With inflation looking sticky, where does the Fed go now?
Flash back to August 2022, when Fed Chair Jerome Powell gave a nine-minute speech at Jackson Hole, Wyo., warning investors to expect “some pain” in the economy in order to lower inflation.
His blunt, hawkish remarks now seem like a distant memory. Over the past six months, Powell and his colleagues have been leaning dovish, strongly hinting they were preparing to cut interest rates.
“They kind of came out and did a victory lap a little too soon,” said Ellen Meade, a former top Fed staffer and now an economics professor at Duke University.
That’s likely going to change this week, economists said.
“Inflation data have turned back up this year. And that will force Powell to become a little more hawkish again,” said Marc Giannoni, chief U.S. economist at Barclays.
Diane Swonk, chief economist at KPMG agreed, saying the goal of being hawkish is to have financial markets more fully reverse the easing of financial conditions that started when Powell and his colleagues started making dovish noises.
By hawkish, economists expect Powell to stress that the Fed intends “to keep policy in its current restrictive stance for as long as it takes to gain that confidence,” said Michael Feroli, chief U.S. economist at JPMorgan Chase.
Some economists think Powell will be patient and more noncommittal, just kicking the can down the road a few more months.
“There’s a lot of time between now and any potential move. So I imagine he’ll let sleeping dogs lie,” said Claudia Sahm, a former Fed staffer and now an independent policy adviser.
The market is already leaning too pessimistic, with many arguing there will be no cuts at all this year, she said.
The yield on the 10-year Treasury note BX:TMUBMUSD10Yhit a five-month high last Thursday and could challenge the October peak of about 5%, economists said.
Markets are now pricing in only one rate cut this year. The dream of six or seven interest rate cuts this year will “remain just that, a dream,” said Scott Anderson, chief U.S. economist at BMO Capital Markets.
The Fed will will meet on Tuesday and Wednesday. Following the second day’s discussion, the Fed will release a policy statement at 2 p.m. Eastern, followed by a Powell press conference at 2:30 p.m.
Here are some of the biggest questions facing Fed officials going into this week’s meeting:
Has the Fed lost the war on inflation?
Almost two weeks ago, Powell said that recent data has not increased confidence in disinflation, and that it will take longer to achieve it.
The Fed wants to build enough confidence that inflation has come down before lowering rates.
Economists say that’ll take a while. After all, the Fed’s own forecasts don’t see inflation returning to the 2% target before 2026, Meade said.
But the Fed has “gone back to square one” in the level of confidence that officials have about getting back to the 2% target, said Carl Tannenbaum, chief economist for Northern Trust.
The question is how many months of benign inflation data the Fed needs to see before confidence is restored, he said.
When is the earliest the Fed could cut?
“We see September as being the earliest opportunity for the Fed to cut rates,” said Giannoni of Barclays. But it is almost as likely that the first cut comes in December, he added.
No matter what, the Fed will only cut once this year, he said.
“We think that the level of rates still above 5% would be justified by year end,” Giannoni said.
Meade, of Duke University, agreed.
“We’ve got to wait for a while. Is September possible? Maybe. I think the end of the year is certainly possible,” she said.
Meade said the Fed would like to see the six-month PCE core inflation rate return somewhere near 2%.
The six-month headline PCE was running at slightly above a 2% rate in December. In March, that rate jumped to 2.5%.
Could the next move be a rate hike?
Economists say that the chances look slim, but they won’t say it’s impossible.
“I would give that a very low probability, but it is not zero,” said Tannenbaum.
If the public started to expect more inflation, “that would set off all sorts of alarm bells and they would change their policy to become more restrictive,” Giannoni said.
But the Fed could also cut rates if they thought it was needed to help avoid a recession.
Newest worry that goes against conventional wisdom: Stagflation
Over the past six weeks since their last meeting, Fed officials have said that the level of the central bank’s policy rate – in a range of 5.25% to 5.5% – was in a “good place” and could be held steady indefinitely to bring inflation down without damaging the economy.
But the latest data – especially the first-quarter gross domestic product, or GDP, report – have cast some doubt on the Fed’s optimistic view.
The report showed that growth slowed in the first quarter to a 1.6% annual rate from a 3.6% rate in the prior quarter, while at the same time PCE inflation accelerated to a 3.7% quarterly rate, from 2% in the fourth quarter.
There are worries that, if this trend continues, the economy could slump into stagflation – unable to expand while inflation remains hot.
While most economists think that a slowdown in growth will lead to slower inflation, Brian Bethune, an economics professor at Boston College, said that the opposite is true.
If growth slows too much, U.S. labor productivity will slump and the wage growth will spike.
“The Fed is caught between a rock and a hard place,” Bethune said.
He said the Fed should cut its policy rate by 50 basis points to support growth. But Fed officials will be reluctant to move without some indication that inflation pressures are easing.
Bethune said the problem is the Fed’s 2% inflation target. He said the Fed would be better off if it adopted a range of acceptable inflation like the Bank of Canada, which has an inflation-control target range of 1% to 3%.
On the other hand, many economists say talk of stagflation seems premature. Economists at Capital Economics said fears of stagflation “are badly misplaced,” especially with early estimates suggesting that GDP growth will rebound to a 3% rate in the April-June quarter.
Fed expected to announce it is slowing down ‘quantitative tightening’ program
Economists think that the Fed will decide at their meeting to reduce the pace of shrinking its $7.5 trillion balance sheet.
Each month since mid-2022, the central bank has been allowing $60 billion of maturing Treasurys to roll off the balance sheet, and up to $35 billion of mortgage-backed securities. The Fed is expected to slow the runoff of Treasurys to $30 billion per month., while the MBS portfolio would be allowed to continue at roughly its current pace.
The Fed bought close to $5 trillion in assets during the pandemic to support the economy and financial markets. It has reduced the balance sheet by $1.5 trillion so far.
When will the Fed stop the QT program?
Lou Crandall, chief economist at Wrightson ICAP, said the Fed is really slowing down the runoff to a crawl and will continue it well into 2025.
But some Wall Street economists think the Fed will stop shrinking the balance sheet by the end of this year.
Mark Cabana, head of U.S. rates strategy at BofA Global Research, thinks the Fed will stop the runoff in December. He said the Fed won’t want to continue the runoff because of a looming debt-limit fight early next year.
The Fed doesn’t want a repeat of September 2019, when its quantitative-tightening program had to end suddenly after turmoil in money markets. – MarketWatch
