Economic Commentary

Waiting for the Fed to pivot

There is little doubt that central banks in general, and the US Federal Reserve in particular, play a key role in driving financial markets. Indeed, in light of the various market interventions and so-called quantitative easing (QE, or bond buying) conducted by the Fed initially during the Great Financial Crisis and subsequently during the Covid pandemic, this influence has arguably increased over the last 14 years or so.

The vigorous rebound in global equity markets that followed the Covid crash of February-March 2020 was triggered by the Fed’s announcement on 23rd March that it would conduct open-ended QE purchases, as well as directly intervening in the corporate bond market. Conversely, the weakness in both bond and equity markets during the first half of 2022 was, in large part, the result of tighter monetary policy (both in terms of actual and expected interest rate hikes and balance sheet reduction) that the Fed has instigated in a bid to rein in inflation.

In recent weeks, the mood in markets has shifted once again. Since mid-June, US equity markets, have rallied on the expectation that, having raised its policy interest rate to 2.25-2.5%, the Fed will soon ease off on the pace of monetary tightening^1/2. Expectations for a shift or ‘pivot’ to a more dovish policy, have been fueled by weaker-than-consensus CPI data for July, which showed the headline inflation rate falling back from a 40-year high of 9.1% in June to 8.5% in July³. Indeed, futures contracts which track expectations for the path of the Fed’s policy interest rate going forward show markets anticipating that the Fed will hike rates to a peak of 3.6% by next March before then cutting rates by around 50 basis points by the end of 2023⁴.

What factors will influence the Fed’s decision to pivot?

Given the Fed’s renewed focus on price stability, any future pivot hinges crucially on the outlook for inflation. The fall in inflation during July was largely the result of lower petrol prices, as well as a pull-back in the prices for used cars (which had seen outsized increases in 2021 as a result of fewer new cars being sold due to the worldwide chip shortage) and airfares⁵. With survey evidence suggesting global supply chain disruptions are easing and cost pressures falling from their highs, there is a good chance that headline inflation in the US has now peaked⁶.

Indeed, with consumer spending patterns now shifting towards services and some retailers reporting excess inventories of certain goods in recent weeks, the prices of some items within the CPI basket are likely to drop on the back of heavy discounting⁷. These factors, along with favourable base effects, bode well for a marked fall in headline inflation during the next 12 months.

Sticky inflation

However, indicators showing an increased breadth and persistence of price increases suggest that bringing underlying inflation back down to the Fed’s 2% target could be trickier. Significantly, several alternative core measures of inflation accelerated to new multi-year highs in July. The annual gain in the Atlanta Fed’s sticky CPI (an index of goods and services whose prices change relatively infrequently) rose to 5.8% in July – its highest since February 1991⁸. Similarly, the Cleveland Fed’s trimmed mean CPI (which excludes the CPI components that show the most extreme monthly price changes, and thereby gives an indication of the breadth of inflation pressures) rose to a new series high of 7.0% y/y in July⁹.

Trends in these alternative gauges of inflation going forward will arguably have more bearing on Fed thinking than headline measures. One factor that could keep these core measures elevated during the coming months is the impact of the rising cost of shelter (i.e., rent and owner’s equivalent rent), that tends to respond with a lag to annual house price inflation, which has been running at close to 20% of late¹⁰.

Tight labour market

More fundamentally, trends in the labour market are likely to be a key determinant as to whether the Fed can call the all clear on inflation. As it stands, a tight labour market is putting upward pressure on wage growth and threatening to make inflation more entrenched. With productivity actually falling this year, unit labour costs rose a hefty 9.5% y/y during the second quarter¹¹. Against this backdrop, the suspicion is that the rate of unemployment (3.5% in July¹²) is currently too low to be consistent with the Fed’s 2% inflation target.

There is some evidence to suggest that the demand for labour is easing somewhat and household inflation expectations are falling back¹³. These factors could serve to rein in pay growth and head-off the risk of a wage price spiral. However, given that there are currently nearly two job vacancies for every person unemployed¹⁴, it is somewhat doubtful that the labour market will have cooled sufficiently by the spring of next year to warrant the interest rate cuts that the market is now pricing in.

Indeed, Fed officials have pushed back against the idea of an early pivot. Minneapolis President Neel Kashkari has said in recent weeks that the Fed is ‘far away from declaring victory on inflation’ and that it was very unlikely that policymakers will cut interest rates next year¹⁵. Chicago Fed President Charles Evans has indicated that the Fed’s policy rate might need to rise to 3.75-4% by the end of 2023¹⁶. These sentiments are understandable; having been surprised by the pace and breadth of inflation during the last two years, policymakers will clearly be wary of easing policy too soon and re-igniting price pressures, even if economic growth is sub-par.

Financial Instability

Of course, there could be other factors that might trigger the Fed to loosen policy, notably a bout of financial instability. There are plenty of historical examples of when the Fed shifted policy to a more accommodative stance as a result of financial distress. For example, following three years of monetary tightening, sharp falls in US equity markets during December 2018 ushered in a more dovish stance on the part of policymakers which resulted in the Fed cutting rates from the summer of 2019¹⁷. The difference now, of course, is that annual inflation is close to multi-decade highs and policymakers’ commitment to reining in inflation is, in Fed Chair Jerome Powell’s words, “unconditional”¹⁸.

Moreover, at the time of writing there are few signs of financial instability. On the contrary, the St. Louis Fed Financial Stress Index fell to a series low during the first week of August¹⁹. Furthermore, with the main US equity market up around 17% from the mid-June lows²⁰ and credit spreads also falling in recent weeks²¹, financial conditions have actually loosened. If anything, these developments could embolden the Fed to continue its aggressive tightening of policy, as looser financial conditions could encourage spending and exacerbate inflation pressures.

It has also been pointed out that, having introduced various emergency facilities to ensure smooth market functioning during the turmoil of March 2020, the Fed need not resort to the relatively blunt tools of interest rate cuts and quantitative easing if part of the financial architecture comes under pressure.

In other words, if the Fed has a targeted tool to address stress in a particular area of the financial plumbing, it can do so without resorting to cutting interest rates or restarting QE, policies which might run counter to the primary objective of taming inflation. Joseph Wang, a former trader with the Fed, notes that as a result, ‘policy can be far tighter and remain so even after “something breaks”’²².

All of this suggests that the Fed, which in the past has been quick to pivot to a more dovish stance when confronted with economic weakness and/or bouts of financial stress, might not be so eager to reverse course during the current cycle.

A marked slowdown in inflation, combined with lacklustre real economy data, will presumably enable the Fed to tighten less aggressively during the coming months as policy becomes more restrictive. However, given the Fed’s desire to oversee a cooling in underlying wage pressures and avoid a reacceleration of inflation, an actual loosening in monetary policy might not come as soon as markets expect.

16th August 2022