The Fed: Higher Until “Highly Confident”
Discussion
What makes the game of markets so fun is that you never know how a thesis is going to ultimately come together. Pieces of evidence come from all different sources, you process them, take some out, leave some in, bring some back. Then ‘poof’ a thesis emerges as if it was staring you in the face the entire time.
For the last couple of weeks I haven’t been able to really formulate what I thought FED Chair Powell was likely to discuss at Jackson Hole. The Fed’s almost done hiking, but they’re highly data dependent and thus likely to respond to an economic reacceleration; but with real rates high across the TIPS curve they’re credibly in restrictive territory, thus they’ll naturally be more cognizant of the labor side of their mandate going forward whether the economy reaccelerates or falls into recession. There’s a whole slew of things, dovish and hawkish, that he could discuss given this two-handed outlook. So, I haven’t had a good feel. Until yesterday.
As I was mowing the lawn (one of the best activities for passive thinking) it hit me like a ton of bricks: “higher until highly confident”. That’s what he’s going to talk about. How do I know? Because he and the Fed said so.
At his July 26 post-FOMC meeting press conference1 Powell went out of his way to say that the discussion about rate cuts would not come until a “full year from now.” If you watch the exchange and read the transcript, he did not need to say that. He went out of his way.
On August 2, FRB New York President John Williams sat for an interview2 with The New York Times. In the interview he made two seemingly contradictory statements. Number one:
“I haven’t seen really any strong evidence that neutral rates have yet risen much beyond what they were, say before the pandemic.” For reference, his work suggests the long-term real neutral rate is 0-.5%.
Number 2. In response to the question “Inflation is coming down now, so why not lower interest rates now, then?” Williams said:
“I look at where real interest rates are, kind of: What’s the real interest rate, inflation-adjusted, going ahead for the next year or two. Those real interest rates to me are moderately above any reasonable estimate of neutral.”
Right now the effective Fed Funds Rate (FFR) is 533 and the TIPS market is priced for 205 bps of inflation over the next two years3, which puts the real FFR at 328, 278 bps higher than the upper end of Williams’ own estimate of the real neutral rate. Back to Powell…
Immediately following Powell’s “full year from now” phrase he said with regard to cutting rates:
“…it’ll be about how confident we are that inflation is, in fact, coming down to our 2 percent goal.”
Later on the press conference he said:
“So the idea that we would keep hiking until inflation gets to 2 percent - it would be a prescription for a policy of going way past the target. That’s clearly not the appropriate way to think about it.”
CPI and PPI just printed 2.95% YoY on average4 and the real FFR is 328 bps. Is the Fed not well on its way to bringing policy “way past the target”? Why is the Fed not yet “confident” inflation is coming down to its 2% target?
Enter: The “Highly Confident” Framework
On July 14, 2022 former FRB New York President Bill Dudley unofficially rolled out the “highly confident” framework in a Bloomberg op-ed5 saying:
“…the Fed needs to be confident that it has succeeded in pushing inflation back down on a sustainable basis. Chair Powell correctly understands that the costs of not hitting the 2% target over the next year or two outweigh the costs of a mild recession – because failure would cause inflation expectations to rise, necessitating an even tighter monetary policy and a deeper downturn later. In the late 1960s and the 1970s, the central bank tightened monetary policy enough to push inflation lower at times, but it reversed course too soon. As a result, the peaks and the troughs for inflation kept moving higher — until the 1980s, when Paul Volcker had to force a deep recession to regain control. Given this history, officials will be hesitant to stop tightening until they’re highly confident (probability greater than 80%) that they’ve done enough — that the labor market has sufficient slack to keep inflation low and stable, and that easing financial conditions won’t lead to a inflation rebound.”
Six weeks later Powell closed his Jackson Hole speech with: “We will keep at it until we are confident the job is done.”
Since Jackson Hole 2022 the Fed has been reticent about its definition of “confident”, but last week they finally defined it - two weeks after Powell’s “full year from now” statement and two weeks before Jackson Hole 2023. Not an accident.
In a post-CPI interview Thursday, FRB San Francisco President Mary Daly defined “confident” in black and white:
“The real piece where we’re going to be doing a lot more thinking and watching is in this core services without housing included - ‘supercore’ some people call it. That is a big component of spending for people and it is something that has really not made much progress so far. Now, that’s not surprising, really, because it’s less interest rate sensitive. But we do need to see that come back to pre-pandemic levels if we’re going to be confident that we can get to 2 percent on a sustainable basis.”
Core Services ex. Housing CPI (supercore) inflation peaked at 6.46% YoY in September 2022 and just printed at 4.13% YoY last month. Yet, Daly said it hasn’t made much progress because the pre-pandemic average is 2.25%.
Later on in the interview Daly said that the Fed will know it’s gone too far when “demand slips below supply.” I think they’re measuring supply and demand using supercore inflation, which means they’re willing to risk deflation in the stickiest part of the inflation basket to ensure inflation returns to 2% on a sustained basis.
I also think supercore inflation is the answer to why the real FFR is just “modestly” above neutral according to Williams. At 533, the FFR is 120 bps above YoY supercore CPI, just 70 bps above the 50 bps upper bound of Williams’ definition of the long-run real neutral rate.
I continue to believe that the financial market has very little appreciation for just how hawkish this Fed is. They are miles behind the “curve”, and intentionally so.
Stay buckled.