The Fed Has a Commitment Problem

This past Tuesday, I offered the following forecast of what would happen at the FOMC meeting this week:

On Wednesday, the Fed will leave its target rate for fed funds unchanged. That decision will keep the federal funds target at 5.50% as set at the July 26, 2023, meeting. Over the course of [13] FOMC meetings beginning March 16, 2022, I’ve been correct in all of my forecasts including the “skipped” rate hikes at the June and September 2023 meetings. I’m confident I’ll be correct on Wednesday also.

The Fed did keep the fed funds rate unchanged as I had projected. At the same time, they warned that rate hikes are still on the table, and they could raise rates again. But they did not offer a date when that might be expected. That makes 14 Fed meetings in a row going back to March 16, 2022, when I got the Fed forecast right.

I don’t say that to brag, it’s just that I know how to interpret what they say beforehand. You just have to know what to look for.

My advice that the Fed would leave further rate hikes on the table was also correct, but the Fed hinted strongly that any further rate hike would not happen until 2024. Events remain uncertain from here, but it’s so far, so good for my forecasting.

Here’s the text of part of the Fed’s Wednesday press release.

The committee seeks to achieve maximum employment and inflation at the rate of 2% over the longer run. In support of these goals, the committee decided to maintain the target range for the federal funds rate at 5.25–5.50%. The committee will continue to assess additional information and its implications for monetary policy.

In determining the extent of additional policy firming that may be appropriate to return inflation to 2% over time, the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

In addition, the committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The committee is strongly committed to returning inflation to its 2% objective.

The FOMC vote in favor of this policy statement was unanimous. This meeting did not include the notorious “dots,” technically the Summary of Economic Projections (SEP) offered by the 19 Fed governors and regional reserve bank presidents and presented in graphical form as a dot plot.

What Comes Next?

It’s important to look at the Fed’s reasoning behind its moves and to consider what’s next both for the Fed and the U.S. economy.

Fed Chair Jay Powell’s press conference following the announcement is always more informative than the official announcement and this meeting was no exception. Powell’s insistence on flexibility going forward is obvious.

But Powell and the Fed are caught in a dilemma.

Inflation remains too high, and Powell acknowledged this. The CPI (annualized) was 3.0% in June, 3.2% in July, 3.7% in August and 3.7% again in September. That’s a steady increase driven mainly (if not exclusively) by higher energy prices.

The Fed’s hard-won gains against inflation are being lost.

At the same time, Powell seemed relaxed about the CPI figures. He referred to other inflation indexes that showed inflation was still coming down. He also said that we might be at the “terminal rate” where inflation comes down further without more rate increases.

Finally, Powell said, “Progress will come in lumps and be very bumpy,” and “We feel like we’re on a path” to reduced inflation. In short, Powell was not troubled by the 3.7% CPI number, he was encouraged by other indexes and he suggested inflation might come down on its own from here.

Of course, Powell did not say the fight against inflation is over. He said, “We haven’t made a decision about December [the Fed’s next meeting]. The idea that it would be difficult to raise again after stopping for a meeting or two is just not right.”

He also said, “We will need to see slower economic growth and some weakening in the labor market before we see a return to price stability.” And “We need to see shortages and bottlenecks go away… We’ll still be left with some ground to cover to get to price stability.” He summarized by saying that if the Fed sees conditions where they need to tighten, “we will tighten.”

On the one hand, Powell was relaxed about current inflation numbers and suggested inflation might come down on its own from here. On the other hand, he left the door open to future rate increases if needed to win a final victory over inflation. Powell was having it both ways.

Take your pick.

There was some discussion about the “term premium” issue that got a lot of coverage the past week. Term premium is the difference between the nominal rate on longer maturity Treasury securities and the rate of inflation. For example, if the 10-year Treasury note yields 5% and inflation is 3.7%, then the term premium is 1.3%.

The Fed’s theory is that term premium is the “extra” interest that the market wants to compensate for risks other than inflation. It’s a completely made-up theory with no empirical support. But the Fed believes it.

Term premium entered the debate recently because the current term premium (about 1.3%) is high by historical standards. That might act as a brake on inflation by itself (through higher mortgage rates) without more rate hikes by the Fed.

Powell poured cold water on the term premium debate without actually denying that the Fed looked at it. He said the Fed needed to consider if tighter monetary conditions were coming from term premium or perhaps other factors such as the strong dollar.

The Fed is not sure if a high term premium would be persistent or if other tightening factors such as a strong dollar would be persistent.

This is the Fed’s convoluted way of saying that term premium and the strong dollar might be inflation-fighting factors. But the Fed is not sure, and they won’t rely on that in setting policy. As they say in New York: “Go figure.”

The only areas where Powell was definitive were: The FOMC is not thinking about cutting rates. And the Fed does not have a recession in its forecast. Neither of those statements means very much.

The Fed is always behind the curve. They will cut rates when they have to, whether they are thinking about it today or not. And the Fed never has a recession in its forecast. But they do happen.

On the whole, it was one of the blandest, non-committal Fed meetings in memory. Not much news really. That doesn’t mean important events are not unfolding. It just means the Fed is not attentive to them.

The next Fed meeting is Dec. 13. As of now, the best forecast is that the Fed will not raise rates at that time. But given a world in turmoil and the Fed’s nonchalant posture, the truth is anything can happen.

Stay nimble.