The Federal Reserve Will Declare a Premature Victory Over Inflation
“When the time comes to raise interest rates, we’ll certainly do that, and that time, by the way, is no time soon.”
Federal Reserve Chairman, Jerome H. Powell, January 13, 2021
The Federal Reserve (Fed) created a monetary policy exit ramp at the Jackson Hole Economic Policy Symposium in August 2020 and they may be about to use it. Back then, the Fed formally agreed to a policy of “average inflation targeting,” meaning that it would allow inflation to run “moderately” above the 2% goal “for some time” following periods when it had run below that objective.
The challenge for investors is that the Fed cleverly didn’t provide much guidance on how hot it would allow inflation to run — or for how long. But we’re all about to find out.
Living with Inflation Above the 2% Target
Despite the Consumer Price Index (CPI) hitting 40-year records, the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Index excluding food and energy, has slowed each month since peaking in February, falling from 5.3% to 4.7%.1 The University of Michigan’s long-run consumer inflation expectations measure also slipped from 3.3% to 3.1%, easing fears that soaring inflation was becoming dangerously entrenched.
The Fed’s interest rate hikes in March, May, June and July — with more expected at future Federal Open Market Committee (FOMC) meetings — combined with slumping commodity prices, including for oil, will likely lead inflation barometers to fall further. Exactly the outcome the Fed desires — stable prices.
Figure 1: Conference Board US Leading Economic Indicators
Yet, despite the PCE Index’s recent deceleration, continued aftershocks from the global pandemic (i.e., supply chain bottlenecks, rising wages and skyrocketing rents), the Russia-Ukraine war and China’s unwillingness to ditch their zero-COVID policy will likely keep inflation above the Fed’s target.
Not so Fast — Dangerous Curve Ahead
Naturally, market participants expect the Fed to continue aggressively raising rates to defeat stubborn inflation. But for how long? Global manufacturing and services surveys continue to show a significant slowdown in economic growth. The US 2-year/10-year Treasury yield curve remains inverted — often a harbinger of recession.
Initial jobless claims have increased by 50% since early April, reaching 256,000 on July 28.2 The Federal Reserve Bank of Chicago’s National Activity Index suffered its first back-to-back negative readings since the start of the pandemic in early 2020. Housing data is falling off a cliff. US single-unit housing permits fell 8.0% month-over-month in June. Existing home sales declined 5.4% month-over-month.3 And, the National Association of Home Builders/Wells Fargo Housing Market Index plunged to 55 in July, to the lowest level since May 2020.4 The US economy is already in a technical recession, defined as two consecutive quarters of negative growth in real GDP.
As for the capital markets, the Fed isn’t concerned about a little volatility, especially with stocks. In fact, the Fed likely welcomes some air being let out of some of the more egregious portions of the everything bubble such as SPACs, NFTs and cryptocurrencies.
What the Fed Won’t Allow
There are, however, two things that the Fed cannot and will not tolerate. First, the Fed’s responses to crises from the Savings and Loans Crisis to the COVID-19 pandemic show that it will work to stop any disruption to the smooth functioning of the credit markets. The Fed also will combat a severe weakening of the labor market (i.e., surging job losses and a rapid increase in the unemployment rate) by quickly easing monetary policy.
The odds of one or both of these politically untenable threats occurring increase with each 0.75% increase in the target federal funds rate. As a result, despite inflation remaining above the 2% average inflation target, the Fed is going to need an exit strategy very soon.
Ironically, the Fed could use forward guidance at this year’s Jackson Hole Economic Policy Symposium in late August to signal that a higher post-pandemic inflation target is justified given the benign inflation environment of the previous decade. That’s how the Fed magically and prematurely declares victory over inflation — it simply moves the goalpost.
The Fed's Policy Dilemma
Investors eager to reach the end of the Fed’s monetary policy tightening cycle will celebrate by sending risk assets higher. Even as inflation decelerates, it will likely stay above the Fed’s 2% inflation target in the post-pandemic environment.
Still elevated inflation and a shrinking economy create a Catch-22 for the Fed. In the end, Chairman Powell is human — meaning he ultimately may revert to the path of least of resistance. Declare victory over inflation and keep interest rates artificially low to boost financial asset prices. And regrettably, Powell will have missed an opportunity to break the cycle of monetary policy leaders thinking the Fed could and should use its power over interest rates to produce desirable economic outcomes.
Figure 2: US Wealth Growth vs. US GDP Growth: Normalized, Base = 0
As the economic data worsens, I expect the Fed to adopt an increasingly flexible stance on the average inflation target. This isn’t the best outcome. It’s just the most likely one. By claiming a false victory over inflation and kicking the can further down the road, economic risks won’t stabilize, they will grow. Supported by monetary policy, household wealth cannot continue to grow at a greater rate than the economy. And, when the day of reckoning finally arrives, it will be much worse than it would have been had the Fed stuck with getting inflation under control in the first place.