The Federal Reserve is under pressure to abandon its monetary policy guidance for the second month in a row in the face of soaring inflation, as market participants increasingly bet the US central bank will raise interest rates by a full percentage point at the end of the month.
Consumer prices across most goods and services rose again in June at a speed that pushed the annual increase to 9.1 per cent, the biggest jump since November 1981.
The advance surpassed even the most aggressive forecast by economists and was yet another unwelcome development for a central bank that has emphasised its “unconditional” commitment to tackling high prices — even at the expense of the economic recovery.
It also threatens to further muddy the Fed’s communications with investors, given that policymakers have sent clear signals to markets that they intend to raise interest rates by 0.5 or 0.75 percentage points at their next meeting, which concludes on July 27.
But following June’s inflation report, economists now expect the Fed to implement a 0.75 percentage point increase at the bare minimum, and traders in federal funds futures contracts put the odds of a full percentage point increase at more than half, according to CME Group.
“The mistake they have been making and maybe they’ve learned from is tying their hands and saying we won’t hike more than 25, 50 or 75 basis points,” said Diana Amoa, one of the chief investment officers at Kirkoswald, a hedge fund.
“If you are indeed data dependent, then you need to leave the optionality to be able to pivot whichever way the data is pointing,” she added. “What the data is saying is the Fed is only at the early stages of trying to tackle this inflation overshoot.”
As such, Amoa said a full percentage point rate rise at the end of the month is the “right thing” for the Fed to do.
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If the Fed does opt for a larger rate increase it would hearken back to the drama surrounding last month’s meeting, when the central bank abruptly abandoned its heavily signalled plans for a half-point rate rise in the days leading up to the announcement. Instead, it implemented the first 0.75 percentage points increase since 1994 after worse than expected inflation data.
Raphael Bostic, president of the Atlanta Fed, on Wednesday raised fears of a rerun of that episode when he responded to a question about a full percentage point increase by saying “everything is in play” following the “concerning” inflation report.
In an interview with Bloomberg on Wednesday, Loretta Mester, president of the Cleveland branch and a voting member on the Federal Open Market Committee, declined to rule out a 1 percentage point rise.
“We don’t have to make that decision today,” she said, noting that the appropriate increase would be discussed at the upcoming meeting and there were still data to be released before then.
However, she said that June’s “uniformly bad” inflation report did not point to a rate rise of less than 0.75 percentage points.
Also on Wednesday, Mary Daly, president of the San Francisco Fed, told The New York Times that her “most likely posture” was another 0.75 percentage point adjustment, but indicated a full percentage point move this month was in the range of possibilities.
Tim Duy, chief US economist at SGH Macro Advisors, said: “The Fed has put itself in a position where to maintain credibility on its intention to restore price stability it almost needs to find a way to escalate with each new bad inflation number.”
For Sarah House, senior economist at Wells Fargo, a 0.75 percentage point interest rate rise is now seen as a “floor rather than the ceiling of what they might do in July”. Economists at Nomura changed their prediction to a full percentage point increase.
Motivating these bets is the latest alarming inflation reading. While the data captured the period before prices for energy and other commodities started to tumble from recent highs, there were clear signs that price pressures were becoming more entrenched in a wider range of sectors.
The “core” measure, which strips out volatile items such as food and energy, increased another 0.7 per cent in June; compared with the same time last year, it is 5.9 per cent higher.
That was led by a pick-up in shelter-related costs such as rent, which was up 0.8 per cent over the previous month — the largest increase since 1986. Ex-energy services inflation, which is less likely to fall away quickly, rose 0.7 per cent as well in June, or 5.5 per cent on a year-over-year basis.
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The other concern is that prolonged periods of elevated prices will alter how consumers and businesses account for future inflation, with individuals demanding higher wages and companies charging more for goods and services. That would threaten to fuel a vicious cycle of increasing cost pressures.
The Fed pointed to this fear in minutes from its policy meeting in June, when many participants concluded there was a “significant risk” of inflation becoming “entrenched if the public began to question the resolve” of policymakers to take bold steps to stamp out soaring prices.
Julian Richers, an economist at Morgan Stanley, said the investment bank’s base case is still for the Fed to deliver a 0.75 percentage point rate rise this month, pointing out that longer-term expectations have not yet become unmoored from the central bank’s 2 per cent target. However, the risk that they will is big enough to compel officials to at least consider a bigger move, he added.
“It’s really uncharted territory in a way, [because] usually monetary policy is all about being subtle, operating on the margins and doing things very carefully,” Richers said.
“But now because of this renewed focus on credibility that we really haven’t had to deal with in the last 30 years, at least in the US, we’re sort of changing the game a little bit, and it makes the outlook just more volatile.”
Other economists believe the Fed will instead extend its string of 0.75 percentage point increases until September rather than switching to smaller increments as previously forecast.
Source: Economy - ft.com
