Wall Street’s Biggest Bear: The Fed’s Jerome Powell

“It’s a very peculiar tango we’re dancing here,” said Torsten Slok, chief economist at Apollo Global Management. “On the one hand, the Fed must surely be very happy with inflation coming down. But they don’t want the markets to complicate the speed at which we’re coming down.”

The fight between the Fed and the markets is ultimately a good sign for President Joe Biden and Congress, as it suggests that the US may be at the end of its war against this onslaught of inflation. But the dispute underscores the central bank’s delicate position: While it maintains broad bipartisan support for its drive to lower prices, it also upsets many Americans, including some lawmakers and labor activists, who complain that higher rates are unfairly burdening ordinary people. and that the Fed is determined to cause a recession.

Markets are looking for a mid-year pause in rate hikes followed shortly by cuts, but Fed officials signal they are determined to keep a grip on the economy until late 2023.

Even amid signs that wage growth is slowing and price spikes are cooling, policymakers such as San Francisco Fed President Mary Daly and Atlanta Fed President Raphael Bostic, have warned in the last week that the war against inflation is not over. In a tough press conference last month, Powell said conditions in financial markets must reflect the Fed’s “policy of moderation.” And the central bank’s rate-setting committee stressed that “unwarranted” market optimism, in the form of higher bond prices and lower rates, could hamper its attempts to reduce inflation.

Thursday’s Consumer Price Index report showed a decline not only in inflation but also in overall prices during the month of December, thanks in particular to falling gas prices. But the annual rate of inflation remains multiples above the Fed’s 2 percent target. Prices rose 6.5 percent over the past year, down from 7.1 percent in November, driven by rising rents.

But as new data continues to show a steady decline from a high of 9.1 percent last June, markets will rightly assess that we are nearing the end of the Fed’s rate hike campaign. But that’s only as long as stocks don’t rise and bond rates don’t fall so much that spending is fueled again.

“I’ve spent enough time on Wall Street to know that they are culturally, institutionally and bullish,” Minneapolis Fed President Neel Kashkari told the New York Times. “They’re going to lose the game of chicken, I can tell you that.”

At the heart of the disconnect is this: Investors expect inflation to fall faster than the Fed expects, giving the central bank room not only to stop rate hikes early, but also to start cutting rates later in the year. ‘this year.

Meanwhile, Fed policymakers have gone out of their way to say they don’t expect rates any lower than the grueling levels of 2023. They have forecast their main policy rate to be above 5 percent by the end of the year, at least three. -quarters of a percentage point higher than where it is now.

But “talk is cheap,” said Mark Cabana, head of U.S. rates strategy at Bank of America Global Research. He argued that the Fed should explicitly set thresholds for unemployment and inflation that would trigger rate cuts.

“Unless you’re willing to write it, you’re not credible,” he said.

The ground could also change markedly under Powell’s feet by the end of the year. The labor market has held up remarkably well in the face of rapidly rising borrowing costs: unemployment fell to 3.5 percent last month, the lowest level in more than half a century. But that could change as rate hikes have more time to feed through the economy and affect spending more.

In fact, it could be an argument for the central bank to make the final leg of rate hikes at a slightly faster pace, said Derek Tang, economist at research firm LH Meyer Monetary Policy Analytics.

“There is a window to raise rates and it’s closing pretty quickly if you think about the likelihood of the labor market weakening,” Tang said. “At that point, a lot of support for rate hikes is going to start to evaporate. If they really feel they need to get to that 5.1 percent cap rate, they might want to do it while they have the full support of the [Fed’s rate-setting] committee, but also the public to do it.”

Another looming threat: the non-zero chance that Congress won’t agree to raise the debt limit before the government runs out of cash, causing it to default on some of its obligations. Cabana said this would be a shock to the markets and also lead to a sudden contraction in government spending.

“This is bad for the economy,” he said. “What does the Fed do in this circumstance? You can’t be so sure you won’t cut rates in 2023.”

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