U.S. Economic Brief || Fed Chair Powell’s testimony before Congress underscores the Fed’s inflation fighting resolve. Will it last?

Fed Chair Powell’s testimony before Congress underscores the Fed’s inflation fighting resolve. Will it last?

*Powell’s testimony and presentation of the Federal Reserve’s semi-annual Report to Congress on Monetary Policy dramatically stepped up the Fed’s inflation fighting rhetoric relative to his testimony in early March, and underscored the Fed’s recent shift to a more aggressive inflation fighting stance. Notably, support among FOMC participants for aggressive rate increases in the near term has been virtually unanimous, as has acknowledgement the Fed will need to restrain demand to bring down inflation.

*With headline inflation at multidecade highs and household survey-based measures of inflationary expectations ticking up toward the upper end of their recent historical range, Powell used his prepared remarks and testimony before the House Financial Services Committee to emphasize the Fed’s “unconditional” commitment to restoring price stability. In his prepared remarks, Powell noted the FOMC continues to anticipate that “ongoing increases in the target range will be appropriate” and went on to stress that the Fed aims to “expeditiously” raise its policy rate.

*These comments chime with other public commentary from FOMC members over the last week that saw even traditionally “dovish” FOMC members, such as President Evans and President Kashkari, indicating their openness to another 75bp policy rate increase in July. This support for an aggressive near-term path of policy rate increases was echoed by Governor Bowman who in a speech on June 23 threw her weight behind a 75bp rate hike in July and “increases of at least 50 basis points in the next few subsequent meetings, as long as the incoming data support them”, as well as Governor Waller who in a June 18 speech stated, “if the data comes in as I expect I will support a similar-sized [75bp] move at our July meeting”. Strikingly, Governor Bowman indicated that with inflation much higher than the federal funds rate (Chart 1), the real funds rate remains negative, and reaffirmed her commitment “to a policy that will bring the real federal funds rate back into positive territory”.

*Consistent with upward revisions in the Fed’s projections of the unemployment rate and downward revisions to projections of GDP growth, Powell acknowledged that orchestrating a soft landing will be “very challenging” and will depend on a confluence of factors beyond the Fed’s control. In his testimony, Powell also conceded that the Fed’s rate hikes could lead to an increase in the unemployment rate and tip the economy into recession. In our view, the Fed’s projections for the unemployment rate remain far too sanguine given the extent to which they forecast inflation will moderate, and we now expect the accumulated effect of elevated inflation and tighter financial conditions to push the U.S. economy into a mild recession (“U.S. Tilting Toward Recession” June 22,2022).

*This would put the Fed in a difficult position and test the Fed’s inflation fighting resolve, particularly if factors beyond the Fed’s control conspire to keep inflation elevated even as economic activity slows, and labor market conditions deteriorate. During his testimony, Powell was asked how the Fed would respond to just such a scenario, in which inflation remains elevated above the 2% target, real GDP contracts, and unemployment rises. In his response, Powell indicated that while the Fed could pause rate increases or even ease policy, “we really have to get inflation down to 2%. So we’re going to want to see evidence that it really is coming down before we declare any kind of victory. And so I think we’d be reluctant to cut”.

*Our expectation is that while the Fed talks a tough talk, if labor markets were to deteriorate markedly and the unemployment rate were to exceed 5% with evidence pointing to further increases, the Fed would likely pause its rate hikes and move to ease policy. As we point out in “U.S. Tilting Toward Recession“, if this scenario were to unfold, the Fed would continue to state publicly that its longer-run target remains 2% average inflation, but that it “must be balanced in its pursuit of its dual mandate”. The Fed’s longer-run low inflation resolve would be called into question, including its true commitment to its 2% target, and financial markets and other observers would have to relearn the implications of terms such as “opportunistic disinflation”. This eventual policy shift would align with Powell and the Fed’s continued emphasis in recent weeks on the need for the Fed to remain nimble and responsive to incoming data.

*A notable element underpinning the Fed’s 75bp rate hike in June and was a 0.3pp increase in the preliminary June release of the University of Michigan’s 5-10 year ahead survey-based measure of consumer inflationary expectations (Chart 2). This reflects the increased emphasis FOMC participants and senior Fed staffers are placing on inflationary expectations and the risk these expectations become embedded in wage and price setting behavior.

*The elevated concern over inflation expectations by FOMC members contrasts sharply with their positions a few months ago, and the shift since the March meeting has been striking. According to the March meeting minutes “a few participants judged that, at the current juncture, a significant risk facing the Committee was that elevated inflation and inflation expectations could become entrenched if the public began to question the Committee's resolve to adjust the stance of policy as appropriate to achieve the Committee's 2 percent longer-run objective for inflation”.

*The degree of concern clearly ramped up between March and May, with the May meeting minutes noting “some participants emphasized that persistently high inflation heightened the risk that longer-term inflation expectations could become unanchored; in that case, the task of returning inflation to 2 percent would be more difficult”. It is likely that the language of the June meeting minutes will shift to indicate that “many/most participants” are now concerned about risks to longer-run inflation expectations.

*While the University of Michigan’s gauge of 5-10 year ahead inflation expectations in June was revised down from 3.3% to 3.1%, it remains elevated at its highest level since 2011 and the underlying survey details highlight the tradeoffs the Fed will need to confront in months ahead. According to the director of the University of Michigan’s survey, the easing in long-run inflation expectations in late June reflected a jump in the number of survey participants expecting “extremely low inflation in the years ahead” with “about half of these consumers [expressing] bleak views about the risks of recession or unemployment”.

*In a recent speech, President Evans indicated tighter monetary policy would be “needed to prevent current large price increases from becoming embedded in pricing dynamics and longer-run inflation expectations”. This theme was reiterated by Governor Bowman who stated “we need to pay close attention and continue to use our tools to address inflation before these indicators rise further or expectations of higher inflation become entrenched”. In a sense, the Fed is now hiking rates not just to preempt higher realized inflation, but to also curtail any further upward drift in long-run inflation expectations. While this policy of fine-tuning and managing inflation expectations will be difficult given monetary policy is a blunt instrument (“Inflation Demands Bold Fed Action”, Levy and Plosser, June 14, 2022), it would be consistent with Powell’s comments at his post-June FOMC meeting press conference that suggested the Fed will respond to elevated headline inflation readings because “headline inflation is important for expectations”.

Chart 1. Core PCE Inflation and Effective Fed Funds Rate

Chart 2. University of Michigan 5-10 Year Ahead Inflation Expectations

Mickey Levy, mickey.levy@berenberg-us.com

Mahmoud Abu Ghzalah, mahmoud.abughzalah@berenberg-us.com

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