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Federal Reserve Chair Jerome Powell caused a stir in financial markets on Wednesday when he said rate hikes would eventually slow and that he would refrain from “clear guidance” on the path for future rate hikes. That contributed to Wednesday’s powerful rally in stocks and bonds, with the Nasdaq Composite Index posting its biggest jump since April 2020. The funny thing is that Powell was actually giving quite a bit of foresight in his press conference following the Fed’s interest rate decision — traders just chose to ignore it.
Why should financial markets celebrate these comments at all? It’s complicated, but the general idea is that the Fed isn’t as committed to higher interest rates as initially thought. It is open to policy design as the data dictates. Of course, the Fed has a dual mandate to encourage maximum employment and stable prices, and US economic expansion is clearly at a crossroads. Of course, some investors think that incoming data on a slowing economy could deter the Fed from tightening further.
But that is misguided. On Wednesday, after raising interest rates by 75 basis points, Powell said he believes stable prices are a prerequisite for the economy and jobs to thrive over the long term. With inflation at a 40-year high and unemployment at just 3.6%, it is clear that fighting inflation is and will remain a priority for the foreseeable future.
But how much will the Fed hike rates to meet its targets? One clue Powell gave on Wednesday was that policymakers’ estimates released in June’s Summary of Economic Projections (SEP) remained “broadly consistent” with the Fed’s current thinking on targeting interest rates. These estimates showed that the median estimate by Federal Reserve Board members and Federal Reserve Bank Governors for the end of 2023 was a policy rate of 3.8%. That’s significantly higher than the 2.85% that fed funds futures markets are currently implying after Wednesday’s rally. Here is the full Powell quote:
We will be guided by the data. And I think you can still think of the target as broadly in line with the SEP in June because it’s only six weeks old. And sometimes SEPs can get old really fast. I think this is probably the best guide we have in terms of where the committee thinks it needs to be at the end of the year and then next year. I would point that out to you.
The other key piece of guidance Powell provided was an insight into his views on the labor market, and that too was far more restrictive than market participants seem to understand. For at least the second time since May, Powell said he believes the natural unemployment rate — the rate associated with stable prices, below which inflation comes under more pressure — may have risen. “I would say it must have moved up significantly,” he said.
Although the variable is very theoretical and difficult to observe in real time, it is a crucial component of how economists think about inflation and the course of interest rates. Economists who have studied the matter believe the matching function in the labor market may have broken down during the pandemic as the economy shifted from services to goods, people moved geographically and some workers continued to be impacted by Covid-19 concerns were restricted. Anna Wong, US chief economist at Bloomberg Economics, thinks this shift in terms of the natural unemployment rate is enough to suggest that the Fed may now need to raise the federal funds rate to as high as 5% in mid-2023. Powell seemed to confirm this call with his last remarks on the subject.
All in all, it’s clear that equity and bond markets displayed some selective listening on Wednesday. Powell’s decision to drop forward guidance could ultimately be a smart move. That means the Fed won’t get caught in a path in a challenging moment with many confusing cross-currents in economic data. Nor will they risk hurting their credibility by saying something they can’t take.
Before the Federal Open Market Committee meets again on September 20-21 to vote on monetary policy, it will be presented with two CPI reports and two unemployment reports, which could well change its assessment of the circumstances. Unfortunately, the inflation problem remains of such concern that the Fed cannot possibly rein in its aggressiveness as much as markets seem to be implying. So ending forward guidance as a formal strategy is a sensible decision and if Wednesday’s events show anything, markets aren’t listening very closely anyway.
More from other authors at Bloomberg Opinion:
• Are interest rates neutral? The markets hope so: Mohamed El-Erian
• Why the Federal Reserve should stay open: editorial
• Do you think the Fed hasn’t done enough? Think again: Nir Kaissar
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the US, covering finance, markets and M&A. Most recently, he was the company’s Miami office manager. He is a CFA charterholder.
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