Fed Chair Jerome Powell’s speech at the Brookings Institution on Wednesday confirmed that the FOMC is on track to raise the federal funds rate by 50 basis points rather than 75 basis points at the December 13-14 meeting of the committee.
Said Powell: “Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”
The key word for investors is “moderation.”
The financial markets seem to believe that the Fed is getting closer to the terminal federal funds rate, which is widely deemed to be around 5.00%, and that the economy can handle that “restrictive” level even if it stays there for a while. Indeed, during the Q&A session following his speech, Powell repeated that he still believes that there is a path to a soft (or “softish”) landing for the economy.
Investors have been fearing that the Fed might turn too restrictive, causing a recession. Powell specifically said that the Fed is aware of that risk and does not want that to happen. Of course, Fed officials are also expecting (hoping) that inflation will continue to moderate to validate the Fed’s moderation pivot.
Inflation remains high and uncertain: Powell spent a good part of his speech talking about inflation. He started his prepared remarks by “acknowledging the reality that inflation remains far too high.” He reiterated a frequent theme from his past statements about inflation: “Without price stability, the economy does not work for anyone.” He also stated that “[t]he truth is that the path ahead for inflation remains highly uncertain.”
Then he proceeded to drill down on the outlook for the core PCED inflation rate: “To assess what it will take to get inflation down, it is useful to break core inflation into three component categories: core goods inflation, housing services inflation, and inflation in core services other than housing.”
Core goods inflation heading in the right direction: Powell was optimistic about the outlook for core goods inflation: “While 12-month core goods inflation remains elevated at 4.6 percent, it has fallen nearly 3 percentage points from earlier in the year. It is far too early to declare goods inflation vanquished, but if current trends continue, goods prices should begin to exert downward pressure on overall inflation in coming months.”
Housing services inflation should moderate late next year: Powell observed that housing services inflation, which measures the rise in rent of primary residence and the rental-equivalent cost of owner-occupied housing, “has continued to rise and now stands at 7.1% over the past 12 months. Housing inflation tends to lag other prices around inflation turning points, however, because of the slow rate at which the stock of rental leases turns over.”
He observed that “market rate on new leases is a timelier indicator of where overall housing inflation will go over the next year or so. Measures of 12-month inflation in new leases rose to nearly 20% during the pandemic but have been falling sharply since about midyear.”
Core services other than housing depends on labor costs: The third category is core services other than housing. It covers a wide range of services from health care and education to haircuts and hospitality. It is the largest of the three categories, constituting more than half of the core PCE index. Powell observed: “Thus, this may be the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”
Powell said that demand still well exceeds supply in the labor market. As a result, “[w]age growth, too, shows only tentative signs of returning to balance. Some measures of wage growth have ticked down recently.”
The bottom line is that financial markets took comfort from Powell’s suggestion that the Fed’s tightening cycle is pivoting to a more moderate stance of rate increases. However, Powell concluded: “It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
Ed Yardeni is president of Yardeni Research Inc., a provider of global investment strategy and asset-allocation analyses and recommendations. This article is excerpted from QuickTakes, a service of Yardeni Research. Sign up to receive them by email at yardeniquicktakes.com.