The FOMC Is Acting As If It Is Blind To Signs Of Retreating Inflation
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Self-Preservation and Credibility
Welcome to 2023 and not soon enough. Last year delivered negative returns across most asset classes, not to mention the worst global bond market rout in a century. Even cash failed to keep pace with inflation.
The bad news is that the new year kicks off with a slew of last year’s known unknowns still unresolved. Will the Ukraine-Russia conflict turn nuclear? Will U.S.-China tensions escalate? Where will the drive to net-zero greenhouse gas emissions take energy prices? What is next for COVID-19? Will China’s U-turn on policy be enough to stabilize the economy? Will the Federal Reserve (Fed) overreact? Handicapping these unknowns remains difficult.
What we do know is that a very unbalanced world economy entered the new year close to or already in recession. China was by far the weakest of the major economic blocs and quite deflationary. Still early days, the Chinese Communist Party rang in the new year with a dramatic U-turn in policy: an abrupt and chaotic end to its zero-COVID strategy and a blitz of growth-enhancing measures. In contrast, the U.S. entered the new year with the Fed hitting the brakes hard while offering a lot of tough talk that the fight against inflation will be bloody enough to cause recession. The world’s two largest economies seem set up for exactly opposite economic cycles this year.
It is a complicated and fragmented collection of developments and prospects, but several themes seem likely to define this year’s macroeconomic road map and drive investment returns. The net of these factors calls for a disinflationary and soft first half of the new year; what happens later depends on the dynamics in the U.S. and China and the credibility of their policy leaders.
Federal Reserve Credibility
This is not your normal business cycle. We still see economic developments as reflections of an economy attempting to normalize from a disaster while simultaneously adjusting to extreme swings in economic policy. It is possible that we are coming to the end of this process in 2023.
- Government-mandated lockdowns pushed the U.S. economy in 2020 into the deepest contraction since the Great Depression. However, the economy quickly rebounded on reopenings and then was chased dramatically higher with massive Modern Monetary Theory (MMT)-like fiscal and monetary stimulus. The combination of reopenings and historic stimulus sent money growth soaring along with financial asset, commodity, and real estate inflation. The economy boomed, and with a lag, so did price and wage inflation.
- Most of this booming recovery was ignored by the Fed. As recently as December 2021, the Federal Open Market Committee (FOMC) Economic Projections showed that the median FOMC member anticipated a meager 80-basis point increase in the federal funds rate for 2022 and a retreat in inflation to well below 3%. By March 2022, only three months later, the CPI inflation rate had risen 8.5% from the previous year and almost 11% over the previous three months (annualized).
The Fed has a credibility issue. It is obvious that the central bank made a big mistake in 2021, underestimating the momentum behind inflation. It finally realized its error in March last year with its panicky U-turn. Since flipping, the Fed has presided over the fastest run-up in policy rates over any comparable period in its history while simultaneously shrinking the balance sheet. The dollar soared as the Fed tightened into a global economic downturn. Research from the Federal Reserve Bank of San Francisco calculates a shadow federal funds rate that takes account of the balance sheet and financial conditions. This measure has risen almost 700 basis points from its low.
What has happened since the Fed’s pivot in March?
In a word, deflation.
Like watching a movie backward, everything that went up during the boom phase of the pandemic has been coming down and in sequence: across-the-board asset prices are deflating; industrial and energy commodities are in retreat; real estate prices have started to fall; and not only inflation rates but price levels are declining in a range of goods. The broad economy has remained supported by consumption, which, in turn, has been propped up by a drawdown of accumulated savings from the earlier fiscal stimulus. However, deceleration is evident almost everywhere in both real and nominal terms. Broad price inflation measures have been rolling over. U.S. headline Consumer Price Index (CPI), which peaked at 9% mid-2022, rose less than 2% over the last six months of data (annualized). Furthermore, survey data suggest lower inflation rates ahead, and there is a clear fall-off in nominal income growth evident from the latest labor reports.
In the meantime, Fed stringency has reached a level not seen in decades: real money supply growth is lower than any time since 1980. Nominal money supply growth is contracting for the first time ever. Commercial bank lending standards are tightening.
Despite these developments, the FOMC is acting as if it is blind to signs of retreating inflation as it was to signs of escalating inflation a year ago. Virtually every member of the FOMC signaled in December that rates need to go higher this year. But based on the yield curve, the market is not buying it.
The intransigence of the central bank definitely increases the probability of recession, with the majority of economic forecasters suggesting one is already in the pipeline. With its credibility at stake, the Fed may have no option but to bombard the market with talk of persistent tightening. Otherwise, acknowledging the retreating nature of inflation too soon could invite a powerful rally in risk assets, which could put the Fed and the economy back in the same boat six months from now. However, if inflation falls as quickly as some current trends suggest to us, it is hard to believe the Fed would not react to these developments earlier. With oil prices down 40% from their peak, some of the “stagflationary” forces have reversed. Putting it all together, a timely response by the Fed to easing inflation could produce a shallow recession or soft landing. Unfortunately, the track record of intransigence implies it could take something more or some event to shift the Fed’s position.
Author: Francis A. Scotland, Director of Global Macro Research
