The Fed must send an extremely hawkish message to the markets

It looks like the Federal Reserve is losing control of the market. Financial conditions have eased to levels not seen since the spring of 2022. This easing has led to commodity price increases, mortgage rate cuts, weaker the dollar and a rally in equities.

The February FOMC will take on added importance as the Fed will have to push back the current easing in financial conditions. If the Fed truly believes that monetary policy is transmitted through financial conditions, then the Fed has failed. Conditions are currently at even levels as the Fed began raising rates. These conditions are accommodating to the economy and helping to expand it, exactly the opposite of the Fed’s desire to grow the economy below trend.

push back to this point of the game may be even more difficult than it was when Powell gave his speech in Jackson Hole. The market knows that the Fed is closer to the end of its rate hike cycle than the beginning. The market also expects inflation to continue to decline. This means that the Fed can either raise rates by 50 basis points, which would be a big surprise for the markets, or signal that financial conditions have eased too much, which will prolong the rate-tightening cycle.

Prices increase

One of the effects of easing financial conditions is rising commodity prices. The national average price for regular unleaded gasoline rose 9.4% in January, indicating that we could see a resurgence in the Consumer Price Index (CPI) month to month. another when the January report is released.

Additionally, copper prices have risen dramatically. Changes in copper prices can cause changes in year-to-year variations in the CPI. The recent increase in copper prices is due to two factors: the reopening of China and a weaker dollar. Although the Federal Reserve cannot control the enthusiasm for a rebound in the Chinese economy, it may attempt to tighten financial conditions, strengthening the dollar and potentially slowing copper’s recovery.

Meanwhile, lumber prices have risen dramatically this month as new home sales begin to recover. This appears to be the result of easing financial conditions.

The return of inflation

These questions challenge Powell and the Federal Open Market Committee because the easing of financial conditions has increased inflationary impulses. According to the latest estimates from the Cleveland Fed, this should lead to a 60 basis point month-over-month increase in the consumer price index in January. This would be the largest increase in the monthly change in the CPI since June.

According to these estimates, the consumer price index (CPI) could increase by 6.4% in January, without any significant improvement compared to December. Inflation swaps for January have also risen in recent weeks, indicating that the market also expects a higher reading in January.

This is a real risk for the Federal Reserve if the Cleveland Fed’s forecast comes true, as it would undo the progress the Fed has made since the summer’s peak of inflation and could call into question whether the The downward trend in inflation that we have seen has started to reverse. .

Ultimately, the Fed cannot afford to ease financial conditions any further and needs them to start tightening again to slow the inflationary impulses that seem to be coming back to life. According to the Bloomberg Financial Conditions Index, conditions have returned to levels seen in February 2022, before the Fed started raising rates and only discussed the possibility of raising rates.

Sufficiently restrictive

Also, from a monetary policy perspective, the overnight rate is roughly equal to the core personal consumption expenditure (PCE) inflation rate. The Fed has made it clear that it wants rates to be tight enough, and for that to happen, rates will need to rise to a point where they are above the core PCE inflation rate.

Chris Waller, a Fed official, pointed to what the Fed considers tight enough in an interview last week when he noted that tight enough rates are when real rates are 1.5% to 2% at above the expected inflation rate. He said that if you look at the end of the year and the market forecast for an inflation rate of 2.5% to 3%, arriving at a rate of 5% would be restrictive enough.

This is perhaps the best indication yet that the Fed has given the market as to what it thinks when it comes to where it thinks rates need to be to get the economy and inflation back to equilibrium and why the Fed is not going to give up on raising rates before they reach an overnight rate of 5% at the lower limit.

Additionally, the key metric the Fed is watching is ex-housing PCE core services, and based on Bloomberg data, that’s a bullish number that hasn’t fallen and hovers around 4.1% .

You have to push back

If the Fed does not act at this point and oppose the current easing of financial conditions, which it has repeatedly noted helps transmit monetary policy to the broader economy, then all could be lost. Because at this point the market doesn’t believe the Fed when they say they want monetary policy to be tight enough and want to slow growth below trend and be prepared to endure these things to kill the inflationary impulses that clearly still exist.

The Fed’s options are limited at this point, but can do so by going against the collective belief that the Fed will only raise rates by 25bps and instead raise rates by 50bps . Or, Powell will have to give a very forceful message, perhaps more forceful than the one given at Jackson Hole, and threaten that rates may not go higher than thought in December due to unwarranted easing financial conditions. Otherwise, he may have to raise the question of the potential increase in the pace of quantitative tightening and balance sheet liquidation.

Everything else would suggest that the Fed is fine with the current easing of financial conditions and is willing to tolerate the market taking control and directing monetary policy, which looks like a disaster just waiting to happen. .

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