The FED Hit the Panick Button
On Wednesday the 16th of June, the FED prioritized fighting inflation over fighting unemployment. This happened six days after a CPI report showing incredibly high annual inflation, which the FED should have realized was a fluke. The FED decision also occurred a day before new data came out indicating a weak jobs market. Altogether, the FED is slowing the recovery down to fight a phantom inflation threat.
Purpose of the FED:
The idea of the FED is to control spending. If too much money is being thrown at overall goods and services in any particular economy, it can dramatically push up prices across the economy (i.e. cause a high rate of inflation). If not enough spending is happening, this can hurt the economy.
The way the FED controls spending is through its ability to put money in or out of circulation, allowing it to borrow or loan as much money as it wants. The FED, by printing out new money, can buy up bonds, mortgage-backed securities and other forms of debt, lowering borrowing costs and supporting financial markets. It also acts as a bank for banks, by offering them a safe place to deposit their money at a rate of interest the FED decides; and it facilitates inter-bank lending. It has the ability to be more of a net lender, injecting money into the economy, lowering interest rates, supporting spending and increasing employment and inflation; or it can do the opposite.
The meeting this week was “contractionary.” This means, it leads to higher interest rates and will ultimately contract spending, inflation, money in circulation and the size of the economy.
The FED meeting conclusion on Wednesday had four significant components which could affect markets. They are:
The official policy decisions of the FED,
The wording of the FED statement,
The official projection materials, and
The Q & A session between Jerome Powell and reporters.
1. The first component, in theory, is the only reason market participants should care about FED meetings. However, other components of FED meeting conclusions can influence expectations for future policy decisions. If the markets expect the FED to raise/cut interest rates in the future, they will price that expectation for the future into current interest rates, which can affect economic activity.
The official FOMC statement did not include any official policy changes from the previous one. This is what market participants expected. Hence, this part of the FED’s meeting conclusion did not move financial conditions.
2. The wording of the new FOMC statement shows a lot more confidence about the economy and concern about inflation than the previous one. For instance, the sentence in the previous statement: “The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world,” was replaced with: “Progress on vaccinations has reduced the spread of COVID-19 in the United States.” The line: “The ongoing public health crisis continues to weigh on the economy,” was replaced with: “Progress on vaccinations will likely continue to reduce the effects of the public health crisis on the economy.” Meanwhile the line, “With inflation running persistently below this longer-run goal,” was replaced with “With inflation having run persistently below this longer-run goal.”
Overall, the change in wording reflects the belief that the effects of the virus are disappearing; and the belief that recent inflation data is not wholly a fluke, rather inflation actually is at or above target.
3. The projection materials from the FED are hard to understand. Here is why:
The FED decisions are made by a group called the FOMC board. There are some positions on that board which are not given voting powers in particular years. However, each member of the board is given the ability to contribute to projection materials each year.
Projection materials happen 4 times a year. They happen every other FED meeting (there are 8 FED meetings in a year).
Each member of the FOMC predicts where the expect certain macroeconomic variables (inflation measured by the “PCE index,” inflation measured by the “Core PCE index,” GDP growth rates, the unemployment rate and the federal funds interest rate) to be at certain times (the end of the current year, the end of next year, the end of the year after and in the “long run.”). This data is then published but we do not know who made what prediction. We do know, for instance, that one member of the FOMC board expects the unemployment rate to be between 5.1% and 5% by the end of this year. But it is unclear whether that opinion even matters right now. Maybe, that projection is made by a currently non-voting member of the FOMC.
Nonetheless, the overall inclinations of the projection material were hawkish (suggesting higher interest rates). Going off of the median projected values, we can say the FOMC (including non-voters) now expects: higher GDP growth for this year; higher inflation over the next two years; and an increase in the federal funds interest rate in 2023.
4. The press conference following the statement and projection release also increased interest rates. Jerome Powell announced that the FED was now “talking about talking about tapering,” (tapering means the FED prints out less money to buy government debt and mortgage backed securities). Previously, Powell had denied they were “talking about talking about tapering.” Furthermore, Powell was less confident that high inflation readings were only temporary. While previously, he explained why high inflation readings would be temporary, now he simply says that analysts say inflation is temporary.
Overall, the FED actions on wednesday had significant implications for the bond market. One can observe this by looking at treasury data on interest rates on government debt and inflation-adjusted interest rates on inflation-adjusted government debt. On the trading day of the FED meeting, inflation-adjusted interest rates on a 5-year contract went up .15% (from -1.67% to -1.52%). Meanwhile the “5-year breakeven inflation” rate (a bond-market based expected inflation rate) fell .05% (from 2.46% to 2.41%).
Recent Inflation Data was a Fluke:
The FED’s inflation target is 2% PCE inflation. However, the CPI, an alternative measure of inflation, is released before PCE data each month. Hence, FED officials were probably looking more closely at the latest CPI data which is for Mar than the latest PCE data which is for April. My first blog post lays out the reasoning why this high inflation reading is a fluke. Essentially, monthly CPI and PCE data is high right now because of the reopening. The reopening has caused certain commodity prices, like oil, to rise. It was also low during the beginning of the shutdown (when commodity prices were falling), although it was slightly higher in the following months (when those prices slightly rebounded). The following charts show this principle.
Overall the data is a bit messy, but it falls more neatly into my narrative than a rising-inflation narrative.
While monthly inflation in both CPI and PCE terms has likely reached its peak in April, the CPI data showed that annual inflation rose from April to May in the report that came out 6 days before the end of the FED meeting. In percent terms, annual inflation was between 4.9% to 5%, which was in the higher range of what I predicted in my first blog post (between 4.5% to 5%).
Regardless, then as now, the reason why annual inflation would go up is obvious. Annual inflation (in log terms) is the sum of the past 12 monthly inflation data points (in log terms). From April to May the economy continued to reopen pushing prices higher which caused a high monthly reading (.642 log-%) to enter the sum. Meanwhile, 12 months ago the economy was shutting down so the monthly inflation reading dropping out of the sum was going to be low (-.098 log-%). However, because the reopening is coming to an end and the period 12 months before us is now a period of price rises, the next annual inflation reading should be lower than this one.
Signs of a Weakening Economy:
Seasonally Adjusted Initial Claims for Unemployment Insurance have been an often used measure of the health of the economy recently. The reason is that they update weekly and can be relied upon to give data on the health of the economy in advance of the unemployment rate. Following 6 consecutive weeks of declining claims for insurance, markets were shocked by a dramatic increase. The data is graphed below.
The unexpected uptick was enough to wipe out the past two weeks' declines in unemployment insurance claims. It comes at an especially unexpected time as it is happening just as many states are making the unemployment insurance programs less generous, which would in theory make people less likely to apply. The report dashed the expectations of many who were predicting a truly rapid recovery following vaccinations, the expiration of enhanced unemployment benefits, the expiration of the eviction moratorium and the strong demand-side support of low interest rates and fiscal stimulus.
The Fed’s monetary policy decision on Wednesday was a colossal error, due in large part to bad timing. Even though the well-educated economists at the FED may know that the nearly 5% inflation rate was largely a blip due to pandemic factors, it was hard for them not to respond. If the FED met shortly before the May report and met after the June report which would prove the 5% number to just be a blip, they would have felt less pressure to push up interest rates. On the other hand, if the weak jobs report numbers had come out 24 hours earlier, that report would have done enough to allay concerns about inflation and given the FED reasons not to raise rates.
The FED meeting ended a day before proof would emerge that the recovery is still in jeopardy and a month before proof would emerge that inflation isn’t really that high. Without these proofs, the FED hit the panic button and unnecessarily hurt the recovery.