- The Fed is considering if near-term rates are too high given the state of the cycle.
- Sub-3% inflation readings don’t sit comfortably with above-5% policy rates.
- The Fed is also tracking if inflation expectations are rising and Fed credibility is weakening.
- Wide ranging measures of inflation expectations don’t point in that direction either.
- Inflation genie may not be going back to the 2% bottle, but rate cuts are coming; they make sense.
Related Insights
Commentary: Putting the inflation genie back in the 2% bottle
Arguments for US inflation to remain well above the Fed’s 2% target in the medium term are many: supply chain realignment will repeatedly inject inflationary shocks; climate change will add to the cost of production; short-term oriented demand support measures will add to wages and pricing power; aging and tight immigration policies will constrain the labour supply; trade and tech wars will culminate into higher cost of doing business, as well numerous inefficiencies and redundancies in the production process. The last argument can be extended to enhanced vulnerability to inflation shocks, as protectionism, by definition, means less competition and weaker price discovery. It follows that getting the inflation genie back in the 2% bottle will be very challenging.
Many of these are valid arguments. But one should also recognise that combating inflation remains a key focus of major central banks around the world, and the Fed is not about to give up on its 2% target. It has kept the policy rate at 5.5% for over a year now, while carrying out substantial withdrawal of liquidity from the financial system (quantitative tightening). These policy steps, along with normalisation of the goods supply chain and benign commodity prices, have allowed inflation to ease steadily over the past year, with various measures of inflation well below 3% presently. These are some of the best readings in five years.
The room for cutting rates has emerged in recent months with inflation downshift and some softness in labour markets, and these considerations are independent of the structural factors raised by those worried about the medium-term inflation outlook. For the Fed, there are two critical issues at hand: first, if the nominal rate is too high given the cycle, and second, second, if there has been a rise in medium-term inflation expectations, denting the Fed’s credibility. The first issue, if nominal rates are too high, is relatively straightforward to resolve. Sub-3% inflation readings don’t sit comfortably with above-5% policy rates, especially if economic softness is beginning to emerge. As an institution in charge of maximising employment, the Fed will find it increasingly hard to justify keeping rates so high, in our view.
The second issue is not a conundrum either. Market-based indicators of inflation expectations, long-term bond yields, and commodity prices do not point to a rise in inflation expectations. Much is made about gold at $2500, but that reflects a 3.7% increase in annualised terms since 1980 (or 2010). There are legitimate worries about prices in the coming years, but for the Fed, there are no markers out there justifying withholding some monetary easing in the near term.
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