Another Quarter Point Higher

The Federal Open Market Committee (FOMC) participants voted unambiguously to raise rates another quarter point to a range of 4.5%-4.75% and warned of more to come at the conclusion of their meeting. The statement following the meeting kept the language that rate hikes would be “ongoing” to underscore the point. The Fed is far from declaring victory on inflation, despite a slowdown in economic momentum and cooling of inflation at the end of 2022. 

Chairman Powell underscored that the Fed would “stay the course until the job is done on inflation” in his prepared remarks at the press conference following the meeting. He also said that the Fed believes that financial conditions are restrictive, but not “restrictive enough.” 

Powell was “gratified’” by the recent “disinflation” but warned that core services (excluding shelter costs) inflation remains elevated. That is where labor market costs play a larger role in determining prices.  

Financial markets rallied and credit market conditions continued to ease on the word “disinflation,” which Powell repeated several times. Lost in translation was Powell’s comment that he still expects to raise rates a “couple” of times before hitting a peak in rates. That is one more rate hike than financial markets have priced in and is consistent with where the Fed stood on rate hikes in December.

Financial markets have front-run the Fed on both a pause and cut in rates. Mortgage rates have fallen, while the spreads between investment grade and high-yield bonds have narrowed from their peaks. Some prices, which drove the deceleration in inflation, including energy and used vehicles, have already bottomed out and begun to rise again.

Powell reintroduced the concept of “transitory” in the inflation conversation. This time he used it to underscore that recent declines in goods prices will not continue; that alone could push underlying inflation higher. 

The employment cost index (ECI), which captures wages, benefits and incentive pay, rose 1% in the fourth quarter. That translates to a 5% gain from a year ago, only 0.1% cooler than last summer. Wages at that pace are consistent with inflation slowing to about a 4% range, double the Fed’s 2% target. 

The Fed made a U-turn in its view on inflation in 2021. A slowdown in inflation prompted it to declare inflation transitory. When inflation accelerated again, Chairman Powell was forced to eat crow and play catch-up with rate hikes. This Fed will not make that mistake again. 

The most recent job openings and labor turnover survey (JOLTS) for December revealed that job openings surged to 11 million in late December. The ratio of job openings to job seekers jumped to 1.9, close to the record high we saw last spring and summer. The Fed would like to see that ratio fall to one-to-one to have a healthier balance between labor demand and supply. 

The Fed is worried that wages could accelerate and add to inflation, given recent data. The move by the nation’s largest employer (a retailer) to raise starting pay from $12 to $14 per hour is another red flag for the Fed. Despite the good news for workers, that increases the risk we could hit too high of a floor on inflation. 

Hence, the Fed sees the battle against inflation as more of a marathon than a sprint. The first phase, cooling inflation from its peak, was relatively easy and expected. The hardest mile has yet to be run. History is littered with central banks that fell short of the finish line and triggered a more prolonged and corrosive bout of inflation, or worse. The Fed does not want to be one of those. 

The Fed has raised rates 0.75% five times in its history; four of those hikes were in 2022. Powell underscored that the risks of undershooting on rate hikes are still less than the risks of overshooting. The bias remains to tighten more rather than less. 

Debate about whether to pause rate hikes is expected to intensify this year. Several members of the Fed who have voiced a desire to space out rate hikes have rotated into voting positions on the FOMC. Powell admitted humility about the course of inflation. There is nothing to compare to this cycle, but he continued to push back on a pause.

Much will depend on the trajectory of wages. Powell said we were not in a wage-price spiral but warned “once you see it, you have a serious problem.”

Bottom Line

The Fed is not done. Financial market participants who front-run the Fed on rate hikes do so at their own peril. Humility is the only constant in the post-pandemic economy.