Today the Federal Reserve (Fed) increased its policy rate by 0.25%, as pretty much everybody expected it would. The post-meeting statement contained only small modifications. Fed Chair Powell reiterated many of the comments that have characterized his recent communications. “Inflation remains too high” and “The Fed is strongly committed to returning inflation to our two percent objective,” Powell said.
Last year many feared the Fed was behind the inflation curve, as it responded slowly to above-target inflation. The environment has since shifted. The Fed may once again be behind, but now in the opposite direction. Chair Powell’s comments today did not fully acknowledge the change in economic data, nor did he convincingly explain why the Fed has a divergent view from the market regarding the path for interest rates. The Fed may now be behind the disinflation curve.
Economic Data
A number of recent data points could have been used to justify the Fed pausing its hiking cycle today, rather than continuing with rate increases at future meetings.
First and perhaps most importantly, consumer price inflation is moderating. Core Personal Consumption Expenditures (PCE), the Fed’s preferred inflation measure, showed that prices increased at an annual rate of 2.9% over the final three months of 2022. This is down sharply from the too-hot pace recorded over the preceding 12 months, when core PCE prices were increasing at an annual rate of 5.2%.
Second, wage growth is decelerating. A number of series, including yesterday’s Employment Cost Index, suggest wage growth has declined to a 4% annual pace. This is down from a pace of nearly 6% early last year. The current 4% pace is close to one that would be consistent with annual price inflation of 2%, assuming productivity returns to more normal levels in 2023. Further deceleration in wage growth remains likely in coming quarters, as hiring has slowed and the gap between job openings and workers has started to narrow.
Finally, economic activity appears to have stalled at the end of last year. Retail sales ended 2022 with two straight months of nominal declines. Manufacturing activity similarly declined in each of the last three months of 2022. And the contraction in housing activity showed no sign of abating. (The GDP data for 4Q22 likely overstated the economy’s momentum, as most of the growth came in inventories and net exports. The quarterly data may also mask some of the deceleration in the last two months of the year.)
Taken together, these three things—moderating inflation, decelerating wage growth and stalling economic activity—make a case for the Fed pausing its rate hiking cycle. Chair Powell’s statement today that additional hikes remain “appropriate” puts him, and the rest of the Federal Open Market Committee (FOMC), a bit behind the economic data.
Market Pricing
Markets have started to anticipate the Fed may cut rates in the not too distant future. This is in contrast to the Fed’s latest projections that rate cuts are unlikely in 2023. Today Chair Powell did not indicate any change to those projections.
This divergence between the market and the Fed has received a fair amount of attention, including from multiple reporters at today’s press conference. Generally, we are disinclined to think the divergence is all that significant. After all, following a year when the Fed’s interest-rate forecasts missed by 350 bps, ending this year within 50 bps of the forecast could be viewed as a respectable result.
Nonetheless, to the extent there is something to be learned, we think the divergence is suggestive of two points. First, the current level of short-term interest rates is unlikely to be sustained for too long. The most acute phase of the inflation episode appears to have passed. Should inflation continue to decline throughout 2023, the current level of rates will become increasingly restrictive, thereby putting additional downward pressure on inflation and hastening the start of rate cuts. Relatedly, when interest rates are cut, they will likely be reduced by a significant amount. Just as the hikes in 2022 were steeper and larger than in previous cycles, it follows that rate cuts, when they happen, will likely also be much steeper and larger than in previous cycles.
The second point suggested by the divergence is that the risks have shifted. Last year, the primary risk was that inflation would continue to surprise higher. This year, in contrast, investors face a two-way risk with regard to inflation (i.e., inflation could surprise either lower or higher), as well as an increasing risk of a more material economic contraction. As a consequence, investors are now considering a number of scenarios in which short-term yields would be falling, and some scenarios in which yields would be falling very rapidly. These scenarios, which are increasingly plausible even if they are not yet most investors’ base case, have in turn pulled market pricing in the direction of lower yields.
Conclusion
The Fed may now be behind the disinflation curve. The recent economic data could justify a pause in the hiking cycle after today’s meeting; the market currently anticipates that rate cuts are on the horizon. The Fed, in contrast, continues to assert that further rate hikes will be appropriate and it does not anticipate cutting rates this year.
There are, of course, a number of ways that this could play out. On the one hand, if inflation were to reaccelerate, the Fed’s slow response could prove prescient. This risk was likely a focus in the Fed’s deliberations today.
On the other hand, if inflation continues to moderate, at some point the Fed will catch up with the data and markets. The timing of that remains uncertain. It’s entirely possible that the market pricing for cuts is a bit premature. Nonetheless, we do think the market pricing has correctly anticipated two points. Interest rates are unlikely to remain at these elevated levels for all that long, and the risks are increasingly tilted toward lower rather than higher yields.