After seven straight rate hikes totaling 4.25% and an eighth anticipated on Wednesday, Federal Reserve governors are preparing to halt their inflation campaign and wait for results.
- Official rhetoric will remain anti-inflationary with a tightening bias.
- Credit markets have turned away from rate hikes, the Fed is next.
- Silver import duty increased from 10.75% to 15%
Do not, however, expect an announcement from Fed Chair Jerome Powell.
His post-decision press conference will continue commentary from earlier this month in Stockholm, “…restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy. The absence of direct political control over our decisions allows us to take these necessary measures without considering short-term political factors.”
Yet regardless of Mr. Powell’s assurances of inflation rigor, change is coming to Fed policy. Economic logic, historical precedence and market perception make a switch inevitable.
Federal Reserve interest rate policy
Four consecutive 75 basis point increases that began last June, followed by a 50-point jump in November and 25 points this week will bring the fed funds rate to 4.75%, its highest level in 15 years, and within 35 basis points of its current year-end estimate of 5.1%. New economic and rate projections will be issued at the next Fed meeting on March 22.
Fed officials and Chairman Jerome Powell are hoping the steepest ramp since Paul Volcker’s campaign in the early 1980s, which crushed inflation but also sent the United States into its deepest post-war recession, will curtail prices without crashing the economy.
Fed rhetoric has been adamant about quelling inflation. Powell’s hawkish comments in Stockholm were the latest in a long line of official assertions promoting the bank’s single focus on prices and determination to prevent embedded expectations of higher inflation.
But markets have already decided that the Fed’s rate campaign is term-limited.
Treasury markets
Treasury yields reversed in early November and continued to fall even as the Fed hiked 0.5% on December 14 and raised the 2023 terminal rate in its Projections Materials from 4.6% to 5.1%.
The 10-year US Treasury bond yield peaked on November 7 at 4.22% and as of Friday’s close at 3.52% was down 70 points. The 2-year topped out at 4.73% on the same day and has shed 52 points to 4.21%. The yield curve is inverted along its entire length from the 10-year note to the 1-month bill.
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The prospect of a further 25-point increase on Wednesday, a near certainty for weeks, has not dissuaded Treasury yields from further declines. The 10-year has lost 36 points from its January high and the 2-year has clipped 24 points (Friday close).
Historically, falling US Treasury yield rates have presaged the first Fed rate cut by an average of five months.
In 2019 and 2020, the 10-year topped out on November 23, 2019, and the first-rate cut came on March 3, 2020, three months later.
In 2018 and 2019 the 10-year yield peaked on November 18, 2018, but the first 0.25% decrease in the fed funds did not arrive until July 31 the next year, a bit over eight months later. In 2007 and 2008 the apex of the 10-year yield was in early July 2007 and the first rate cut came mid-September in just over two months. Finally, in 2000 and 2001 the delay from peak to cut was about seven months from mid-May 2000 to early January 2001.
In none of those four circumstances was inflation a problem, which let the Federal Reserve focus solely on prospective economic weakness, or in the case of 2008, acute financial system distress. Were the current economic situation a standard recession, markets might anticipate a rate cut at the May or June Fed meeting.
Equities and the US Dollar
Equities, not surprisingly, have mirrored the decline in US Treasury yields. All three major stock averages – Dow Jones, NASDAQ and S&P 500 – reversed course in October and November, and are well above their 2022 and 2023 lows, though far less than their prior highs.
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The US Dollar likewise has tracked US Treasury yields down. The greenback has lost ground against every major since the start of the fourth quarter. The EUR/USD has gained 13% since its late September low and the USD/JPY is down a similar amount since the third week in October. The Dollar Index has dropped 11% since its 2022 top.
Economic and market logic
The market logic predicting a rate cut is based on the economy and the probable Federal Reserve reaction as growth approaches a stall. Markets do not believe the Fed governors will continue to hike rates if the economy slides towards recession, no matter how strenuous their previous promises.
Having added 475 basis points to the fed funds rate in eleven months, easily the most precipitous cycle since the Volcker era, a pause is warranted and good policy. Rate hikes take time to retard inflation and ever-higher interest rates will do little to speed the price reaction but become increasingly likely to push the economy into recession.
In addition to the diminishing inflation return from higher rates, economic statistics have deteriorated over the past few months while price gains have eased.
Retail Sales have fallen in three of the last four months. Spending on services was flat in December after accounting for inflation. Real disposable income, which is corrected for inflation and taxes, saw the second largest percentage drop in history in 2022, behind only 1932, the worst year of the Depression.
Though the Consumer Price Index (CPI) has fallen from its 9.1% annual peak of last June, it has been above 5% for 19 months. That is the longest bout of inflation since the 1980s. The US economy is about 70% dependent on consumer spending and contracting consumption is one of the surest paths to recession.
The business contribution to Gross Dpmestic Product (GDP) is under strain as well with investment expanding just 1.4% in the fourth quarter and almost all of that due to inventory growth. The ISM Purchasing Managers’ Indexes for manufacturing and services were both in contraction in December with particular weakness in the new orders gauges of incoming business. Consumer credit card debt is rising even as revolving interest charges soar and savings last year fell below 2009 levels.
One bright point in the economy has been the labor market. Non-farm Payrolls (NFP) have expanded for 24 straight months. But even here the trend is negative. The NFP monthly average has fallen from 539,000 in the first quarter to 247,000 in the fourth and the December total of 223,000 is the lowest in two years. Job layoffs have started at several prominent companies, including Goldman Sachs, Amazon, and Google.
A further consideration in the job market is how many of these newly created jobs actually exist. In past years large portions of the new hiring credited to NFP have turned out to be the temporary creation of Bureau of Labor Statistics (BLS) models that have been far more optimistic than reality. When the estimated new employment is checked against actual payrolls from the tax rolls in the annual BLS revision, those jobs vanish. It is more than likely that a good portion of last year’s NFP gains is fictitious.
Conclusion: A change in Federal Reserve policy is coming
The Federal Reserve cannot achieve its soft landing and avoid a recession if it continues to hike through the first half of the year. Inflation seems to be ebbing. Consumer spending is under pressure and there are substantial questions about the strength of the labor market. Business spending will follow consumption down if it craters.
The potential economic disaster of a heavily indebted consumer sector, and a Federal government approaching $500 billion yearly in interest payments, exacerbated by a deep recession is a possibility even worse than surrendering the inflation fight before complete victory.
Expect Fed officials to soon begin noting progress on inflation, even if Fed Chairman Jerome Powell is not likely to be overly sanguine on Wednesday. One of the unstated purposes of the Fed’s rapid hikes was to gain as much inflation insurance as possible before the economy cracks from the weight of the rate increases. That point has nearly arrived.
Given the credit markets’ clear bias towards a change in policy, any hint from Mr. Powell, deliberate or inadvertent, of a change in economic perception will send interest rates and the US Dollar rocketing lower and equities soaring. Wednesday afternoon could be far more exciting than expected.
