Last week was another big week in what has become perhaps the most prominent cycle of inflation and interest-rate movements since the historic era of the “Great Inflation” 40-odd years ago.
The latest round of consumer price index (CPI) data was released 11 days ago, data which suggested that while the rate of inflation continues to decline, price pressures have become “sticky.”
At basically the same time these inflation numbers were revealed, the Federal Reserve delivered an equally “mixed-message” sort of announcement about interest rates at the conclusion of its latest policy meeting: Rate increases will be paused, but interest rates likely will be raised at least two more times before the end of the year.
If all of this leaves you feeling rather clueless about what’s next for interest rates, it’s understandable. And looking to the world’s most successful money managers for guidance likely won’t clear things up for you. It seems even they disagree about what’s in store for monetary policy through the near term.
Here’s an example: Larry Fink, CEO of world’s-largest-asset-manager BlackRock, recently said he expects the Fed to raise interest rates as many as four more times this cycle.
“The Fed is not finished,” Fink said. “Inflation is still too strong, too sticky.”
OK. Let’s see if Jeffrey Gundlach, founder of DoubleLine Capital hedge fund, agrees.
“I don’t think the Fed’s going to be raising interest rates again,” Gundlach said last week. As justification of his view, Gundlach pointed to what he sees as various signs of economic weakness, including a recent manufacturing purchasing managers’ index figure which he said is “massively recessionary.”
The fact that two very-smart and highly successful investors have such different perspectives on the future of interest rates in the near term says a lot about just how unpredictable the economic and monetary-policy environment is right now. But what may say even more about that environment is the degree to which there’s disagreement in the perspectives of Fed officials themselves.
It seems there are two, somewhat-opposing views on the future of monetary policy right now living within the halls of the Federal Reserve: one that says the central bank should be more dovish in its handling of rates, going forward, while the other suggests the Fed should remain decidedly hawkish. The justifications for each position are equally compelling.
And that implies that the usual crystal balls anyone might look to in hopes of gaining a useful idea about what lies ahead for interest rates could be particularly cloudy for the foreseeable future.
Let’s take a closer look at just what’s going on, including the principal issues that are energizing both interest-rate “doves” and “hawks” right now.
One factor suggesting it may be prudent for the Fed to remove its foot from the interest-rate accelerator is that inflation has shown meaningful signs of declining. Last June, the headline consumer price index (CPI) was more than 9%…a level it had not seen in four decades. Since then, however, the rate of inflation has slowed in every month that has followed. As of May, CPI is down to 4%.
The fact that inflation is coming down as steadily as it has over the past year is a development that would prompt central bankers to reconsider maintaining a more stringent rate environment. But there’s another factor at play, as well: the added stress that tends to be placed on an economy when the cost of money – interest rates, in other words – is higher.
To be clear, the goal of higher rates is to curb the demand that is, at least in part, fueling inflation. So, it’s essentially the purpose of that rate-tightening to increase the general stress on the economy. That’s understood. Even accepting that as a given, however, the central bank still strives to manage rates in as measured a way as possible so as to limit the chances that the increased stresses on the economy ultimately result in recession.
Unfortunately, the historical record of avoiding recession when rate increases are as purposeful as they’ve been this cycle is not great. According to research last year by investment bank Piper Sandler, in the previous six decades, recession has resulted in eight of the nine previous attempts by the Fed to bring down inflation with a rate-tightening campaign.
Unemployment and consumer-spending levels continue to reflect an economy that’s not on the verge of recession. But there are signs of weakness beginning to emerge. For example, manufacturing indexes both here and abroad are signaling “contraction” right now. And commercial real estate, which represents about $20 trillion to the economy, is viewed as a particularly vulnerable sector right now.
The chance that higher interest rates could tip the country into recession is a concern by itself. This time, however, there is another consideration beyond the prospects of a general downturn.
