By Howard Schneider
WASHINGTON (Reuters) – The Federal Reserve’s hawkish message on inflation was quickly felt in U.S. housing markets this summer as mortgage rates soared and home sales slowed.
But it was the only significant and expected adjustment in an economy that faced the most aggressive monetary policy shift from the US central bank in a generation with a relative shrug.
Stock prices on major indices have jumped more than 15% since June; businesses created around half a million jobs in July; the premium investors demand to hold the lowest-rated corporate debt, an indicator of general risk sentiment, has fallen and issuance of “junk bonds” is rising after falling in July.
For a central bank whose influence on the economy comes through financial markets, this was evidence of potential struggles yet to come.
“The Fed is really fighting a battle of sentiment right now…trying to prepare the markets for the idea that they have more wood to cut” to curb a spike in inflation not seen in 40 years, Andrew Patterson said, senior international economist at Vanguard. “The market reaction is a bit premature.”
Since March, the Fed has carried out the steepest series of interest rate hikes in decades. Its key rate had been set near zero since March 2020 to combat the economic impact of the pandemic, but a price spike that began last year caused the central bank to reverse the trend in a bid to maintain the inflation to its annual target of 2%.
The first hike – a 25 basis point move – was the standard increase in recent years, but was raised to half a percentage point in May, followed by increases of 75 basis points in June and July. With a range now fixed between 2.25% and 2.50%, the fed funds rate is already in line with the peak reached during the last hike cycle which ended in mid-2019, reaching this point in seven months this time against 38 months then.
Chart: Financial conditions are easing https://graphics.reuters.com/USA-FED/ECONOMY/zjpqkbnkgpx/chart.png
“DON’T CHANGE MY ANALYSIS”
All in all, it’s the furiousest crunch pace since the early 1980s.
Yet for more than a month, a Chicago Fed index made up of 105 measures of credit, risk and leverage has been falling, the opposite of what one would expect in a world primed by surprise central bank rate hikes and tighter borrowing conditions.
Markets linked to the Fed’s key rate now see it peaking between 3.50% and 3.75%, with cuts beginning next July due to a possible recession or a slump in inflation.
Either premise is risky, with economic data and language from Fed officials pointing to a more protracted fight against inflation and openness to allow for at least a modest recession along the way.
If investors see even a cursory slowdown as likely to trigger rate cuts, Fed officials are not making that promise.
“Whether we’re technically in a recession or not doesn’t change my analysis,” Minneapolis Fed President Neel Kashkari said last week. “I’m focused on the inflation data” and the need to keep raising rates until they’re snuffed out, said Kashkari, who published a blunt essay in May “I was wrong about the inflation”.
The past few weeks have delivered the first positive inflation surprises after more than a year in which Fed officials have seen prices soar with a persistence that caught them off guard.
Yet even with these early signals that inflation may have peaked, consumer prices still rose 8.5% year-on-year in July. Another inflation target from the Fed remains surprisingly above the central bank’s 2% target.
Other developments show that much of the Fed’s work is yet to come, which officials have tried to make clear.
‘HUGE DISTANCE TO CLOSE’
The easing of financial conditions is itself worrying. If businesses, banks and households do not respond as expected to the higher rates the Fed has already signaled, they could continue to borrow, lend and spend at levels that keep inflation high – and force the Fed to use even tougher drugs.
“It’s financial conditions, including interest rates, that affect spending and the degree to which the economy slows down,” said John Roberts, a former one of the Fed’s top macroeconomic analysts. “So to the extent that financial terms are easier given the funds rate, then the funds rate should do more.”
July’s gain of 528,000 jobs, coupled with strong wage increases and lagging productivity, shows businesses are still racing to meet demand, even as the Fed has signaled its intention to cut demand to fight inflation. The ratio of vacancies to unemployed remains historically skewed at nearly two to one, although it has declined somewhat in recent months.
There is disagreement on how much unemployment may need to rise to control inflation. Policymakers presented technical and qualitative arguments as to why they might be able to defeat inflation this time by curbing only “excess” demand for workers without a sharp rise in unemployment, and cuts in spending, demand and price pressures that go along with that.
Chart: Job vacancies/unemployment ratio in the United States https://graphics.reuters.com/USA-ECONOMY/JOLTS/lbvgnarwbpq/chart.png
But Fed officials largely agree that the current unemployment rate of 3.5% is above the level consistent with full employment and will likely rise.
An unresolved question is how much unemployment Fed policymakers would tolerate to nullify each further increase in inflation, and whether there is a red line for unemployment that they would not cross.
This may be next year’s battle.
Fed officials often note that the economy is slow to adjust to changes in monetary policy, which, quoting US economist Milton Friedman, operate with “long and variable lags”.
“There is likely … significant additional tightening in the pipeline,” based on currently anticipated rate hikes, Fed Chairman Jerome Powell said last month.
It is unclear whether this will be enough to bring down inflation, but according to some calculations, there is a long way to go.
David Beckworth, an economist and senior fellow at George Mason University’s Mercatus Center, estimates the Fed needs to mop up about $1 trillion in excess spending. If he is to do so without a deep recession, that means keeping pressure on credit markets until 2024, a longer horizon than many U.S. markets expect.
“It’s a huge distance to go,” Beckworth said. “We had a month of slightly falling inflation… If you want to get down to 2% in a stable way that doesn’t generate mass unemployment, it has to be a long process.”
Chart: Frequency of unemployment rates https://graphics.Reuters.com/USA-FED/JOBS/gdpzymnnavw/chart.png
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)