Podcast Summary
Fed's Commitment to Raising Rates Despite Disinflationary Trends: The Fed signaled their intention to maintain restrictive interest rates for an extended period, potentially leading to a recession, despite recent disinflationary trends in the data.
The Federal Reserve, represented by Chair Jerome Powell, signaled their commitment to raising interest rates to restrictive levels for an extended period, potentially leading to a recession. This stance comes despite recent disinflationary trends in the data, which may raise questions about the necessity of such a move. Tim Dewey, Chief US Economist at SGH Macro Advisors and a professor of practice in economics at the University of Oregon, summarized Powell's press conference by emphasizing the Fed's determination to maintain restrictive rates. John Turek, founder of JST Advisors and the author of The Cheap Convexity Substack, added that the Fed seems to be moving from determining the terminal rate to deciding how long to stay there. This shift, along with Powell's comments, suggests that the Fed is in the ballpark of what they consider to be sufficiently restrictive rates. The macroeconomic discussion revolves around the possibility of a turning point in the high inflation, interest rate hiking cycle. The guests, Tim Dewey and John Turek, provided insights on the latest Fed decision and its implications.
Fed targets real interest rate of 160 bps for restrictive policy: The Fed aims for a real interest rate of 160 bps to curb inflation, but the definition of 'sufficiently restrictive' is dynamic and influenced by real-time data.
The Federal Reserve is aiming for a real interest rate of around 160 basis points over the next two years to achieve a sufficiently restrictive monetary policy and curb inflationary pressures. However, the definition of "sufficiently restrictive" is dynamic and will depend on real-time data. The recent CPI report showing a 0.2% monthly increase in core inflation and a 0.1% increase in headline inflation may indicate a potential trend reversal, but it's essential to remain cautious and consider it as part of the larger economic picture. The Fed's approach is likely to be informed by data and subject to adjustments as needed.
Fed's focus on reducing inflation may shift: Despite easing core inflation pressures, the Fed is unlikely to abandon its goal of anchoring inflation at 2% due to labor market dynamics and potential negative impact on expectations.
The Fed's focus on reducing inflation may be shifting as core inflation pressures begin to ease. However, this doesn't necessarily mean the Fed will embrace a disinflationary trend or abandon their goal of anchoring inflation at 2%. The labor market dynamic, which was a tailwind for inflation in late 2021 and early 2022, is now a headwind. Powell has emphasized that above-target inflation expectations are not just about trend but also about level, and allowing inflation to remain above target for an extended period can negatively impact inflation expectations. Therefore, the Fed is likely to remain cautious and hesitant in embracing disinflationary trends.
Fed's Caution in Raising Interest Rates: Despite the Fed's projections, uncertainty around inflation, labor market, and the long-term effects of monetary policy make a 'soft landing' for the economy a challenging prospect.
The Fed is cautious about raising interest rates too aggressively due to past experiences and the uncertainty around inflation and the labor market. Powell expressed hope for a modest increase in unemployment, but history suggests that it's not a reliable tool for controlling inflation. Additionally, the long-term effects of monetary policy and the timing of inflation are difficult to predict, adding to the complexity of the situation. The Fed's projections anticipate a rise in unemployment, but it remains to be seen whether this will be enough to tame inflation. The uncertainty around these factors makes a "soft landing" for the economy a challenging prospect.
The Fed's challenge: Inflation and the labor market: The Fed is hoping for a 'handoff to procyclical tightening' but questions if inflation will return to trend without significant unemployment increase. They'll closely monitor inflation data and financial conditions to avoid a recession.
The Fed is currently facing a challenging decision regarding inflation and the labor market. They are hoping for a "handoff to procyclical tightening," where the natural disinflation process raises real effective funds rates, allowing for positive policy rates across the curve to serve as the new form of tightening. However, the possibility of an "immaculate disinflation" where inflation returns to trend without a significant increase in unemployment is being questioned. The Fed is concerned that persistently high wage growth not matched by productivity growth could lead to upward pressure on inflation and expectations. The Fed will closely monitor inflation data, especially core services numbers, to determine if they can believe in the possibility of a soft landing without inducing a recession. The term "immaculate disinflation" was first mentioned in Matt Klein's newsletter. Additionally, financial conditions are a concern as the Fed navigates this delicate balance.
Fed's monetary policy efforts partially offset by softening dollar and rallying markets: The Fed's efforts to tighten financial conditions through monetary policy are being offset by a softening dollar and rallying stocks and bonds. The Fed may need to intervene if financial conditions continue to loosen, but for now, they are not overly concerned as long as labor market and inflation data remain strong.
The Fed's efforts to tighten financial conditions through monetary policy have been partially offset by recent developments such as a softening dollar and rallying stocks and bonds. Neel Kashkari, a former Fed official, believes that the Fed has largely achieved its goal of neutralizing the commodity super cycle through the strong dollar, but now faces the question of whether to intervene if financial conditions continue to loosen. Powell's recent comments suggest that the Fed is not overly concerned at this stage, as long as the improvement in labor market and inflation data is sustainable. However, if there are signs of sustained deflation or weakness in the labor market, the Fed may need to reaffirm its hawkish stance to keep the market's confidence. The market's reaction to changing data will be crucial in determining the Fed's next steps.
