Dancing in the dark: The Fed’s rate conundrum is shaking markets
The US Federal Reserve Board is now being driven by economic data that implies a “higher for longer” outlook for interest rates. That makes data to be released over the next week of particular importance, and of acute sensitivity for financial markets.
Shares on Wall Street fell sharply and bond yields rose on Monday after Jerome Powell’s testimony before the Senate banking committee, in which the Fed’s chairman said the latest economic data had come in “stronger than expected”, and that it suggested “the ultimate level of interest rates is likely to be higher than previously anticipated.”
From pricing in a 25 basis point increase in the federal funds rate at the next meeting of the Fed’s Open Market Committee (which makes the rate decisions) on March 21 and 22, the markets are now pricing in the strong possibility of a 50 basis point increase.
That would be a significant development. This US rate cycle started a year ago with a 25 basis point increase, followed by 50 basis points in May and then four consecutive 75 basis point rises. In December, a taper started, with a 50 basis point increase followed by 25 basis points in February.
The market had factored in two more of those smaller moves, taking the federal funds rate (equivalent to the Reserve Bank’s cash rate) to a peak of just over 5 per cent. The Fed is currently targeting a rate of between 4.5 per cent and 4.75 per cent, but Powell’s comments suggest it is conceivable that it could peak at 5.75 per cent or more late this year.
Where, after the Fed’s last meeting early last month, Powell referred to signs that a disinflation process had started and suggested there needed to be “a couple more rate hikes to get to that level that we think is appropriately restrictive,” he now says the data over recent weeks – “core” inflation levels mainly, and services sector inflation particularly – has been stronger than expected, hence the likelihood that rates would end up higher than previously thought.
How much stronger will become clearer once the latest US jobs data is released on Friday and the next set of inflation data is published next week.
US unemployment has remained at historically low levels despite the 450 basis point rate rises over the past 12 months. The overall inflation rate has been trending down, but inflation in the services sector has remained stubbornly high.
During this early part of 2023, markets had been positioned for a relatively soft landing for the US economy, although there has been a divergence of opinion between the bond market, where bond prices have been falling and yields rising (there is an inverse relationship between prices and yields) and the sharemarket, which is up about 4 per cent since the start of the year.
The more pessimistic bond market seems to be winning the argument, with Powell’s comments helping to push yields even higher.
‘Will working people be better off if we just walk away from our jobs and inflation remains 5 [or] 6 per cent?’
Fed chair Jerome Powell
Yields on two-year US Treasury notes broke through 5 per cent on Monday for the first time since mid-2007. The spread between two-year and 10-year yields is now more than a percentage point, the first time that has occurred since 1981.
The US yield curve is now quite steeply inverted – yields on the shorter-dated securities are higher than those of longer duration, which upends the notion that investors should be compensated more for the risk of holding the securities longer.
There has been a yield curve inversion before every post-war recession in the US, although not every inversion of the curve has been followed by a recession.
The Fed is in a similar position to the Reserve Bank, confronted with the delicate and invidious trade-offs involved in combating decades-high levels of inflation. Central bankers are very aware of the potential for unnecessary damage to economic growth, and the high levels of unemployment and social distress that they will engineer if they raise rates too high or leave them elevated for too long.
When US Senator Elizabeth Warren suggested that the Fed was trying to throw people out of work, with millions of Americans losing their jobs, Powell’s response was that inflation was extremely high and that was hurting workers badly. The Fed was taking the only measures it had to bring the inflation rate down.
“Will working people be better off if we just walk away from our jobs and inflation remains 5 [or] 6 per cent?” he asked. RBA governor Philip Lowe has made similar comments.
Central bankers know that, with the price and availability of money their only tools for responding to inflation outbreaks, increased unemployment and household stress are the unpleasant but necessary consequences – objectives, even – if an inflationary cycle is to be broken.
Their job has been made more challenging by the post-pandemic environment of very tight labour and housing markets, disrupted (albeit much-recovered) supply chains and strong consumption from households with savings that bulged during the worst of the pandemic as governments opened the fiscal spigots.
The war in Ukraine, heightened geopolitical tensions and the decoupling of significant sectors of the US and other economies from China have added to the global economic uncertainties and risks.
The difference between the abnormal post-financial crisis era of negative real interest rates and negligible inflation that preceded the pandemic, and what monetary policy settings and tolerable inflation rates should be in a “new normal” environment are also complicating considerations.
In the US, an additional risk factor and one with global implications is the face-off between the Biden administration and the Republicans over the US government debt ceiling. At a US Senate hearing on Monday, ratings agency Moody’s Analytics’ chief economist Mark Zandi said seven million jobs could be lost, there would be a deep recession and markets would plunge if there were a default on the government’s debts.
Moody’s also said that 2.6 million jobs and a year’s worth of economic growth would be lost if Joe Biden surrendered to the Republicans’ demands and slashed government spending to avoid such a default. The best estimate is that the US will default in July or August without an agreement to raise the debt limit, which currently stands at $US31.4 trillion.
All those “known unknowns” have left the Fed and, to varying degrees, other central bankers – and financial market participants – essentially dancing in the dark and increasingly data-dependent and reactive.
Each new piece of economic information becomes more important than the last, and has the potential to rock expectations and produce wild swings in financial markets
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Source: Thanks smh.com