In making his speech at Jackson Hole in August, Federal Reserve Chairman Jerome Powell told us that he had a narrower focus than in previous meetings. "The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal," he said. It appears that such resolution – and the Chairman's single-minded focus – may have ended after the FOMC increased the Federal Funds rate by another 75 basis points earlier this month.
Despite several references in the text as to why inflation was likely to continue at a rapid pace – and well above the central bank's 2% target – minutes of the discussions on November 1 and 2 released Wednesday seemed intended to make markets believe that the pace of rate increases is about to slow, perhaps as early as December 14. Taking the minutes as dovish, investors pushed the S&P 500 and the Dow Jones Industrial Average to a winning week. The DXY dollar index continued its losing streak.
Contrast the more relaxed posture presented by the minutes to the urgency Powell expressed at Jackson Hole in controlling inflation. "In current circumstances, with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause" on rate increases, he said on August 26. And even though the most recent figures on consumer and producer prices were positive surprises, inflation rates remain far above where the Fed would want them to be.
Even the Fed's favorite measure, inflation in the core Personal Consumption Expenditure deflator that excludes food and energy, remained at well over twice the central bank's targeted level, accelerating in the latest reading from 4.9% to 5.1%. Why then did the minutes suggest that future rate increases will be slower? The answer is hidden in the briefing provided by the economic staff to the voting members of the FOMC. "The possibility that the economy would enter a recession sometime over the next year [is] . . . almost as likely as the baseline," reads the economics report.
The Fed rarely, if ever, forecasts a recession. Suggesting that chances of a recession are almost 50% is the highest likelihood the central bank will attach to the impending downturn. To get the picture, think of an analyst providing a "Hold" rating for a stock when the recommendation actually is meant to suggest "Sell," but the analyst wants to avoid that word! Following four rate increases of 75bp each at successive FOMC meetings, Fed economists were concerned that the economy would be pushed to a recession next year but could not bring themselves to suggest a higher probability.
To see how rare dire economic calls are, recall then-Fed Chairman Ben Bernanke's testimony before the Senate Banking Committee on July 19, 2007. He estimated the losses from subprime loans at between $50 billion and $100 billion which, given the size of the US economy, were too small to seriously threaten economic growth. Given his confidence, the Federal Reserve did not cut interest rates. Not withstanding the Chairman's optimism, the next downturn, so severe that it was dubbed the Great Recession, commenced six months later.
Given that experience, could the minutes' concern about the cumulative impact of this year's rate increases on the overall economy justify a slowdown in tightening? Are Fed officials acting with caution rather than just taking the foot of the brake?
Not really. Despite the poor record of anticipating the 2007 - 2008 financial crisis, the Fed still has no rules for policy setting, nor quantitative tools developed to measure the impact of rate increases that have already taken place. Unquantifiable fears of a recession appear to have been the sole catalyst behind the dovish prescription for monetary policy contained in the Fed minutes. What about the other part of the Fed's mandate – inflation mitigation – and Powell's own expressed concern about the stickiness of price increases?
The minutes did pay lip service to inflation being "unacceptably high" and "the burden of high inflation . . . falling disproportionally on low-income households." The minutes also noted some participants' view that "the risks to the inflation outlook remained tilted to the upside." These concerns did not, however, stop the Fed from putting out a market-friendly message regarding future tightening.
Assume that the FOMC does slow rate increases to 50bp on December 14, and prepares for a total end to rate hikes sometime in the first half of 2023 despite inflation remaining well above its target. At his press conference following the FOMC deliberations, how will Powell justify the shift from the stern posture he adopted at Jackson Hole, to becoming the benevolent Uncle Jay four months later?
Will he say "I talk like a Paul Volcker but walk like an Arthur Burns!"? I can't wait to find out.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California