Today the Federal Open Market Committee (FOMC) increased its policy rate by 0.5%. This was a step down from the pace of hikes seen over the past few meetings. More consequentially, in the post-meeting press conference Federal Reserve (Fed) Chair Jerome Powell signaled that the FOMC is moving toward a more forward-looking policy-setting process. This is the start of an important transition in monetary policy, which we expect will culminate with a pause in the hiking cycle early next year.
For the past few meetings the FOMC has primarily been reacting to the incoming economic data. Reactive policy is obviously not ideal, both because the economic data has well-documented lags and also because monetary policy impacts the economy with a lag. The FOMC would strongly prefer to focus more on the outlook and the risks around the outlook, rather than be stuck responding to last month’s data. Until now, however, the FOMC has been unable to be forward-looking, as surprises in inflation through the summer and early fall forced the committee to repeatedly react.
The most recent data has provided a welcome change. Consumer Price Index (CPI) inflation has come in below expectations for two months in a row. A number of other inflation indicators have also turned in recent months, including house prices, rental costs, commodity prices and the prices of a number of consumer goods. Not only is the current level of inflation less alarming than it had been, the emerging trends suggest further progress in coming months.
The recent moderation in inflation data has given the FOMC an opportunity to move toward more forward-looking policy. This is obviously a positive development, as Chair Powell noted today: “[The recent inflation reports are] very much in line with what we have been expecting and hoping for. It provides greater confidence in the forecast of declining inflation.”
As the Fed transitions to more forward-looking policy, it will be able to expand the set of data it considers in assessing the outlook for inflation. No longer constrained to just responding to realized CPI, the Fed will be able to put more weight on things like home prices, which are falling rapidly in private surveys even though they are not yet falling in the CPI data, as arguably better indicators of where inflation is headed. Indeed, today Chair Powell spoke to exactly this point. In his responses to multiple questions, Powell referenced falling home prices as an important part of outlook for lower inflation in 2023. The implications are significant. A modified CPI measure that uses higher frequency prices for housing and rent, instead of the lagged measures produced by the Bureau of Labor Statistics, suggests that inflation may already be at or even below the Fed’s 2% target.
More forward-looking policy will also allow the FOMC to put additional weight on economic activity, which could in turn make it more cautious with regard to downside growth risks. In a speech a few weeks ago Chair Powell said that he does not aim to raise rates so high that they have to be cut immediately afterward. In his own words, Powell does not plan to “crash the economy.” Powell prefers instead to raise rates to a restrictive level and then hold them there for some time. This implies a shallower drop in growth as well as a more gradual decline in inflation. Discussing his preferred path for rates was not a luxury Powell had just a few months ago when the inflation data seemingly demanded an assertive reaction. But now that the inflation data has turned, it makes sense that Powell is once again returning to a discussion of his policy preferences.
One outstanding question is what policy rate is consistent with a reduction in inflation over time. For the past few meetings the FOMC’s judgement has been that the policy rate was too low. This judgement was likely relatively straightforward, considering that inflation was generally higher than the policy rate. After today’s hike and with the most recent data, however, the policy rate is now higher than the inflation rate. In particular, after today’s hike the policy rate range is 4.25%-4.50%, whereas the most recent data suggest that the run-rate of core inflation may be closer to 3%. This simple comparison was likely what Powell had in mind when he said today, for the first time all year, that policy is now “restrictive” and “getting close to the level where it is sufficiently restrictive.” With policy now in a restrictive setting, the Fed will have more confidence that inflation will fall further in coming quarters.
The FOMC’s move toward more forward-looking policy should allay some of the concern that an overshooting on rate hikes will cause an unnecessary recession. Indeed, Powell has recently said that he is on guard against exactly that outcome. While being on guard is far from a guarantee that it won’t happen, it is certainly better than the alternative. By allaying some of this concern, forward-looking policy should provide some support for risk assets, especially those risks assets that are particularly vulnerable to a downturn in economic activity.
Finally, the fact that the policy rate is nearing a point that the FOMC will deem sufficient could support a stabilization in US Treasury bond yields, with risks tilted toward further declines in yields over the coming months. 2022 will likely end up being the worst year on record for the US Treasury market, and only the second time in the last 150 years that there have been back-to-back years of negative total returns for US Treasuries. The combination of continued surprises in inflation and a very aggressive response from the Fed caused many would-be fixed-income investors to avoid the asset class, or at a minimum to pare their risk. As the inflation and Fed dynamics change, however, it may become increasingly difficult to justify remaining on the sidelines.