It seems that the Federal Reserve is losing control of the market. Financial conditions have eased to levels not seen since spring 2022. This easing has led to increases in commodity prices, falls in mortgage rates, a weakening of the the dollar and a rally in stocks.
February’s FOMC will become even more important as the Fed will need to backtrack from the current easing of financial conditions. If the Fed really believes that monetary policy is transferred through financial terms, then the Fed has not been successful. Conditions are currently the same as when the Fed first started raising rates. These conditions are accommodating to the economy and aid in its expansion, the exact opposite of the Fed’s desire to keep the economy growing at a below-trend rate.
Push back to this point in the game is perhaps even more difficult than when Powell gave his Jackson Hole speech. The market knows that the Fed is closer to the end of its rate hike cycle than it started. The market also expects inflation to fall further. This means that the Fed could either raise rates by 50 basis points, which would come as a big surprise to markets, or signal that financial conditions have eased too much, prolonging the cycle of interest rate tightening.
Prices are rising
One effect of easing financial conditions is rising commodity prices. The average national price for regular unleaded gasoline rose 9.4% in January, indicating we could see a month-over-month rebound in the consumer price index (CPI) when the January report is released.
Copper prices have also risen dramatically. Changes in copper prices can lead to changes in year-over-year changes in CPI. The recent rise in copper prices is due to two factors: China’s reopening and a weaker dollar. While the Federal Reserve cannot contain enthusiasm for a rebound in China’s economy, it may try to tighten financial conditions, strengthen the dollar and possibly slow the copper rally.
Meanwhile, timber prices have risen dramatically this month as new home sales begin to pick up again. This appears to be due to the easing of financial conditions.
The return of inflation
These issues challenge Powell and the Federal Open Market Committee as the easing of financial conditions has increased inflationary impulses. According to the Cleveland Fed’s latest estimates, this is expected to result in a month-over-month increase of 60 basis points in the aggregate consumer price index in January. This would be the most significant increase in the monthly CPI change since June.
Based on those estimates, the consumer price index (CPI) could rise 6.4% in January, showing no significant improvement from December. Inflation swaps for January have also been ticking higher in recent weeks, indicating that the market is now expecting a higher value in January as well.
This is a real risk for the Federal Reserve if the Cleveland Fed’s predictions come true, as it would negate the progress the Fed has made since the summer peak of inflation and could raise the question of whether the downward trend we have seen in inflation has begun to reverse .
The bottom line is that the Fed cannot afford to see financial conditions ease any further and they need to start tightening again to curb the inflationary impulses that seem to be revived. Conditions are back to February 2022 levels, according to the Bloomberg Financial Conditions Index, before the Fed started raising rates and only discussed the possibility of rate hikes.
In addition, from a monetary policy point of view, the overnight rate is roughly equivalent to the core inflation rate of personal consumption expenditure (PCE). The Fed has made it clear that it wants rates to be sufficiently restrictive, and for that to happen, rates will have to rise to a point where they are above core PCE inflation.
Chris Waller, a Fed official, indicated in an interview last week what the Fed considers sufficiently restrictive when he noted that sufficiently restrictive rates are when real rates are 1.5% to 2% above predicted inflation. He said if you look at the end of the year and market forecasts for inflation of 2.5% to 3%, reaching a rate of 5% would be limiting enough.
This is perhaps the best indication yet that the Fed has given the market as to what it is thinking about when it comes to where it thinks rates should be to bring the economy and inflation back into balance and why the Fed does not intend to go back on raising rates until it reaches a daily rate of 5% at the lower limit.
In addition, the main metric the Fed is watching is PCE core services excluding housing, and based on Bloomberg data, that’s a stubborn figure that hasn’t fallen and hovers around 4.1%.
It has to push back
If the Fed does not act now and oppose the current easing of financial conditions, which it has repeatedly noted helps drive monetary policy through the economy, then all may be lost. Because right now the market doesn’t believe the Fed when it says it wants monetary policy to be restrictive enough and slow growth below trend and is willing to put up with these things to avoid the inflationary impulses that still clearly exist, to kill.
The Fed’s options are limited at this point, but they can do so by going against the collective belief that the Fed will only raise rates by 25 basis points and raise rates by 50 basis points instead. Or Powell will have to send a very strong message, possibly stronger than Jackson Hole’s, threatening that interest rates will not go higher than thought in December due to an unwarranted easing of financial conditions. Otherwise, he may need to raise the topic of possibly increasing the pace of quantitative tightening and unwinding the balance sheet.
Anything else would indicate that the Fed is okay with the current easing of financial conditions and is willing to tolerate the market taking control and driving monetary policy, which appears to be a disaster waiting to happen.
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