If Donald Trump were still president, he would be breaking up the Federal Reserve. President Biden, for his part, has kept his mouth shut. But he can’t be happy about a depressed Fed refusing to celebrate the steady improvement in inflation.
On Dec. 13, markets cheered as the monthly inflation report showed a better-than-expected decline, from 7.7% annual inflation in October to 7.1% in October. The details were generally encouraging. Commodity prices have stabilized as Americans shift spending back to services, returning to pre-Covid norms. Gasoline prices have dropped and are likely to drop further. Used car prices, which rose at an insane rate of 41% in January, are finally starting to come down.
Stocks rose on the inflation news, as it suggested the Fed may soon ease its monetary tightening. Since the first rate hike in March, the Fed has raised rates by about 4 percentage points, one of the fastest tightening cycles in its history. The Fed had telegraphed another half-point hike in Dec. 14, which happens. So far, so good.
But the public statement of the Fed and the chair of Jerome Powell after the hike shows that the Fed is the last group in town to find the news of inflation encouraging. The Fed’s rate-hiking committee has forecast higher rates in 2023 than just a few weeks ago, and indicated that they don’t think a new cycle of interest rate cuts will begin until 2024. That’s a more hawkish scenario than markets expected. “Restoring price stability will require maintaining restrictive policy for some time,” Powell said on Dec. 14.
Markets have been mixed all week, with the S&P 500 (^GSPC) down 5% from the moment Powell began speaking on Dec. 14. Disappointment will become familiar. Since the summer, the gradually improving outlook for inflation has led the market to empty rallies that the Fed has quickly choked on the next interest rate hike. “This has to end soon,” Mr. Market seems to think, before the Fed comes in and says, “Nope, this isn’t going to end anytime soon.”
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The risk isn’t just waiting too long for inflation to normalize and the Fed to stop moving. The Fed’s military may end up causing a recession than necessary, or a recession, or a recession worse than necessary. “Stocks Gain as Recession Fears Grow,” headlined the Wall Street Journal on Dec. 16, echoing investors’ fears.
Forecasters are now lowering their outlook for 2023 and beyond, based on the Fed not seeming to care if it’s causing a recession, if that’s what’s needed to end inflation. In the report of Dec. 16, Bank of America predicted a “policy error” caused by the Fed and other central banks going too far, leading to a “Main St. hard landing.” B of A economists said, “Unemployment, savings, crime and default rates look set to rise rapidly.” They noted that while the unemployment rate is 3.7%, the average for the past 50 years is 6.2%, and the Fed would not mind pushing it higher again, slowing wage growth and depressing spending.
The Fed now looks for another half-point rate hike in February, followed by a quarter-point increase in March. Then the Fed can pause for a while to see if it moderates inflation for good – or causes more damage. Then the picture will be bigger. Most forecasters think the Fed will slow the economy so fast that it will have to start cutting rates again in late 2023, as a new stimulus. The Fed doesn’t see it that way yet – but it could change its mind as circumstances warrant.
Trump has praised the Fed every time it falls under his original policies by raising rates slowly when Trump wants a hot economy that will boost his re-election chances, as one example. By one measure, Trump bashed the Fed 100 times on Twitter alone, although Fed tightening under Trump was mild and short-lived.
Biden has promised to leave the Fed alone and not subject it to political pressure. But he should be skeptical about whether the Fed will go too far, as most economists do. “The US economy will need a lot of luck to avoid a recession next year as headwinds are set to strengthen,” Oxford Economics advised clients on December 16. “The central bank is now waiting to go [rates] more than we or the financial markets expect.”
There are already signs that higher rates are depressing growth. Advertising is slow. Consumers are spending less of the savings they accumulated during the COVID recession. Industrial production fell for four consecutive months. A few more months of this could signal a recession.
It is not known in real time if the Fed is tightening too little, too much, or just the right amount, because it takes months for the Fed to increase the rate of the economy. Inflation can be dangerous, so the Fed may decide that it is safer to risk overshooting rather than undershooting it. The next time inflation seems to be getting better, remember that the most important arbiter may see things differently.
Rick Newman is a top columnist Yahoo Finance. Follow him on Twitter here @rickjnewman
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