Recent banking events revealed potential fragility in the financial system. Some central bankers – notably, Fed Chair Jerome Powell – expressed concerns that elevated interest rates could place even greater pressure on banks that have seen their portfolios of government securities lose value in the higher-rate environment. According to the Wall Street Journal, “Fed regulators are keeping close tabs on 20 to 30 institutions they see as more vulnerable following this spring’s banking turmoil.”
Following last week’s decision by the Fed to pause rate hikes, Powell said that signs of increased stress on the banking system are a monetary-policy consideration of his right now. “We don’t know the full extent of the consequences of the banking turmoil that we’ve seen,” Powell said. “It would be early to see those.”
But there’s a flip side to the interest-rate coin, one that suggests the potential consequences of not continuing rate hikes are just too big to accept. And according to other Fed officials, those consequences actually are rooted in the same inflation data that says it may be time to bring rate hikes to an end.
CPI has been dropping steadily for months. But a closer look at the data reveals a murkier inflation picture than a year-long decline in headline CPI might otherwise indicate.
It’s core CPI data – which excludes more volatile food and energy prices – that essentially makes the argument for maintaining a restrictive rate posture.
In May, core CPI rose 0.4% on a monthly basis – faster than the monthly rate at which headline CPI rose in May (0.1%).
As one sign of just how stubborn core CPI has been, the monthly pace has remained at 0.4% or higher since December.
The year-over-year core CPI figure also has shown signs of real stickiness for many months now. From September 2022 through December 2022, annual core CPI declined from 6.6% to 5.7%. Since December, however, the rate has declined more slowly and less evenly, and remains above 5% – 5.3%, to be exact – as of May.
Additionally, key CPI subindexes show signs of upward price pressure well above that 5%-plus pace. For example, the shelter index, which makes up one-third of headline CPI and more than 40% of core CPI, was up 8% year over year in May.
Just days after the conclusion of the Fed’s most recent policy meeting, one Fed official publicly clarified his belief that more rate hikes are in order.
At a moderated discussion in Oslo, Norway last Friday, Fed Governor Christopher Waller had core CPI, specifically, in his sights, saying, “Core inflation is just not moving and that’s going to require probably some more tightening to try to get that going down.”
Waller also said directly that for as long as inflation remains an issue, he’s not in the camp of those Fed officials who might be inclined to back off rate hikes out of deference to signs of possible bank distress.
“Let me state unequivocally: The Fed’s job is to use monetary policy to achieve its dual mandate, and right now that means raising rates to fight inflation,” Waller said. “It is the job of bank leaders to deal with interest rate risk and nearly all bank leaders have done exactly that. I do not support altering the stance of monetary policy over worries of ineffectual management at a few banks.”
And if you needed any more evidence that there may be little in the way of real consensus right now among Fed officials about the future of monetary policy – and interest rates, in particular – you need look no further than at central bankers’ most recent Summary of Economic Projections.
Let’s talk briefly about that as we finish up this week.
The interest-rate projections of the Federal Open Market Committee (FOMC) – as reflected in the Fed’s June 14 Summary of Economic Projections – seem to underscore the differing views among members about monetary policy and where interest rates should be headed from here.
Granted, there is greater general agreement among members, overall, about where rates will be by the end of this year. But it’s hardly a uniform agreement.
The 18 members of the FOMC indicated where they saw rates at the end of 2023 and beyond. As for this year, nine of the 18 projected two more rate increases before the end of 2023. Of the other nine committee members, four project one more increase, two say we’ll have three more rate hikes, and one expects four more. Oh…and two others say rate hikes for the year are finished.
There’s even less agreement when looking ahead to Fed projections for years 2024 and 2025.
The median fed funds rate projected by the FOMC for the end of 2024 is 4.6%. But only two committee members actually penciled that rate in as their actual projection. Overall, the 2024 projections range from 3.6% up to 5.9%. And the projections for 2025? The median projection is 3.4%, but the actual projections range from as low as 2.4% to as high as 5.6%.
In other words, there’s little enough agreement about where rates will be at the end of 2023, and even less agreement about where they’ll be in the next two years.
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