(Reuters) – The unexpectedly large jump in U.S. consumer prices last month has bolstered the view that the Federal Reserve is late to the fight against the strongest inflation since the early 1980s and needs to take dramatic action to make up lost ground.
With investors sharply upping their bets that the U.S. central bank will start with a “big bang” 50-basis-point interest rate hike at its March 15-16 policy meeting, debate over the possibility is sure to intensify within the Fed in the coming weeks.
Until this moment, Fed policymakers had largely resisted the idea. “I don’t think there’s any compelling case to start with a 50-basis-point” rate increase, Cleveland Fed President Loretta Mester, often among the Fed’s more hawkish voices, said on Wednesday,
Fast forward a day, and the latest U.S. inflation reading appears to have tipped that on its head. Household prices were up 7.5% in the 12 months through January, the Labor Department reported earlier on Thursday.
A few hours later, St. Louis Fed President James Bullard – who last week echoed Mester’s view – told Bloomberg News he had become “dramatically” more hawkish and called for a full percentage point worth of rate hikes over the course of the Fed’s next three next meetings, in March, May and June.
Market participants had already begun pricing a bigger likelihood of a half-percentage-point rate hike in March on the back of the inflation data, up from a one-in-four probability when Mester spoke.
After Bullard’s bombshell they finished the job: bets are fully on a half-percentage-point hike next month and then some, with rates expected to be in the 1%-1.25% range by June and 1.75%-2.00% by the end of the year.
Fed policymakers have already flagged that they will begin raising the central bank’s benchmark overnight interest rate from near zero at the March meeting, just days after it stops its two-year spree of buying billions in government bonds each month. It began the bond purchases to keep financial conditions loose and spur borrowing amid the COVID-19 pandemic.
By many measures they are already late to the party, with inflation at its highest level in 40 years and a super-tight labor market at odds with a Fed only just getting ready to remove crisis-era policy support.
“All this logically supports a 50-basis-point move in March,” says Karim Basta, chief economist at III Capital Management. “Whether the Fed ditches its gradualist approach remains the most relevant question.”
To Mark Cabana, head of U.S. interest rates strategy at Bank of America (NYSE:BAC) Global Research, the case only gets stronger as market bets on a bigger rate hike in March continue to build.
“The logic for them to go is compelling,” he said, noting that doing so would get Fed policy faster to where it needs to be in the face of inflation while keeping borrowing costs still far below the level where they would put the brakes on economic growth.
“Are you going to tell the market that it’s wrong and you need to go slower?” Cabana said. “If the market gives the Fed the option, we do not believe that the Fed will tell the market that it’s wrong.”
Economists at Deutsche Bank (DE:DBKGn) on Thursday said they now think the Fed will kick off its policy tightening with a 50-basis point hike next month.
Still, many economists for now are predicting the U.S. central bank will stick to quarter-percentage-point increments for future rate increases.
Instead of going bigger to start, they say, the Fed will just speed up the pace of rate hikes quicker than the one-per-quarter pace it has stuck to in recent memory or begin to reduce its balance sheet sooner than expected.
With one more big inflation reading and more jobs data due before the March meeting, Fed officials will be watching the data closely.
Graphic: Fighting the Fed – https://graphics.reuters.com/USA-FED/INFLATION/akvezawxopr/chart.png
BOXED IN?
The Fed is leery of spooking financial markets, which have required diligent handholding in recent years to avoid a knee-jerk tightening of financial conditions and repeats of episodes like the 2013 “taper tantrum,” which was widely seen as a communications misstep.
A half-percentage-point hike in March wouldn’t itself hurt the economy, economists say, but the signal it sends about the future path of policy could if traders expect similar-sized increases in rates at future meetings.
“The market goes from pricing five (quarter-percentage-point rate hikes) to pricing eight, 10 and then you are potentially causing some real sharpening in financial conditions,” said Aneta Markowska, chief financial economist at Jefferies.
“They are way behind the curve, and I think they have a lot of catching up to do,” Markowska added, “but I think it makes sense to move, not slowly, but not too aggressively.”
Keeping rate hikes to 25-basis-point increments allows the Fed to better tailor policy to the data if inflation soon cools on its own, as Atlanta Fed President Raphael Bostic said earlier this week he thinks is likely.
In fact, up until now Fed officials have been betting much of the inflation spike will ebb on its own in the second half of this year as supply chains get untangled and an easing COVID-19 pandemic allows more people to return to work, making the need for a bigger rate hike less important.
And already, the relative tightening in financial conditions that has occurred in just a few months means there is less catch-up for the Fed to do, despite the apparent disconnect between keeping its policy rate near zero and inflation running at more than twice its 2% target.
One way to quantify that tightening is the Wu-Xia “shadow” rate, which uses bond yields and other market clues to show how loose monetary policy really is when the actual policy rate is stuck near zero.
After the pandemic-triggered recession, the Fed’s monthly purchases of $120 billion in Treasuries and mortgage-backed securities pushed that rate as low as negative 2%. Since November, when Fed Chair Jerome Powell began signaling a quicker end to the bond-buying program and an earlier start to rate hikes, the rate has risen by about 1.65 percentage points.
Narayana Kocherlakota, an economics professor at the University of Rochester who was known for his dovish views after the 2007-2009 recession when he was the Minneapolis Fed’s president, sees it differently, and expects dissents, including perhaps from Fed Governor Christopher Waller, should the central bank not go harder in March.
“I think going 50 now also puts it on the table in every meeting going forward … so it expands optionality in a big and useful way,” he said. Much-higher-than-expected inflation, he said, “deserves an aggressive response.”
Source: Economy - investing.com
