What’s Morphed in 2024Q1?
- It’s all about inflation and the Fed’s interest rate reaction function. From the absence of forward guidance to the incessant data dependency – understandably in a time of uncertainty – the Fed is feeling its way to a landing.
- In the prepared remarks of every Jay Powell speech, he affirms the dual mandate: “the Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.” This is somewhat unique to the U.S. for focusing both on (1) keeping the consumer inflation expectation anchored at the 2% target rate and (2) maintaining “full” employment. (Today it is lower than the past 5% unemployment neutral levels.) So, it is a balancing act of keeping interest rates at the “right” level and ultimately landing on the illusive neutral rate (or r*) on the one hand and yet being tight enough to keep inflation under control while maintaining “full” (including minority and women) employment on the other hand.
- Since 2022, the Fed has been focused on bringing down inflation fast enough to prevent the unanchoring of consumers’ inflation expectations. The unprecedented speed and scale of raising interest rates tell us that the Fed was serious about the price stability part of its mandate at a time when the labor market was at a historically tight level coming out of COVID. The surprising speed of CPI coming back down that ensued (primarily due to the disappearance of goods inflation as supply chain and manufacturing production healed) led the Fed to stop hiking and determine that the cycle interest high was reached last year.
- Approximately 70% of the U.S. economy is made up of the service sector; thus, the efforts of reducing the lingering sticky inflation above 2% must be focused on consumer demand. There is a direct relationship between employment, wages, savings, financial conditions, and consumption. As the Fed awaits the full impact of the long and variable lag, it is hopeful that, by holding rates high and inflation grinding downward, the “real” interest rate would increase and make financial conditions more restrictive.
- The Fed is now pivoting more of its focus on the “full employment” mandate to see how a normalizing labor economy (more workers entering the job market and more immigration) would tamp down wage growth, labor market tightness, and excessive consumer demand on services. The Fed is NOT trying to engineer a recession (i.e., a hard-landing) to successively meet their dual mandate with the smooth interest rate glidepath to r*.
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