Powell Presser Shows Little Concern on Inflation Uptick. There are two main ways of confronting adverse developments. The first is to face them frontally and deal with the consequences. The second is to act as if nothing significant happened. Federal Reserve Chairman Jerome Powell's press conference Wednesday was a classic case of the latter option. Speaking after three successive monthly inflation figures signaled a movement away from the central bank's thesis on declining inflationary pressures, he said, "I think it's unlikely that the next policy rate move will be a hike." He has said in the past that interest rates were likely at their peak and rate cuts were in prospect. Even though he no longer looks for quick rate cuts, he does not anticipate policy tightening either.
While Powell ruled out the likelihood of rate hikes, he did not stay away from suggesting two situations under which rates would be reduced. First would be that "inflation is moving sustainably down to 2 percent." Another reason would be an "unexpected weakening in the labor market." There are problems with interpreting either criterion. It is impossible to judge if inflation is moving sustainably to the Fed's target. Recall that lower inflation rates in the second half of 2023 led the central bank to think it was winning the war against inflation, only to find inflation ratcheting up in 2024.
As for the labor market, do figures published yesterday by the US Bureau of Labor Statistics amount to the weakening that Powell had discussed? The US economy created only 175,000 jobs in April, down from a 242,000 monthly average during the prior 12 months. Last month recorded the smallest job creation after October 2023. Also, the unemployment rate moved up from 3.8% in March to 3.9% in April. The markets – both equities and Treasurys – posted massive rallies after the jobs report.
Recall, however, that the relatively low level of job creation last October and November had been interpreted as a sign of a "goldilocks" labor market and a precursor to a soft landing of the US economy, only to have job creation perk up in March 2024. The unemployment rate was 3.9% in February, but fell to 3.8% in March. Simply put, there is too much volatility in monthly statistics to be able to give the Federal Reserve confidence regarding an "unexpected weakening" in the labor market that would allow a reduction in the interest rate.
These were the uncertainties that Powell implicitly set aside in suggesting imminent rate cuts last December and, again, in ruling out rate increases last Wednesday. In each of the two cases, the resulting rally in financial markets has made the task of inflation mitigation more difficult for the central bank – a recurring theme in SriKonomics discussions.
Rate cuts were not the only domain where markets detected a dovish Federal Reserve. The Federal Open Market Committee also decided this week to slow the pace of Quantitative Tightening, i.e., to reduce the volume of bonds that the Fed would put into the market every month. Effective June 1, it will reduce the monthly ceiling for Treasurys that mature but not get reinvested from $60 billion to $25 billion. The ceiling on agency mortgage-backed securities being put back into the market was left unchanged at $35 billion per month, for a total ceiling of $60 billion. The total ceiling had been $95 billion at the start of this QT cycle.
Why would the Fed want to slow QT? First, in addition to rate increases, reduction in the Fed's balance sheet is a form of tightening monetary policy. It operates by reducing the quantity of money rather than through an increase in the price of credit (interest rate). In some instances, QT can be shown to be more powerful than rate hikes in curtailing the level of economic activity.
The Fed found to its dismay that the QT that it had been pursuing led to a sudden surge in overnight money market rates in September 2019, forcing it to abruptly switch to Quantitative Easing. Powell has explained at his press conferences that he does not want a repeat of the 2019 experience.
Second, with the surge in the fiscal deficit and the federal debt, the Federal Budget Office estimates that the federal government will spend $870 billion in interest during 2024, exceeding for the first time the projected $850 billion to be spent on defense. Think of the slowing of QT as Chairman Powell's gift to Treasury Secretary Janet Yellen and President Joe Biden in an election year.
The Fed's decision to put fewer Treasurys into the market significantly lowered bond yields in the second half of last week, making it easier to service US obligations. The change was especially dramatic in the case of two-year obligations which dropped in yield from 5.03% just before the Powell press conference which started at 2:30 pm Eastern time on Wednesday to close last night at 4.82%.
Then-Chairman Ben Bernanke called Quantitative Easing a temporary measure in the aftermath of Lehman Brothers' failure in September 2008. But the Fed balance sheet never went back to the $800 billion level just before the Fed's and Treasury's cleanup operation. Fed's assets quintupled to $4 trillion at the start of 2020. Powell's belief that the pickup in inflation was related to supply bottlenecks and, therefore, self-correcting, pushed him to again more than double the balance sheet to almost $9 trillion by the time QT began in 2022. Even today, after two years of QT, the Fed's portfolio of assets amounts to $7.4 trillion. To understand the surging dominance of the Fed, let us analyze the balance sheet relative to the US gross domestic product.
That ratio rose from 5.4% in late-2008 to 19% in early 2020, and to over 35% by early 2022. It stands at about 29% today. Even if assets held by the central bank do not return to their 2008 level, when can we expect the "temporary" QE that Bernanke discussed to be reversed, if not in trillions of dollars, as a percent of GDP? The answer, as a mathematician would appreciate, would be: At ∞ (infinity). For non-mathematicians, that would translate to "Don't hold your breath!" The Fed is a bureaucracy and does not give up power. Expect future crises to increase the size of the Fed's portfolio, both in dollar terms and as a share of GDP.
What comes next? Investors whose enthusiasm has waxed and waned with Powell statements, found a new reason for euphoria in the jobs numbers. However, the recent data points provide little clarity on the long-term outlook for inflation and interest rates. If anything, FOMC members' habit of relying on the latest numbers is more likely to create a new rally that would increase inflationary pressures.
My conclusion has not changed: Other than as a response to a "breakage" in the system or due to election year imperatives, do not expect a rate cut during 2024.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California