Sunday, March 26, 2023

Federal Reserve’s inflation fight enters a new phase

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After the Federal Reserve delivered its fourth consecutive 0.75 percentage point rate rise on Wednesday, it soon became clear the US central bank’s battle against persistently high inflation was entering a new phase.

In a statement accompanying the increase, which lifted the federal funds rate to a target range of 3.75 per cent to 4 per cent, the committee that sets monetary policy indicated it was preparing to ease up on the accelerator.

From now on, the Federal Open Market Committee will take into account how far rates have already risen this year as well as the fact it takes time for such increases to filter through to the real economy. That suggests a slower pace of rate rises in the future.

“They are obviously a bit more confident about where policy stands relative to where they need to be and relative to where they were a couple [of] weeks ago,” said Tim Duy, chief US economist at SGH Macro Advisors.

Since embarking on 0.75 percentage point increases, “the objective has always been to get policy up to a range that allows them to be more purposeful about their future policy stance”, Duy added.

But as traders digested what at first appeared to be a dovish shift from the Fed, sending the S&P 500 up roughly 1 per cent, chair Jay Powell swiftly crushed their hopes.

At the subsequent press conference, Powell warned that the “terminal” rate at which the fed funds rate tops out will be higher than previously expected — even if it takes longer to get there with smaller increments.

For investors, the terminal rate is more important than the speed of travel, and by close of trading on Wednesday the blue-chip stock index had erased its earlier gains to close down 2.5 per cent.

For Powell, getting off the 0.75-point train was always the plan. In June, when the central bank delivered what would become the first in a series of jumbo rate rises, he framed increases of such magnitude as “unusually large”, adding: “I do not expect moves of this size to be common.”

But even if a downshift is on the way, Powell made clear the Fed remains committed to bringing inflation under control: “We have some ground left to cover here, and cover it we will.” Talk of pausing rate rises altogether was “very premature”, he added.

Torsten Slok, chief economist at Apollo Global Management, described the new messaging as “incredibly complex”, but investors seemed to get the idea.

Traders in federal funds futures priced in a half-point rate rise at the December meeting and remained committed over wagers that the benchmark rate would peak at about 5 per cent next year. In September, when the Fed last released its compilation of officials’ forecasts, most saw it topping out at 4.6 per cent.

“There’s always this artful dance between the Fed and markets,” said Ellen Zentner, chief US economist at Morgan Stanley. She added Powell had done a “good job” of laying the groundwork for smaller rate rises while pushing back against “misperception” that the Fed was easing up.

“It’s safer to slow the pace of the ascent, and you actually give yourself a better chance of getting to a higher peak rate,” she said.

Chief among the fears of policymakers, economists and market participants is the stability of the financial system amid rapidly rising borrowing costs and sluggish growth, which could expose “landmines”, said Diana Amoa, chief investment officer at Kirkoswald.

“Moving at a measured pace will allow policymakers to be more responsive to these things and allow them to calibrate what they need to do in a much more elegant way,” she added.

A slower pace of rate rises might mean the Fed avoids an unintended market meltdown. But a higher terminal rate — along with a pledge to keep monetary policy at a point where it constrains the economy for a prolonged period — only increases the likelihood of a sharper downturn, say economists.

Powell even went so far as to acknowledge that the path to a soft landing, in which the Fed brings down inflation without a painful recession, had narrowed even further.

Slok interpreted that as more evidence of the Fed’s unwavering commitment to getting inflation back down to its 2 per cent target.

David Kelly, chief global strategist at JPMorgan, said: “I think the Federal Reserve feels guilty because inflation has gotten to too high a level, and that has made them aggressive in trying to kill [it].”

He added: “Everyone talks about a soft landing, but we hardly ever achieve one.”



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