Inflation has become as much a political problem as an economic one. That will be on full display this week as Federal Reserve Chair Jerome Powell heads to Capitol Hill.
Powell will deliver the central bank’s semiannual monetary-policy report to the Senate Banking Committee on Wednesday, one week after the Fed initiated the biggest interest-rate increase in about three decades. Expect legislators to focus on the trajectory of inflation and the odds of a recession, and demand more clarity on the Fed’s long-range projections.
The Fed offered mixed guidance on June 15 in announcing an increase in the federal funds rate of 75 basis points, or three-quarters of a percentage point, to a targeted rate of 1.50%-1.75%. According to CME FedWatch, the market is expecting about two percentage points of additional rate hikes as the Fed struggles to contain and suppress inflation.
Whether that degree of monetary tightening actually happens will depend as much on politics and the markets as the economy, says Christopher Wood, global head of equity strategy at Jefferies. “At some point in coming months the focus of vote-seeking American politicians is likely to switch from worrying about the need to be seen to be doing something about inflation to worrying about the impact of monetary tightening on Americans’ 401(k) plans,” he says.
Expect Powell’s comments to be parsed in light of these conflicting concerns. Here’s a guide.
Inflation
Rising prices are making consumers increasingly miserable. If fact, they’re as glum as they’ve ever been, according to the University of Michigan’s latest sentiment survey, which was launched in 1978.
Expect Republican members of Congress to hammer the inflation issue, pointing to stimulus spending by the Biden Administration, in addition to energy policies that have reduced supply. Expect Democratic members to remind viewers that stimulus spending in response to the pandemic began under the Trump administration.
Quickly rising prices have an outsize impact on lower-income households, especially because inflation is most acute today in basics such as food, gas, and rent. While many lower-income households traditionally voted for Democrats, the party is in an awkward position because it has been unable to pass legislation to help struggling consumers. More government spending arguably would exacerbate inflation by further juicing demand. Yet, attempting to cool prices via tighter monetary policy is raising the cost of credit at a time when more households are using plastic to pay for essentials.
Powell will get many questions about inflation. Look for updated answers on these. Is inflation peaking? Can inflation sufficiently cool as the war in Ukraine continues to push energy prices higher? How long will it be before inflation falls back to the Fed’s 2% target, and is there a possibility that the target is lifted to 3%-4%?
What else can be done to relieve inflation pressure, especially since monetary policy works with a lag of about a year? What can the federal government do to help families and businesses without adding to the problem?How can policymakers focus on core inflation, which backs out food and energy, at a time when those categories are causing the most pain?
Recession
Many officials might see a political advantage in bigger and faster monetary-policy tightening. For Republicans, more painful rate increases and balance-sheet tightening might make midterm elections easier to win. (Voters go to the polls on Nov. 8). Some on the other side of the aisle might also prefer front-loaded tightening in the hope that inflation is cured and the economy is on the upswing by the 2024 presidential election.
There is a long time between now and November, but the political will to tighten aggressively would mean the odds of a recession are higher than they may already appear. Many Wall Street economists and the Fed itself have said for months that a recession can be avoided, but that thinking is starting to change. Consider a Wall Street Journal poll that shows 44% of economists surveyed now expect a recession within the next 12 months; that number is nearly double the share in April and up from just 18% in January. As EY-Parthenon Chief Economist Greg Daco puts it, a recession is likely in the coming months as persistent inflation forces more pronounced monetary-policy tightening.
Expect Powell to get questions around the likelihood and severity of a recession. U.S. economic growth was negative in the first quarter, and activity is flagging in the second quarter, even before the impact of the June fed-funds increase kicks in. Plus, the second part of this tightening cycle, the Fed’s attempt to shrink its balance sheet after trillions of dollars in pandemic bond purchases, is just getting started.
After going from “soft” to “softish” and then to “bumpy” and involving “some pain” to describe the economy’s prospective landing, Powell seemed to acknowledge last week that the path to a soft landing is getting harder. He has pointed to the strong labor market as reason to believe a recession isn’t inevitable, but that is a lagging indicator.
Economic projections
When the Fed concluded its latest policy meeting last week, it issued its quarterly summary of economic projections, or SEP. While there were substantial changes from the March SEP, the latest forecasts still look too rosy.They also don’t add up.For example, the Fed predicted enough of a rise in unemployment to trigger a recession, and it predicted growth close to trend through 2024. How can the Fed see inflation within striking distance of its 2% target by 2024 without pushing unemployment higher than about 4%? Perhaps some in Congress will ask that.
Consider what former Treasury Secretary Larry Summers said in a speech over the weekend,after tellingBarron’slast week that the Fed’s forecasts were still unrealistic.The U.S. will need five years of unemployment at 6% to contain inflation—or two years of joblessness at 7.5%, or one year of unemployment at 10%, Summers said, according to press reports. The unemployment rate is currently 3.6%.
Powell will reiterate the Fed’s commitment to battling inflation, but the Fed’s latest forecasts undercut that message. Mixed messaging is tied in part to the fact that inflation is rising as growth is already slowing, whereas rising inflation usually comes with stronger growth.
Powell may attempt this week to square some of the incongruous Fed forecasts. Something has to give, and investors want to know if it will be more unemployment and falling growth, or high inflation for longer. The chance is rising that inflation will stay high and the economy will have little to no growth for a while, with more economists talking about a stretch of stagflation before recession.
Terminal rate
The Fed chair may also be questioned about the so-called terminal rate, or where the main policy rate will peak in this cycle. The latest SEP showed a terminal rate of about 3.75%, notes Roberto Perli, head of global policy at Piper Sandler. That level is below what markets and many economists expect. Yet it is also well above any reasonable definition of neutral, even taking into account that inflation expectations will be higher than normal for a while, says Perli.
“History tells us that tightening above neutral rarely ends well. So, at some point it’s legitimate to expect a deterioration in the labor market, and at that point the Fed tone will change significantly,” he says.
This is week is too soon for Powell to change his tone, but investors should look for clues as to when the Fed will become more concerned with growth numbers than inflation numbers, which will help determine when and at what level tightening will peak.
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