Will investors care if the Fed lessens its commitment to 2 percent inflation?
FILE - An American flag flies over the Federal Reserve building on May 4, 2021, in Washington. (AP Photo/Patrick Semansky, File)
During the past year, investors have been fixated on how pro-active the Federal Reserve would be in tackling inflation. When inflation surged to a four-decade high, the Fed began playing catch up in June as it proceeded to raise rates by 75 basis-point increments at four consecutive Federal Open Market Committee (FOMC) meetings. This marked the fastest pace of tightening in four decades and raised investor concerns that it would lead to a recession.
More recently, Consumer Price Index (CPI) inflation eased to 7.1 percent in November from a peak of 9.1 percent in June, and it is expected to decelerate further in the coming year. The Fed responded by slowing the pace of rate hikes to 50 basis points at this week’s FOMC meeting to 4.2 percent to 4.5 percent, and it signaled that the funds rate could peak at 5 percent to 5.25 percent early next year. Fed Chairman Jerome Powell emphasized that the Fed retained its commitment to its 2 percent inflation target, and rates are likely to stay elevated until it is confident that inflation is under control.
The Fed’s median forecasts for 2023 call for real GDP growth of 0.5 percent, while the unemployment rate is expected to reach 4.6 percent. Its preferred measure of inflation – the personal consumption deflator – is forecast to slow to 3.1 percent by year’s end, down from 5.6 percent currently.
Harvard economist Jason Furman, however, warns that the economy could be headed for an “incomplete hard landing.” He envisions inflation coming down to about 3.5 percent under current policy, which would leave it well above the stated goal of 2 percent. If so, the Fed would either need to do another round of tightening to meet its target or raise it. In Furman’s view, the latter may be preferable if job losses are high and persist for a long time.
Former New York Fed President Bill Dudley disagrees. He believes the Fed already has raised its inflation objective implicitly, as there is no mention of it aiming for a rate below 2 percent to offset recent large overshoots. Another consideration is that a higher target could increase economic friction and uncertainty as households and businesses determine where inflation is headed.
The key issue for many economists is that raising the target rate could undermine the Fed’s credibility. As Dudley states: “Moving the goal posts would be interpreted as a failure, making it more difficult to anchor expectations around the new objective.”
This begs an important question: Will investors care if the Fed tolerates inflation of 3 percent to 4 percent if the economy slips into recession?
One of the most unusual aspects of the current environment is how wrong bondholders have been about inflation. They initially concurred with the Fed’s view that the spike was linked to supply- chain disruptions, and they thought it would be temporary. Then, when the Fed became more aggressive about lowering inflation, investors’ expectations about where rates were headed lagged what policymakers were signaling.
The bond market, for example, currently is pricing in a funds rate that is lower than the Fed’s projections. Moreover, bondholders believe the Fed will respond to economic weakness by lowering rates in the second half of 2023.
For their part, equity investors appear more concerned about the impact Fed tightening will have on the economy and corporate profits than on whether inflation will increase uncertainty. Thus, the stock market has rallied on economic weakness, because it increases the likelihood that the Fed will pivot from tightening policy further. Conversely, the market has sold off when data are strong.
Can one infer then that the Fed has a free pass to ease policy if inflation proves sticky?
My take is that investors ultimately will assess both the near-term and longer-term consequences of monetary policy. The main reason they appear unconcerned about the spike in inflation is that it has come after three decades in which it was under control.
During that span, the Fed established its credibility as an inflation fighter, and there is no evidence to suggest it is in jeopardy now. This is apparent from the behavior of U.S. financial markets and the strength of the U.S. dollar.
A test of the Fed’s credibility, however, could occur if inflation were to stay elevated for a while longer and the Fed paid greater attention to unemployment. If so, investors could take away the “free pass” the Fed currently enjoys.
In a Wall Street Journal commentary, Mickey Levy and Charles Plosser contend that the Fed needs to reformulate the strategic plan that was adopted in 2020. It deviated from the fundamental theme of the Volcker-Greenspan era that price stability is the most important contribution monetary policy can make for sustained economic growth and job creation. Specifically, they call for the framework of average inflation targeting to be discarded in favor of a simple 2 percent target with numeric tolerance bands. They see this as the clearest way to convey the Fed’s commitment to keep inflation low.
In the end, a key reason for the Fed to maintain its 2 percent inflation target is that it was integral to the “Global Moderation” — the period of economic prosperity and relative macro stability that lasted for three decades. During this period, central banks successfully targeted low inflation, which increased the confidence of households and businesses and enabled interest rates to stay low.
By comparison, the past three years suggest we may be entering a period of “Great Volatility” as the global economy has been buffeted by the COVID-19 pandemic, Russia’s invasion of Ukraine and the effects of climate change. While these forces will likely lead to weakness ahead, the decisions that the Fed and other central banks take to deal with high inflation can mitigate and limit the ultimate impact of these shocks. This is the main reason the Fed should persevere in keeping inflation low.
Nicholas Sargen, Ph.D., is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”