The Federal Reserve needs to send an extremely hawkish message to the markets
The Federal Reserve appears to be losing control of the market. Financial conditions have eased to levels not seen since the spring of 2022. This easing has led to rising commodity prices, declines in mortgage rates, weakening the dollar and the stock rally.
The February FOMC will take on added significance because the Fed will need to push back on the current easing of financial conditions. If the Fed truly believes that monetary policy is transmitted through financial conditions, then the Fed has failed. Conditions are currently at levels similar to when the Fed first started raising rates. These conditions are accommodating to the economy and support its expansion, just the opposite of the Fed’s desire to keep the economy growing below trend.
Push back at this moment in the game may be even more difficult than it was when Powell gave his speech in Jackson Hole. The market knows the Fed is closer to the end of its rate hike cycle than the beginning. The market also expects inflation to continue falling. That means the Fed could either raise rates by 50 basis points, which would be a big surprise to markets, or give guidance that financial conditions have eased too much, extending the rate-tightening cycle.
Prices are going up
One effect of easing financial conditions is rising commodity prices. The national average price of regular unleaded gasoline increased 9.4% in January, indicating that we may see a rebound in the Consumer Price Index (CPI) on a monthly basis when the January report is released.
In addition, copper prices rose dramatically. Changes in copper prices can lead to changes in the annual changes in the CPI. The recent increase in copper prices is due to two factors: the reopening of China and the weaker dollar. While the Federal Reserve cannot control enthusiasm for China’s economic recovery, it can try to tighten financial conditions, strengthening the dollar and potentially slowing the copper rally.
Meanwhile, lumber prices rose sharply this month as new home sales began to pick up again. This appears to be a result of the easing of financial conditions.
The return of inflation
These questions have challenged Powell and the Federal Open Market Committee as the easing of financial conditions has increased inflationary impulses. This is expected to lead to a 60 basis point monthly increase in the core CPI in January, according to the Fed’s latest estimates in Cleveland. That would be the biggest increase in the monthly CPI change since June.
Based on these estimates, the consumer price index (CPI) could rise by 6.4% in January, showing no significant improvement from December. Inflation swaps for January have also risen in recent weeks, indicating that the market now expects higher readings in January.
This is a real risk for the Fed if the Cleveland Fed’s predictions come true, as it would undo the progress the Fed has made since the summer inflation peak and could call into question whether the downward trend we are witnessing in inflation , has started to turn around.
The bottom line is that the Fed cannot afford to ease monetary conditions further and needs them to start tightening again to slow the inflationary impulses that seem to be coming back to life. According to the Bloomberg Financial Conditions Index, conditions have returned to levels seen in February 2022, before the Fed began raising rates and only discussing the possibility of a rate hike.
Also, from a monetary policy perspective, the overnight rate is roughly equal to the core Personal Consumer Expenditure (PCE) inflation rate. The Fed has made it clear that it wants rates to be sufficiently restrictive, and for that to happen, rates would have to rise to a point where they are above the core rate of PCE inflation.
Chris Waller, a Fed official, pointed out what the Fed considers restrictive enough in an interview last week when he noted that interest rates are sufficiently restrictive when real interest rates are 1.5% to 2% above the projected rate of inflation. He said if you look at the end of the year and the market forecasts for an inflation level of 2.5% to 3%, getting to a level of 5% would be restrictive enough.
This is perhaps the best indication the Fed has given the market about what it thinks when it comes to where it thinks interest rates need to be to bring the economy and inflation back into balance, and why the Fed won’t refrain from raising interest rates before reaching the 5% overnight rate floor.
Also, the key gauge the Fed is watching is non-housing core services PCE, and based on data from Bloomberg, that’s a stubborn number that hasn’t fallen, hovering around 4.1%.
It has to be pushed back
If the Federal Reserve does not act now and oppose the current easing of financial conditions, which it has repeatedly noted is helping to transmit monetary policy through the economy, then all may be lost. Because right now the market doesn’t believe the Fed when it says it wants monetary policy to be tight enough and wants to slow growth to below trend and is willing to put up with those things to kill the inflationary impulses that are still clearly there.
The Fed’s options are limited at this point, but it can do so by bucking the collective belief that the Fed will only raise rates by 25 basis points and instead raise rates by 50 basis points. Or Powell will have to give a very strong message, possibly stronger than the one given at Jackson Hole, and threaten that interest rates may not go higher than what was thought in December due to undue easing . Otherwise, it may have to raise the issue of a potential increase in the pace of quantitative tightening and balance sheet outflows.
Everything else suggests that the Fed is on board with the current easing of financial conditions and is willing to tolerate the market taking over and driving monetary policy, which looks like a disaster waiting to happen.
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