A Federal Reserve Board member says US inflation is on a path that should enable the central bank to cut interest rates three times this year. Despite his apparent optimism, the US sharemarket fell and bond yields spiked in response to his comments.
Christopher Waller is one of the 12 voting members of the Fed and so his views have weight, as the markets’ reactions demonstrated.
But why did the apparently “dovish” remarks from a former monetary policy hawk (Waller was a strong advocated for the aggressive, five percentage points-plus rate hikes that the Fed has made since March 2022) evoke such a sour response?
It’s because the three 25 basis point rate hikes that Waller suggested were within sight this year are half of what financial markets have been pricing in. The Fed sees 75 basis points of cuts this year, but investors had priced in six cuts lowering rates by 150 basis points.
That’s why shares slumped – the Dow Jones index was down about 300 points in the immediate aftermath of Waller’s speech at the Brookings Institution – and bond yields rose across the board by between 10 and 13 basis points.
The US dollar spiked against the other major currencies, including the Australian dollar, which fell nearly a US cent. It has now slumped almost 3 US cents in the past three weeks to trade below US66 cents.
The market had priced in perfect, or at least near-perfect, outcomes for inflation and interest rates, and Waller was suggesting the Fed wasn’t as confident as investors that the path of inflation would be that smooth.
‘I see no reason to move as quickly or cut as rapidly as in the past […] The key is we have the flexibility that we can be methodical and careful.’Fed Reserve Board member Christopher Waller
That caution was expressed in his commentary. While he said the progress on inflation and the data available on economic and financial conditions made him more confident than he had been since 2021 that the inflation rate was on a path to 2 per cent, when the time was right to begin lowering the Fed’s policy rate he cautioned that “it can and should be lowered methodically and carefully”.
“In many previous cycles, which began after shocks to the economy either threatened or caused a recession, the FOMC (the Fed’s Open Market Committee that makes decisions on rates) cut rates reactively and did so quickly and often by large amounts.
“This cycle, however, with economic activity and labour markets in good shape and inflation coming down gradually to 2 per cent, I see no reason to move as quickly or cut as rapidly as in the past,” Waller said.
“The healthy state of the economy provides the flexibility to lower the nominal policy rate to keep the real policy rate (the rate after inflation) at an appropriate level of tightness.”
If current trends seen in the data continued, “we can slowly calibrate the real rate down” and move faster, he explained. “But the key is we have the flexibility that we can be methodical and careful.”
The Fed, from Waller’s perspective, is in no rush to start cutting rates, let alone carve into them to the degree the markets – which were factoring in a start to the rate-cutting in March – had expected.
With the US economy starting to slow but performing better than expected, particularly in terms of employment, the Fed doesn’t want to err by moving too early or too fast, having misjudged the start of the huge post-pandemic surge in the inflation rate, which peaked at 9 per cent.
That bias towards caution would have been strengthened by last week’s US inflation data, which showed an increase in headline inflation from 3.1 per cent to 3.4 per cent, suggesting that the “last mile” in this fight against inflation might not be as straightforward as investors had anticipated.
One data point within quite volatile external settings, of course, doesn’t say anything definitive about the future, and the longer-term trends in the core inflation rate, which strips out fuel and energy prices, and in the personal consumption expenditure index that the Fed focuses on show an inflation rate much closer to the Fed’s 2 per cent target.
Even if the US domestic settings appear on track, the conflicts in the Middle East and Ukraine, the disruptions and costs flowing from the impact of the attacks on shipping in the Red Sea and low water levels in the Panama Canal, the continuing tensions between China and the US-led West, the outcome of the elections in Taiwan and the political dysfunction within the US are examples – and potential sources – of the kinds of events that have unforeseen and unpredictable consequences for economies and inflation rates.
But there is also an obvious risk the Fed is overly cautious.
Until the December quarter, the US economy was growing at an annualised rate of almost 5 per cent, which was too hot. The growth rate more than halved in the December quarter – monetary policy works with long lags – easing the pressure on the Fed and raising the prospect that, if the Fed calibrates its policies effectively, the world’s largest economy can experience the holy grail of policymakers – a “soft landing”.
If the Fed were to leave monetary policy too tight for too long – that is, if the markets’ view that rates should be cut early and hard is correct – it could push the US economy into an apparently avoidable recession. The judgments are a fine line, but the disparity between outcomes and the consequences of getting it wrong – in either direction – are profound.
With the US sharemarket trading at near-record levels and bond yields having come off nearly a full percentage point over the past three months, markets and investors are highly sensitive and exposed to the Fed’s actions and its members’ utterances, and every data point that provides any insight into the likely near-term path of inflation.
This will be a jittery year for investors, the Fed and, given it is an election year, US politicians.
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Source: Thanks smh.com