Understanding the Fed's reaction function and inflation expectations: Misalignment between the Fed's approach and market's expectations on inflation data could lead to tension, potentially impacting the economy's soft landing and the Fed's primary objective to manage inflation.
The Fed's ability to maintain inflation expectations and financial conditions hinges on the market's understanding of its reaction function. If the data starts to shift towards disinflation, the market may not follow the Fed's approach, leading to potential tension. This tension could be amplified if the Fed and markets focus on different components of inflation data. A soft landing for the economy may require the Fed believing they can achieve one, but the anticipated rise in unemployment may not align with this outlook. The bigger concern for the Fed could be stagflation - inflation combined with negative economic growth. In such a scenario, the Fed's primary objective would be to bring inflation back down to trend, and their response would heavily depend on their perception of inflation expectations.
Fed's Statements vs Market Pricing: Inflation Expectations and Economic Cycle: The Fed's stance on interest rates hinges on inflation expectations and the economic cycle. Market pricing reflects investors' concerns about the economy and potential future Fed actions.
The current tension between the Federal Reserve's (Fed) statements and market pricing regarding interest rates hinges on inflation expectations and the perception of the economic cycle. When inflation was perceived to be persistently high and unemployment was rising, the Fed might have pursued a more aggressive policy to keep inflation in check. However, if they believed inflation expectations were falling, they could focus more on the employment mandate and potentially adopt an easier policy. The market's pricing for rate cuts and the inversion of the 3-month, 2-year curve reflect investors' concerns about the economy and the potential for the Fed to adjust its stance. The first stage of this divergence was driven by market expectations of imminent cuts due to economic uncertainty. Now, as the Fed signals that the cycle may be nearing its end, the market is considering the possibility of cuts in the future based on potential economic scenarios.
RBNZ's Hiking Cycle and Market Reaction as a Guide: The RBNZ's accelerated hiking pace and forecasted terminal rate offer insights into the potential end of the hiking cycle and market reaction.
While the Federal Reserve may not be able to do much about the current economic situation at a certain point, other central banks, such as the Reserve Bank of New Zealand (RBNZ), have provided valuable insights into the potential trajectory of interest rates and the economy. The RBNZ's decision to accelerate its hiking pace and forecast a terminal rate close to 6% was a significant indicator of the end of the hiking cycle and how markets may react. Central banks around the world are expected to be in a divergence period, with some experiencing clear signs of growth deceleration and others, like the Fed, not showing such obvious signs. The composition of economic growth and financial market volatility will play a significant role in how economies fare. The RBNZ's experience serves as a North Star for understanding the potential end of the hiking cycle and the market's reaction to it.
Fed's approach to interest rates depends on inflation and labor market data: Speakers anticipate a 25 basis point rate hike in February, but beyond that, uncertainty arises. A soft landing could allow the Fed to pause rate hikes if inflation stays low and labor market softens.
The economic landscape is expected to diverge significantly across the world, and the Fed's approach to interest rates will depend on the evolution of inflation and labor market data. The speakers anticipate a 25 basis point rate hike in February, but beyond that, uncertainty arises. If inflation numbers remain sticky on the downside and labor market softening continues, the Fed might pause its rate hikes. The Economic Cycle Index (ECI) is one indicator both speakers mentioned as crucial for signs of a soft landing that could allow the Fed to potentially ease up on rate hikes. However, the Fed's stance on inflation and wage growth suggests that a soft landing will depend on the behavior of these indicators in the coming months.
Fed monitoring wage growth to avoid unemployment below 4.7%: The Fed is focused on wage growth to prevent low unemployment, but the market expects rate cuts while the Fed remains hawkish, complicating their efforts to manage inflation and employment
The Federal Reserve (Fed) is closely watching wage growth as a key indicator to determine if they can avoid unemployment rates below 4.7%, which could potentially lead to a recession. The discussion also touched upon the potential discrepancy between the market's expectations and the Fed's stance on interest rates. The market is currently pricing in rate cuts, while the Fed maintains their hawkish stance. This divergence could complicate the Fed's efforts to manage inflation and employment levels. Additionally, the complexities of international central banks' actions and the potential impact of changing inflation trends on consumer behavior add to the challenges facing the Fed in the coming year.
Navigating the complex global economy in 2023: Understanding the US consumer's resilience, Federal Reserve's stance, Europe's economic situation, China's response to COVID-19 and potential monetary policy changes, and the impact of oil prices is crucial for navigating the global economy in 2023.
The global economic landscape is complex and full of moving parts, with various factors influencing different regions in unique ways. For instance, the US consumer's resilience to inflation, coupled with the Federal Reserve's stance, could lead to a stronger US dollar. However, the situation in other parts of the world, such as Europe, could result in weaker currencies and slower economic growth. Additionally, China's response to the economic impact of COVID-19 restrictions lifting and potential monetary policy changes is a significant wild card. Furthermore, the reopening of China and the subsequent impact on oil prices is another factor to watch. Overall, the global economy is facing numerous challenges, and understanding these interconnected factors is crucial for navigating the economic landscape in 2023.
