In his latest press conference, Federal Reserve Chair Powell argued that monetary policy might already be sufficiently restrictive. In future decisions, economic data will be particularly important but this does not imply that the latest data are the only thing that matters. The delayed effects of past rate hikes need to be taken into account, considering that they will only show up in the data published over the following months. This is why in past tightening cycles, the Fed has tended to stop hiking rates although the pace of job creation was still rather healthy and well before the unemployment rate picked up significantly. Today it is torn between inflation that is still well above target and the prospect that past rate hikes and tighter credit standards should weigh on activity in the coming months.
“But the labor market is very, very strong, whereas inflation is, you know, running high, well above our -- well above our goal.”[1] Judging by the very strong labour market report that was released two days later, Fed Chair Powell’s comment during his post-FOMC press conference almost sounded prescient.
Nonfarm payrolls increased 253,000 in April -the Bloomberg consensus had expected an increase of 180,000- and the unemployment rate declined to 3.4% from 3.5%. Moreover, growth in average hourly earnings picked up to 4.4% from 4.3% (consensus 4.2%). The two-year Treasury yield jumped 10 basis points and the 10-year yield moved 5 basis points higher, but this didn’t stop equity indices of reacting positively, reflecting a belief that the resilient labour market implies that the economy will not be in recession anytime soon. The rise in bond yields partly corrected their drop during Jerome Powell’s press conference earlier that week, following his acknowledgment that after the latest rate hike, the policy stance may be sufficiently restrictive: “I think - I think you feel like, you know, we're - we may not be far off for. We're possibly even at that level.” The Fed Chair’s assessment is based on, firstly, the cumulative increase in the policy rate (500 basis points), which has brought real rates clearly above the neutral rate.[2] Secondly, interest-sensitive activities have started to react to the increase in rates. Thirdly, access to credit is being tightened. Finally, quantitative tightening reinforces the effect of higher official interest rates.
Going forward, economic data will be particularly important: as mentioned repeatedly in the past by Fed officials, monetary policy is data dependent. However, this does not imply that the latest data are the only thing that matters, because the delayed effects of past rate hikes need to be taken into account, considering that they will only fully show up in the data published over the following months. This may imply that, despite inflation still being above target and/or a rather strong labour market, the central bank might stop hiking rates based on the view that, given past rate hikes, the labour market will weaken, and inflation will decline sufficiently. In this respect, the data line-up when, in the past tightening cycles, the FOMC stopped raising rates may provide insights that are relevant for the present situation. The accompanying table[3] provides information on inflation using the Federal Reserve’s preferred measure -the change in the price index of personal consumption expenditures excluding food and energy (core PCE)-, the unemployment rate, the creation of new jobs[4], a financial conditions index[5], the layoff and discharges rate and the job openings rate.[6]
In May 1989, inflation had been declining but was still above the previous low of 2.8% y/y reached at the start of 1987. The unemployment rate was stable and there was ongoing job creation although with a clear loss of momentum. Financial conditions were tightening. In 1995, the Federal Reserve succeeded in engineering a soft landing: monetary tightening cooled down inflation but did not cause a recession. The unemployment rate had declined the year before and stabilised thereafter, job creation was strong, credit standards were loose and inflation low, which enabled the Fed to stop raising its policy rates. In May 2000, inflation was below target, the labour market was still in good shape, financial conditions were close to neutral but credit standards had tightened significantly. In June 2006, the unemployment rate was stable but the pace of job creation was slowing. Access to credit was easy, financial conditions were accommodative and inflation at 2.6% must have been considered sufficiently close to target to justify no further rate increases. In December 2018, inflation was in line with target and the unemployment rate was low. The rate of job openings was still high but the pace of job creation was slowing. With inflation at target, there was no need to hike further.
At the current juncture, the labour market remains very strong (the unemployment rate, the job openings rate -although this has been declining from exceptionally high levels-, the pace of job creation -although here again it is down). Financial conditions remain easy whereas credit standards have tightened strongly. Inflation is still well above target.
Based on past experience -admittedly with a small number of observations-, it seems that each end of the hiking cycle was different: tight financial conditions and a slowing job growth in 1989, the feeling of ‘mission accomplished’ in 1995 (soft landing), the credit crunch in 2000, a clear worsening of the labour market (job growth) in 2006 and slowing job creation with low inflation in 2018. Moreover, the Fed has tended to stop hiking rates although the pace of job creation was still rather healthy and well before the unemployment rate picked up significantly. Today, the challenge is huge, also compared with history, with still high inflation, still strong job creation -though less than before- and a huge tightening in credit standards. Reading between the lines, this last point -which has been mentioned on several occasions- in combination with the cumulative tightening is what pushes Powell to hint at conditions being sufficiently tight. This is also what the market is pricing in.
US data when Fed funds reach its cyclical peak
William De Vijlder
The Federal Reserve is torn between inflation that is still well above target and the prospect that past rate hikes and tighter credit standards should weigh on activity in the coming months.
