by Hubert Marleau, Market Economist, Palos Management
Federal Reserve officials raised interest rates by a quarter-point last Wednesday to a range of 5% to 5.25%. It was the 10th straight increase, capping the fastest series of rate increases since the 1980s and reaching a level not seen since 2007. Investors did not like the action, thinking that it was superfluous, unnecessary and bold. The S&P 500 fell 33 points registering a weekly decrease of 0.7%.
Yet there was a meaningful shift in the Fed’s assessment. Wednesday’s language softened some more. Within three months, the language went from “Ongoing increases in the target range will be appropriate” to “Some additional policy firming may be appropriate” to “We're closer, or maybe even there”.
Concerns about the banking contagion, the debt-ceiling issue and recession risks plus some consideration for falling inflation were the headline reasons behind the apparent shift. There is also another less talked-about reason for the change. Several key Fed officials believe that grim productivity, ageing population, de-globalization and changing societal habits will keep the neutral rate low. I’m putting it at 3.00%, which is higher than the Fed’s long run estimate of 2.25%. In this connection, the policy rate is now 2.125% above the level that it ought to be for neutrality. Should this spread be maintained over the coming months as Powell suggests, the money supply is bound to fall some more, forcing inflation and economic growth down a few more notches.
My take is that over the next 6 months economic growth will be positive but near zero. The Atlanta Fed just raised the second quarter GDP growth to 2.7% from 1.8% on May1 because the April job report was unexpectedly strong in a cooling economy. Thus, it follows the impact of the monetary stance and financial conditions has and will fall mainly on inflation, where the fat exists. According to research produced by the NY Fed, both inflation persistent and global supply chain pressure is consistently falling.
Perhaps surprisingly to some observers, the short end of the yield curve is predicting that in one year’s time, the year-over year inflation will be below the Fed’s target at 1.9%. I’m not as optimistic as that, but I would venture a year-over-year increase in the CPI of 3.1% by September/2023 and 2.2% by March/2024.
This is what is needed to turn the monetary policy around. Indeed, history shows that when payroll growth dissolves and inflation closes in on the target, things can happen very fast. On Thursday last, swap contracts were giving 95% odds that the FOMC will pause all rate hikes at the next meeting in Mid-June and 55% chances that it will cut the policy rate as soon as late July.
As the economic data heads south, the Fed will have no problem abandoning its current view that the policy rate must stay higher than the neutral rate. The job is done.
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