Fed chairman Jerome Powell’s hawkish comments at Jackson Hole last week brought the summer’s nascent market recovery to a screeching halt. The Fed chair reiterated the central bank’s commitment to combating inflation through future rate hikes and suggested that, in his view, rates would remain elevated throughout 2023. Mr. Powell’s comments took the market by surprise and, since last Friday, U.S. stocks have fallen nearly 6%. Futures markets are now pricing in a 66% probability of a 0.75% interest rate hike at the Fed’s September FOMC meeting.1
From a messaging perspective, it makes sense for the Fed to continue flexing its anti-inflation muscles—investors, consumers, and politicians all want reassurance that the Fed is serious about bringing inflation down. After all, most Fed critics believe the Fed was too slow to act to combat inflation in 2021, a move that seriously questioned the Fed’s anti-inflation credibility. However, after a series of steep interest rate hikes over the past few months, the message is now quite clear ─ the Fed is dead serious about bringing inflation down. But it’s also clear that the Fed’s rate hikes, the steepest since 1994, have begun to work their magic. Significantly higher mortgage rates have led to steep declines in new and existing homes sales (declining 22% and 17%, respectively) and, most important to the Fed, inflation finally showed signs of cooling in August’s CPI report (headline inflation, for example, was 0% in July, down from 1.3% in June).2 By any measure, the Fed’s rate hikes are working—lower inflation, slowing growth, and higher rates are exactly what the Fed wanted.
However, it’s not clear that the economy needs another 0.75% increase at this month’s FOMC meeting. While year-over-year inflation was 8.5% through July, that number is backward looking and includes base effects from prior months’ CPI reports. Interest rate hikes impact future inflation, not past inflation; there’s nothing the Fed can do now to change past months’ inflation rates. In fact, the July CPI report suggests the Fed is winning its war on inflation; headline inflation flatlined in June and core inflation (headline minus food and energy) came in at 0.3% (about 3.6% annualized). Ironically, it looks as if the Fed just might be close to achieving its original goal, a “soft landing” (bringing down inflation without pushing the economy into a severe recession), only to now snatch defeat from the jaws of success. The policy goals of a “data dependent” Fed—as it so often claims to be—might be better served with lower rate hikes (e.g., 0.25%) spread out more slowly over time. Such an approach would allow time for the Fed’s rate hikes to continue working their magic and more time for the Fed to collect data on what is a highly complex and ambiguous economic picture—while also limiting the likelihood of a hard landing (severe recession).
1 YCharts, Inc. Return data is for the Russell 3000 Index.
2 Bureau of Labor Statistics, August 2022 CPI Report
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