“It’s a very special tango that we’re dancing here,” said Torsten Slok, chief economist at Apollo Global Management. “On the one hand, the Fed must certainly be very pleased with the fall in inflation. But they don’t want the markets to complicate the rate at which we’re going down.”
The battle between the Fed and the markets ultimately bodes well for President Joe Biden and Congress because it suggests that the US may be at the end of its war against this wave of inflation. But the conflict underscores the Fed’s tricky position: while it retains broad support from both political parties for its price-cutting campaign, it also angers many Americans, including some lawmakers and labor activists, who complain that higher interest rates are the easy charging people unfairly and that the Fed is desperate to create a recession.
Markets are hoping for a pause in mid-year rate hikes followed by rate cuts in the near future, but Fed officials are signaling they are determined to keep the economy firmly in hand through the end of 2023.
Even amid signs of slowing wage growth and cooling spikes in prices, policymakers such as San Francisco Fed President Mary Daly and Atlanta Fed President Raphael Bostic have warned over the past week that the fight against inflation is yet to come is not over. In a dour news conference last month, Powell said financial market conditions must reflect the Fed’s “political dovishness.” And the central bank’s rate-setting committee stressed that “unwarranted” market optimism in the form of higher prices and lower bond yields could hamper their attempts to lower inflation.
Thursday’s consumer price index showed a fall not only in inflation but also in overall prices in December, thanks in particular to falling gas prices. But the annual inflation rate is still several times above the Fed’s 2 percent target. Prices rose 6.5 percent last year versus 7.1 percent in November, driven by rising rents.
But as new data continues to show a steady decline from a peak of 9.1 percent last June, markets will rightly assess that we are nearing the end of the Fed’s rate hike campaign. But that’s only as long as stocks don’t soar and bond yields don’t fall enough to reignite spending.
“I’ve spent enough time on Wall Street to know that they’re cultural, institutional and optimistic,” Minneapolis Fed President Neel Kashkari told the New York Times. “You’re going to lose the chicken game, I can tell you that.”
The crux of the discrepancy is this: Investors expect inflation to fall faster than the Fed is forecasting, giving the central bank leeway not only to halt its rate hikes soon, but also to start cutting rates later this year.
Fed policymakers, meanwhile, have gone out of their way to say they don’t expect to cut rates from grueling levels in 2023. They have forecast that their policy rate will be above 5 percent at least by the end of the year, three-quarters of a percentage point higher than now.
But “talking is cheap,” said Mark Cabana, head of US rates strategy at Bank of America Global Research. He argued that the Fed should instead explicitly set unemployment and inflation thresholds that would trigger rate cuts.
“If you’re not willing to write it down, you don’t have credibility,” he said.
The ground could also shift significantly under Powell’s feet later this year. The job market has held up remarkably well given the rapid rise in borrowing costs – unemployment fell to 3.5 percent last month, the lowest level in more than half a century. But that could change as rate hikes have more time to permeate the economy and weigh more on spending.
That could actually be a case for the central bank to speed up the final leg of its rate hikes, said Derek Tang, an economist at research firm LH Meyer Monetary Policy Analytics.
“There is a window for rate hikes, and it’s closing fairly quickly given how likely the job market is to weaken,” Tang said. “At that point, much of the support for rate hikes will start to evaporate.” If they really feel they need to hit that peak 5.1 percent rate, they might want to do so while having the full support of [Fed’s rate-setting] committee but also the public to do so.”
Another lurking threat: the non-zero possibility that Congress will not approve a debt ceiling hike before the government runs out of money, causing it to default on some of its obligations. Cabana said this would shock markets and also lead to a sudden fall in government spending.
“It’s bad for the economy,” he said. “What is the Fed doing in these circumstances? You can’t be so sure you won’t cut rates in 2023.”
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