There were no encouraging signs in the Labor Department’s report Thursday that showed the consumer price index surged a greater-than-forecast 7.5% in January from a year earlier, marking a fresh four-decade high. The gains were broad and deep, suggesting that inflation is becoming entrenched and potentially putting the Federal Reserve in a no-win situation.
Immediately after the release of the CPI report, the money markets priced in the possibility that the central bank will be forced to raise interest rates higher and faster than it has projected, including a 50-basis-point increase at policy makers’ March 15-16 meeting. Traders also now expect a full percentage point of increases by the end of July, according to Bloomberg News. Moreover, the difference between short- and long-term bond rates — better known as the yield curve — continued to collapse.
What all this means is that the markets increasingly see the only way for the Fed to get inflation under control is to engineer a sharp slowdown in the economy, and perhaps even force a recession. This would be the hard landing that policy makers have wanted to avoid. As recently as Wednesday, Federal Reserve Bank of Cleveland President Loretta Mester, who votes on monetary policy this year, said she didn’t see a “compelling case” for a half-percentage-point increase. In a sign of what may come if the Fed decides to do what Mester said was unlikely, the S&P 500 Index quickly fell 1% and bond yields soared after Federal Reserve Bank of St. Louis President James Bullard, who is also a voter this year, told Bloomberg News on Thursday that he supports raising interest rates by a full percentage point by the start of July. That implies at least a half-percentage-point increase at one of the three meetings between now and then.
In each of the past two monetary policy tightening cycles, from 2004-2006 and 2015-2018, the Fed raised rates only in quarter-point increments, flagging each move well in advance to avoid disrupting financial markets. The reason the Fed is so concerned about not introducing extra volatility into markets is because of something call the “wealth effect.” This is not an official Fed policy, but central bank officials over the years have talked about how rising prices for stocks and other assets tend to boost consumer spending and the overall economy. “So equities play a hugely important role, which I think is grossly underestimated,” former Fed Chair Alan Greenspan said at a Bloomberg event in 2012.
Being forced into a “shock and awe” move would also further damage the Fed’s credibility and bolster the perception that it is behind the curve. Even as inflation accelerated through much of last year, the Fed wrongly maintained that the gains were most likely just transitory. As recently as December, the Fed was forecasting just three quarter-point rate increases this year; the market is now anticipating six.
To be sure, a lot of important economic data is scheduled to be released before the Fed’s next monetary policy meeting in mid-March. In a couple of weeks, we’ll get the personal consumption expenditure report for January, which the Fed considers a more important measure of inflation than the CPI. And on March 4, we’ll get the monthly jobs report for February, followed by the CPI report for February, which is scheduled to be released March 10.
But the Fed may have no choice but to accelerate its tightening plans no matter what the hit to its reputation, the markets and economy — which could be large. The “wealth effect” downside could be far more substantial now than in past hiking cycles “because retail investors are far more active than in the past, especially in younger age cohorts, for whom significant volatility could be a new experience,’’ FHN Financial economist Chris Low wrote in a recent report. Almost 75% of chief executive officers surveyed by the Conference Board said rate increases are unlikely to quickly bring down inflation. The Fed has backed itself into a corner.
Bloomberg
