As Jay Powell tries to reframe how the Federal Reserve will tackle the highest inflation in roughly 40 years, one of his most challenging tasks has been convincing investors of the US central bank’s commitment to doing so.
Having jettisoned an initially “patient” approach in favour of being “humble and nimble” about moving “steadily” towards tighter monetary policy settings, the Fed chair has embraced moving “expeditiously” towards “neutral” rates that will neither stoke demand nor constrain the economy.
Powell repeatedly invoked that message at the press conference following Wednesday’s rate decision, as he explained the Federal Open Market Committee’s rationale for raising the federal funds rate by half a percentage point for the first time since 2000, to a new target range of 0.75 to 1 per cent.
But even as the Fed embraced a much more aggressive approach to tackling elevated inflation, investors detected dovish signals that suggested a less-forceful central bank than financial markets had expected.
Heading into the meeting, the odds of the Fed delivering a 0.75 percentage point rate increase at a forthcoming meeting were creeping higher, as traders bet the Fed would keep all options on the table as it stepped up its response to elevated inflation.
When asked about that possibility at the press conference, Powell effectively ruled out such a big adjustment and instead signalled half-point rate rises at the next two meetings.
That sent US stocks soaring, with the S&P 500 and technology-heavy Nasdaq Composite both closing roughly 3 per cent higher. Government bonds also rallied, with the yield on the two-year Treasury note, which is particularly sensitive to central bank policy, dropping 0.13 percentage points to 2.64 per cent.
“Do I think that as Jay Powell entered the press conference that on his list of objectives was to ease financial conditions? I don’t,” said Nathan Sheets, global chief economist at Citigroup and a former under-secretary at the US Treasury.
“I don’t think if you were to compare it to other Fed meetings or Fed rhetoric over time, that this was a dovish Fed, but when you compare it to some of the expectations of the market and some of the worries that were in the market, it was not as hawkish as some had feared.”
The stock market rally ignited by scrapping the prospect of a larger rate rise undid some of the “good work” the Fed had accomplished in recent months, said Aneta Markowska, chief financial economist at Jefferies, as it guided financial markets to price in a much more hawkish policy path.
“Everything’s rallying, but the more the markets celebrate, the more the Fed is actually going to have to lean against it,” she warned.
Liz Ann Sonders, chief investment strategist at Charles Schwab, added that should it persist and “froth” returns to the market, the Fed will have to go “a little bit harder” to tighten financial conditions.
Powell also stopped short of acknowledging that interest rates will need to rise to a level that actively constrains economic activity, in order to bring core inflation — running at an annual pace of 5.2 per cent, according to the central bank’s preferred metric — back in line with its longstanding 2 per cent target.
Rather, he only admitted it was “certainly possible” rates will need to move above neutral in order to tame inflation, but that the Fed “can’t know that today”. He added, however, that if warranted by the data, the Fed “will not hesitate” to do so.
“The reality is that they will have to go past neutral in order to slow the economy,” said Seth Carpenter, who spent 15 years at the central bank but is now the global chief economist at Morgan Stanley. “The tricky part is slowing it that much, without slowing it so much that it tips over into a recession.”
Complicating matters is what exactly the neutral rate is today — a level Powell admitted on Wednesday was “not something we can identify with any precision”. Fed officials broadly view neutral to be about 2 and 3 per cent, when inflation is at 2 per cent, but some economists argue it is now much higher — potentially as much as 5 per cent — given the magnitude of price pressures.
Despite that challenge, Powell wavered little from his earlier optimism that the Fed can achieve a “soft or softish landing”, not least because of the strength of household and corporate balance sheets as well as the historically tight labour market.
“It just seems like he painted this sort of fictional Goldilocks scenario that’s going to somehow fix inflation without the Fed having to overshoot the neutral rate significantly or maybe not at all,” Markowska said. “It doesn’t really add up to be honest.”
Source: Economy - ft.com
