Fed’s choice between a soft landing or bringing down inflation
We received several inflation data points this week, all of which point to another large Fed rate hike (either 75 or 100 BPS) at its September 20/21 FOMC meeting. The Fed went from saying “we’re going to try to have a soft landing and bring down inflation” earlier this year to now signaling it has a choice between a soft landing or bringing down inflation. And the central bank is intent on bringing down inflation through a crackdown on economic growth.
There are the unfortunate costs of reducing inflation (higher interest rates, slower growth, and softer labor market conditions) that will bring some pain to households and businesses, but a failure to restore price stability would mean far greater economic pain. Markets have interpreted recent Fed comments as: “We are going to raise rates higher and keep them there longer than the market is anticipating. People now understand the seriousness of our commitment to getting inflation back down to 2%. If we have a hard landing and cause a recession, so be it.”
Restoring price stability will take some time
Restoring price stability will take some time and requires forceful action to bring demand and supply into better balance. The Fed wants to see demand destruction, not just an improvement on the supply side. Read another way, falling commodity prices and an improvement in supply chain issues are necessary, but not sufficient, to get the Fed to pivot towards a more accommodative monetary policy. On the bright side, the housing supply – demand imbalance should likely prevent a nationwide home price decline of large significance. This is more of a “buyer’s strike” than a “forced selling” event.
The Fed likely wants to see at least 4% unemployment before it thinks of pulling back. And a fed funds rate of above 4% is expected by the end of the year.
More important than the policy action at this upcoming meeting will be the path forward and communication of that path.
Chair Powell is expected to expand on the Committee’s view that at some point ratcheting down the pace of hikes will be appropriate. Markets are looking for specific metrics that the Fed will be targeting. The Fed likely wants to see at least 4% unemployment before it thinks of pulling back. And a fed funds rate of above 4% is expected by the end of the year.
As risks tilt slightly towards higher rates and flatter curves, the effect on the yield curve has been much more pronounced at the short end. The 2-year bond yield has picked up 23 BPS in yield over the past two days, while the 10-year is up about 8 BPS. The yield curve continues to invert, and the spread between the 2-year and the 10-year is now -36 BPS. The amount of tightening that has yet to hit the market is piling up. Luckily, since mortgage rates are more influenced by longer-term rates, we aren’t seeing much of an impact on mortgages (at least not yet). It will be more important to watch what happens in Treasury re-investments. The last time the Fed tried to reduce its Treasury holdings, repo rates spiked, which forced them to suspend roll-offs.
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