Credibility Is A Terrible Thing to Waste

Imagine crying wolf, only to have the warning ignored repeatedly. The Federal Reserve found itself in that position in recent weeks. Minutes of the last Federal Open Markets Committee meeting released January 4 indicated that members expected to continue increasing the Federal Funds rate steadily during 2023 after raising it from a 0 - 0.25% range last March to 4.25 - 4.5% on December 14. No member expected to lower rates during the new year. Various Fed officials have also been giving this message in speeches over the past week.

On the other hand, Fed Fund futures, reflecting market expectations rather than actual policy, suggest that the interest rate will peak at 4.9% after the central bank holds its first two meetings of the year in the first quarter. Investors anticipate that the Fed will start to lower interest rates before the end of 2023. The various US equity averages rose by more than 2% last week in anticipation of the easing, and the yield on 10-year US Treasurys fell from 3.6% to 3.45%.

Such a sanguine investor reaction is not the take away that officials had hoped to get from releasing the minutes. The rally has eased conditions in financial markets, and would make it that much more difficult for the Federal Reserve to complete its tightening operation. Stated differently, the rise in asset prices last week would call for additional rate increases and / or reduction in the central bank’s balance sheet than otherwise.

Some investors believe otherwise. Data released Thursday by the US Bureau of Labor Statistics indicated that the consumer price index rose by a much smaller 6.5% in December over the previous year compared with 7.1% in November. The core inflation rate, that excludes food and energy, rose by 5.7% compared with the 6% in November. The headline number actually fell by 0.1% month on month, prompted largely by the declining retail price of gasoline.

While these numbers were positive factors in the Fed’s fight against inflation, and a major tailwind in the rally at week’s end, another key statistic suggests that the rally may have been way overdone. The University of Michigan survey on consumers’ investors’ inflation expectations over the coming five to 10 years — “long-term inflationary expectations” — remained stubbornly high at 3%. This statistic has been a better indicator of the staying power of inflation rather than the month-to-month figures that politicians use whenever it suits them to suggest that inflation is dying.

Furthermore, while goods price inflation has definitely cooled and rent growth has slowed, key sectors do not share this trend. “Food at home” component of the BLS calculation, aka groceries, increased by 11.8% in the year ending December 2022. And in the services area, have you noticed the still surging prices at hotels, restaurants, airfares and plumbers’ services?

Rather than rally, why has the market not given enough weight to these developments? The answer is found in two events in Jerome Powell’s five-year history as Chairman of the Federal Reserve, one four years ago, and the other less than a year back. In December 2018, the FOMC increased rates with Powell saying in his post-decision press conference on December 19 that there would be more hikes in 2019. But with stocks cratering in the days after his speech, the Chairman buckled, and the Fed cut rates in 2019. Stocks thanked Powell and rallied.

In the second development, the Fed’s mantra throughout 2021 was inflation being “transitory” — facts and history be damned! Even after he recognized that inflation was likely to be sustained, he waited until March 2022 to increase rates, concerned as he was by “market stability”. Doubling of the balance sheet in the two years ending that month, and maintenance of zero interest rates way beyond when that would have been consistent with inflation mitigation, are partly why the Fed finds itself in the quandary it is in today.

As the Fed realizes that credibility is easy to lose but extremely difficult to regain, the the outcome will not be positive for investors. Watch out for the fallout!

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

January 14, 2023

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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