The forward guide sounds like a great idea. Central banks should set their long-term goals for influencing financial markets. Just as hockey great Wayne Gretzky skated where the puck was going, rather than where it was, monetary authorities would try to guide markets where policy was expected to be months ahead. But central banks are far less adept than the Big One at determining where the puck is headed.
The Federal Reserve has effectively shied away from forward guidance, opting instead to leak decisions from its policy-setting Federal Open Market Committee a few days before meetings. Likewise, since there have been erratic zigzags lately.
In his press conference on May 4, Fed Chairman Jerome Powell stated that a 75 basis point increase in his target federal funds rate was “not something that the committee is actively considering.” At the mid-June FOMC meeting, the rate was raised by 75 basis points, to the current range of 1.50%-1.75%; the decision was apparently leaked to The Wall Street Journal a couple of days earlier. (A basis point is 1/100 of a percentage point).
Last week, the Journal reported that the FOMC is leaning toward another 75-basis-point hike at the two-day meeting that begins Tuesday, rather than the 100-basis-point increase that some Fed watchers had expected. they had predicted after an impressive 9.1% jump in the consumer price index was reported over the past 12 months, and the Bank of Canada, surprisingly, decided on a full point boost. But fed funds futures on Friday pointed to an 81% chance of a 75 basis point move by Thursday, according to CME’s FedWatch site. On July 13th, after this disastrous CPI report was released, the odds of a 100 basis point hike peaked at 80%.
The big picture that emerges from these sudden changes is that the investment environment is radically different from the one that prevailed between 2009 and 2019, in the decade following the 2008-09 financial crisis, observes Gregory Peters, co-chief investment officer of PGIM Fixed Income. And with that, he says, comes “as wide a range of plausible outcomes as I’ve seen in my career.”
Forecasters and market participants are clearly uncertain about the path of Fed policy and the economy, even after the FOMC belatedly raised its outlook for the year-end federal funds rate to 3.4% in its June summary of economic projections, up from just 1.9% in March. , an implausible figure, given rising inflation.
The FOMC largely hammered its numbers to the market. The futures market sees fed funds hitting the central bank’s year-end estimate at its Nov. 2 meeting, up more than 25 basis points at the Dec. 14 FOMC confab, which brings the range to 3.50%-3.75%. This could mark the peak, with the market signaling that the Fed will change course and cut the fed funds rate by 25 basis points next March.
This path suggests a slowing economy and moderating inflation, allowing the Fed to reverse course next year. But some observers think that the central bank’s tightening will have to exceed its own estimates and what is set in the markets.
Jefferies chief financial economist Aneta Markowska agrees with the consensus call for a 75 basis point hike at the next meeting, but then sees the Fed moving to a 50 basis point hike in September , not the 75 basis points. towards the future But he says the market is underestimating the eventual top funds rate, which he expects to reach 4%.
Markowska sees central banks setting policy based on reported data, rather than their own forecasts (which have been way off). He also sees the numbers appearing on the sunny side for a while, the opposite of the stagflationary slogan heard by most investors and consumers.
For starters, he notes, nominal growth has been very strong, resulting in robust spending in current dollars, although much of that can be attributed to inflation. With gas prices falling sharply in recent weeks, look for a series of benign CPI reports with almost zero monthly changes.
But that could mask continued upward price pressure on “core measures” of inflation, which exclude food and energy, as discussed in this space a week ago. Once energy prices stop falling, the realization of the tightness of underlying inflation will catalyze markets to reassess their expectations for Fed policy, he predicts.
And, says PGIM’s Peters, inflation will mathematically move rapidly from the recent year-on-year rate of 9% to 7% or 6%. But what if it’s stuck at 4% or 5%? “Is the central bank’s job done? It is entirely too optimistic that it will be enough to contain inflation,” he says.
Like Markowska, Peters sees strong nominal economic growth, which he says is under-recognized. The good news is that this will bolster reported corporate earnings, leading to many problems, even if the earnings mostly represent inflation.
Markowska sees a recession as the concern for next year. He dismisses the recent surge in new unemployment insurance claims. State data show that much of it is concentrated in Massachusetts, he notes, anecdotally in biotech and technology companies squeezed by tighter financial conditions. Continuing claims have not increased, suggesting to him that those laid off are finding new jobs quickly in a strong labor market.
Peters believes the Fed will stay on course to reduce inflation and restore its credibility. Relieving at the first sign of weakness would be like quitting a marathon with only a few miles to go. From an investment perspective, he is wary of corporate credit risk due to the possibility of a recession, and prefers long-dated Treasuries, which should benefit from the Fed’s fight against inflation.
Fed chief Powell insists the central bank will return inflation to its four-decade-old target of 2%. On this point, Société Générale global strategist Albert Edwards writes: “Recent events may have forced a Damascene conversion at the Fed, and it now understands that its monetary financing of fiscal deficits in the pandemic era has been a major contributor to high inflation, despite his earlier protestations that he would not.”
Conclusion: The market is betting on a data-driven Fed to taper in 2023 after raising the fed funds rate to just mid-3%, still well below all but the most bullish inflation forecasts . That could avoid a deep recession, but lead to a double dip, like in 1980 and 1981-82, at the start of the Fed’s successful war on inflation four decades ago.
This is not an advance guide, but it is a relevant story.
Write to Randall W. Forsyth at randall.forsyth@barrons.com