even with these early signs that inflation may have peaked, consumer prices still rose 8.5% yoy in July. Another inflation measure targeted by the Fed remains worryingly above the central bank’s 2% target.

Other developments show that most of the Fed’s work may still lie ahead, something officials have been trying to make clear.


The easing of financing conditions is itself a problem. If companies, banks and households don’t react as expected to the higher interest rates the Fed has already announced, they may continue to borrow, lend and spend at levels that keep inflation elevated – and demand that the Fed that she uses even harder drugs.

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“It’s financial conditions, including interest rates, that are affecting spending and the degree of slack in the economy,” said John Roberts, formerly one of the Fed’s top macroeconomic analysts. “So to the extent that the funding terms are easier given the funds rate, the funds rate would have to do more.”

July’s 528,000 job gains, coupled with strong wage increases and sluggish productivity, show companies are still trying to meet demand, even as the Fed says it intends to trim demand to fight inflation . The vacancy-to-unemployment ratio remains historically skewed at nearly two to one, although it has fallen somewhat in recent months.

There is disagreement about how far unemployment may need to rise https://www.piie.com/publications/policy-briefs/bad-news-fed-beveridge-space to control inflation. Policymakers have provided technical and qualitative arguments https://www.federalreserve.gov/econres/notes/feds-notes/what-does-the-beveridge-curve-tell-us-about-the-likelihood-of-a – soft-landing-20220729.htm why they might be able to beat inflation this time around just by curbing the ‘excess’ demand for labor without reducing unemployment and the concomitant decline in spending, demand and price pressures.

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But Fed officials are largely in agreement that the current unemployment rate of 3.5% is above levels consistent with full employment and is likely to rise.

One question left unaddressed is how much unemployment Fed policy would tolerate to quell any additional inflationary spurt, and whether there is an unemployment redline that they would not cross.

That could be next year’s fight.

Fed officials often find that the economy is slow to adjust to changes in monetary policy, which they quote American economist Milton Friedman as operating with “long and variable lags.”

“There’s likely…significant additional tightening in the pipeline,” Fed Chair Jerome Powell said on the basis of currently expected rate hikes over the past month.

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Whether that will be enough to bring down inflation is unclear, but according to some calculations there is still a long way to go.

David Beckworth, an economist and senior research fellow at George Mason University’s Mercatus Center, estimates that the Fed needs to squeeze out about $1 trillion in excess spending. If it wants to do that without a sharp recession, that means keeping credit markets under pressure until 2024, a longer horizon than many in US markets are anticipating.

“It’s a huge distance to close,” Beckworth said. “We’ve had a month with a slight fall in inflation numbers… If you want to get down to 2% in a stable way without creating mass unemployment, it’s going to have to be a long process.”

(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)

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