If Donald Trump were still president, he’d be shredding the Federal Reserve. President Biden, for his part, is keeping his mouth shut. But he can’t be happy about a gloomy Fed that refuses to celebrate the steady improvement in inflation.
On Dec. 13, markets rejoiced as the monthly inflation report showed a better-than-expected decline, from 7.7% annualized inflation in October to 7.1% in October. The details were broadly encouraging. The price of goods was stabilizing as Americans shifted spending back toward services, in a return to pre-COVID norms. Gasoline prices were down and likely to fall further. Used-car prices, which rose at a crazy 41% rate in January, finally started to fall.
Stocks rose on the inflation news, since it suggested the Fed might be able to ease up a bit sooner on its rapid monetary tightening. Since its first interest-rate hike in March, the Fed had raised rates by nearly 4 percentage points, one of the fastest tightening cycles in its history. The Fed had telegraphed another half-point hike on Dec. 14, which is what happened. So far, so good.
But the Fed’s public statement and chair Jerome Powell’s remarks following the hike suggest the Fed is the last group in town to find the inflation news encouraging. The Fed’s rate-hiking committee forecast higher rates for 2023 than they had just a few weeks earlier, and indicated they don’t think a new round of interest-rate cuts will begin until 2024. That’s a more hawkish stance than markets anticipated. “Restoring price stability will likely require maintaining a restrictive policy stance for some time,” Powell said on Dec. 14.
Markets tanked for the rest of the week, with the S&P 500 (^GSPC) down more than 5% from the moment Powell began speaking on Dec. 14. The disappointment is becoming familiar. Since the summer, a gradually improving outlook for inflation has duped the market into hollow rallies that the Fed promptly chokes off with its next interest rate move. “This has to end soon,” Mr. Market seems to think, before the Fed comes along and says, “Nope, this isn’t ending any time soon.”
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The risk is not just a prolonged wait for inflation to normalize and for the Fed to stop hiking. The Fed’s militancy could end up causing more of an economic slowdown than necessary, or an outright recession, or a worse recession than necessary. “Stocks swoon as recession fears increase,” the Wall Street Journal’s main headline blared on Dec. 16, capturing the gloom among investors.
Forecasters are now downgrading their outlook for 2023 and beyond, based on a Fed that doesn’t seem to care if it causes a recession, if that’s what it takes to whip inflation. In a Dec. 16 report, Bank of America predicted a “policy mistake” caused by the Fed and other central banks hiking too much, leading to a “Main St. hard landing.” The B of A economists said, “Unemployment, savings, delinquency and default rates look set to rise sharply.” They also noted that while the current unemployment rate is 3.7%, the average of the past 50 years is 6.2%, and the Fed might not mind pushing it that high again, to slow wage growth and depress spending.
The outlook for the Fed now is another half-point rate hike in February, followed by a quarter-point hike in March. Then the Fed could pause for a while to see if it has tamed inflation for good—or caused excessive damage. The picture gets murkier after that. Many forecasters think the Fed will slow the economy so abruptly that it will have to start cutting rates again in late 2023, as a new form of stimulus. The Fed doesn’t see it that way yet—but could change its mind as conditions warrant.
Trump harangued the Fed whenever it fell out of step with his me-first policies by raising rates to slow growth when Trump wanted a hot economy that would boost his odds of reelection, as one example. By one count, Trump bashed the Fed 100 times on Twitter alone, even though Fed tightening under Trump was mild and short-lived.
Biden has pledged to leave the Fed alone and not subject it to political pressure. But he must have doubts about whether the Fed is going too far, given that many economists do. “The U.S. economy will need a lot of luck to avoid a recession next year because the headwinds are about to intensify,” Oxford Economics advised clients on Dec. 16. “The central bank now anticipates hiking [rates] more than either we or financial markets anticipate.”
There are already signs that higher rates are depressing growth. Retail sales are slowing. Consumers are spending down savings they accumulated during the COVID downturn. Industrial output has declined for four months in a row. A few more months of this could signal a de facto recession.
It’s not knowable in real time if the Fed is tightening too little, too much, or just the right amount, because it takes months for Fed rate hikes to dose the economy. Inflation can be pernicious, so the Fed may have decided it’s safer to risk overdoing it than underdoing it. The next time inflation seems to be getting better, remember that the most important arbiter of that may see things differently.
Rick Newman is a senior columnist for Yahoo Finance. Follow him on Twitter at @rickjnewman
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