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June 2023: Thoughts on the Fed and Inflation
The Fed changes trajectory
About every six weeks, the Federal Open Market Committee (FOMC) meets to discuss interest rates. For much of the past 15 years, this was not big news. Sometimes the FOMC would fiddle with interest rates slightly, but due to the state of the economy, especially in the wake of the Great Recession, there wasn’t much action. Interest rates were kept low as the economy recovered from one of the greatest financial crises of all time.
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How times change. Since inflation began to skyrocket in 2021, financial markets watch inflation reports and FOMC meetings with bated breath. Everyone is waiting to see what happens with interest rates. When markets expect the Fed to raise rates, the stock market plunges. On Tuesday, June 13, the latest inflation numbers were posted. They showed that inflation increased by 4.0 percent over the last year. (Note: there are several different measures of inflation, as I discussed here. For whatever reason, the media likes to focus on the CPI, while the Fed uses the PCE.) This represents a decrease from previous months (see chart below), and a large decrease since the peak in May 2022.
Due to the decreased inflation, financial markets expected the Fed to maintain the current interest rate after 10 straight increases. This duly happened on June 14, when the FOMC announced it would leave the interest rate unchanged. The S&P 500, my preferred measure of “the stock market”, increased by roughly three percent in just a few days.
Did the Fed make the right decision? None of us has a crystal ball, so without the benefit of hindsight it’s impossible to know. That said, even as an inflation hawk I’m satisfied, if not thrilled, with this decision. I think the Fed needs to take the threat of entrenched inflation very seriously. The longer inflation stays high the harder it will be to decrease. Inflation becomes a self-fulfilling prophecy; if everyone expects inflation to continue then they will continue to demand large raises and be willing to pay increased prices, thus continuing inflation. So it’s important that the Fed act relatively quickly to clamp down on inflation before the expectations of Americans change.
So far the Fed has done a good job taking inflation seriously by steadily increasing rates, but not increasing them so quickly it causes a recession. I personally would have preferred faster rate hikes, but I think their course of action is totally reasonable. The Fed’s goal of pulling off a “soft landing”, that is, reducing inflation to two percent without causing a recession, is still a distinct possibility. At the same time, the threat of stagflation, where inflation remains elevated AND the economy stalls, could still happen. The Fed is taking a gamble by trying to accomplish a soft landing while risking stagflation, but I think that’s the right course of action.
The FOMC statement that accompanied the notice that inflation rates would remain static sends all the right signals. It says, “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals.” This indicates that the Fed has maintained its two percent inflation target, and will not shy away from rate increases in the future.
So what next? Now all eyes turn to next month’s inflation numbers. If the CPI continues to decrease by any margin, even from 4.0 to 3.9 percent, I expect the Fed will leave the interest rate unchanged when they meet again in six weeks. If the CPI increases by any margin, I expect the Fed to increase rates by a quarter point. If the CPI is unchanged, then the Fed has a difficult decision to make.
Assuming, and this is a strong assumption, that inflation continues to decrease by significant amounts, then the Fed’s goal changes. Instead of deciding how hard to push the break, as they have for the last two years, they need to decide how fast to let up. Changing interest rates is like steering a large ship; if you want to change direction there is a lag between actions you take and a response. The Fed wants inflation to be at two percent. However, if they were to keep interest rates at their current 5.25 percent until inflation reached two percent, then inflation would likely continue to decrease below the two percent target and the Fed would overshoot. Instead, the Fed needs to start taking its foot off the brake and reduce interest rates as inflation continues to increase, and try to level things out slowly.