Are markets right in expecting an ‘immaculate disinflation’?
Federal Reserve Chairman Jerome Powell’s press conference following the Feb. 1 Federal Open Market Committee (FOMC) meeting was notable for his inability to convince the financial markets that the central bank intends to keep policy rates at elevated levels for an extended period. Stocks and bonds rallied, and financial conditions further eased despite a 25-basis point rate hike and promises of further FOMC rate hikes. Investors appeared willing to bet that the Federal Reserve (Fed) will not maintain its tight monetary stance much longer.
A blockbuster jobs report (released on Feb. 3) gave investors pause as markets digested data indicating a labor market that continues to be characterized by robust hiring and decent wage growth. While the much-feared 1970s-style wage-price spiral has yet to materialize, the risk that services sector inflation will become sticky at somewhat elevated levels and thus reduce the likelihood of a quick return to the 2 percent inflation target is quite real.
The sharp drop in energy and durable goods prices has generated disinflationary trends in headline inflation measures. But it is worth noting that sticky inflation (primarily driven by services sector inflation) remains substantially elevated. Lingering effects from the pandemic shock have led to a continuing shortage of workers in the restaurant, travel, leisure and hospitality sectors.
A recent Washington Post report highlighted some of the factors responsible for a sustained labor shortfall in consumer-facing service sectors: “An estimated 2.5 million people have died, retired or otherwise dropped out since 2020. Americans older than 55, in particular, stopped working at heightened rates during the pandemic because of covid-related health risks. Plus, rapid run-ups in home values and stock prices made it financially viable for scores of older Americans to retire. Those extra vacancies in the job market, researchers have found, created room for people in the service industry to move into new lines of work.”
At present, there is considerable disagreement regarding the outlook for the U.S. economy, and this has given rise to sharply differing expectations about the future trajectory of policy rates. If rapid restoration of price stability were to take place, it is feasible that the Fed will not have to stick to its “higher for longer” policy rate stance.
In fact, rising levels of optimism in early 2023 indicate a growing belief among market participants that the U.S. economy may attain some sort of an “immaculate disinflation” that does not entail an actual economic contraction or substantial deterioration in labor market conditions.
If the market prognosticators are wrong, they are certainly making the Fed’s task much harder and creating the potential for heightened market volatility down the road. For the Fed’s monetary tightening to affect the real economy sufficiently enough to generate some degree of economic slack and corral inflation, financial conditions must tighten (and remain tight for a while).
Lately, Powell and his colleagues at the Fed appear to be struggling with their attempts at forward guidance. The danger with following an explicit “data-dependent” monetary strategy is that markets will ignore any feeble attempts at forward guidance by the Fed and react aggressively to every new piece of data. In this scenario, the Fed will be forced to reach for a much higher terminal rate than necessary, which in turn may raise the risk of financial instability.
Intriguingly, the dip in average 30-year mortgage rates from the October 2022 high of 7.08 percent to a recent low of 6.09 percent appears to have breathed some life into the U.S. housing market.
Some economists have even noted the possibility that easing financial conditions may lead to a reheating of the economy and a potential resurgence in headline inflation.
Meanwhile, some market participants are also questioning the Fed’s commitment to fully restoring the 2 percent inflation target. Is the Fed actually willing to generate a spike in the unemployment rate to achieve its stated inflation goals? What if the Fed is willing to settle for inflation that is above the 2 percent target (say, in the 3-4 percent range)?
Given the extraordinary buildup in public debt over the past three years, the temptation to utilize a sustained bout of elevated inflation to reduce the real debt burden is also worth noting. Bond market investors appear to be largely ignoring this possibility. The Euro Area, Japan, the U.K. and the U.S. are not only facing historically high debt-to-GDP ratios but are also increasingly encountering rising net interest cost. In a politically polarized environment where reaching consensus (in the form of higher taxes and lower government spending) appears unlikely, an inflation tax may offer the most palatable avenue for restoring fiscal balances.
All in all, it appears that both the stock and the bond markets may be getting ahead of themselves by assuming that the worst is over. Far too much is now riding on expectations for an early Fed pivot. Some analysts have also argued that stock investors may be ignoring negative operating leverage and a possible squeeze on profit margins.
Given the ongoing uncertainty about the future pace of disinflation, and potential risks involving premature easing of financial conditions and stickiness in services inflation, it may be in the interest of market participants to avoid excessive exuberance.
It is too early to claim victory in the inflation battle or even to rule out a resurgence in underlying inflationary pressures — that was one of the key takeaways from the experience of the 1970s.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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