Inflation: Fed Not Sure Which Side is Up

Central Bank Faces Difficult Road Ahead

Last week’s SriKonomics outlined the risk of inflation picking up in 2025, and the implication for Treasurys. Higher inflationary expectations, and with them, rising bond yields, became reality this week. From the start of the week, data releases challenged Federal Reserve Chairman Jerome Powell’s assertion that a weakening labor market required the assistance of the central bank in the form of easier monetary policy. That was his rationale for a 50 basis point-cut in the Federal Funds rate in September, followed by two 25bp reductions in subsequent months. He and his colleagues on the Federal Open Market Committee repeatedly asserted that inflation, though on a bumpy road, was on its way to reaching the 2% Fed target.

Both these positions were challenged this week. Policymakers must have been jolted by the release Tuesday of the JOLTS report — no pun intended — that showed 8.1 million job openings in November compared with the 7.7 million that had been anticipated. This was the highest openings figure since May. The same day, we learned that the Institute of Supply Management’s Services PMI rose to 54.1 in December from 52.1 in November, above market expectations. Any figure above 50 suggests expansion. Services account for the bulk of US gross domestic product.

The biggest shock to equity and bond markets was the release yesterday of data by the Bureau of Labor Statistics that showed 256,000 jobs created in December, up from 212,000 in November and well above consensus expectation of 155,000. 10-year Treasurys zoomed in yield to close the week at 4.76%, more than a full percentage point higher than the yield just before September 18. That was when the FOMC lowered the Federal Funds rate, by not just 25bp but by 50bp as the Chairman argued that the jobs situation had become the major concern for the central bank.

According to yesterday’s data release, the unemployment rate fell from 4.2% in November to 4.1% last month. This occurred even as the labor force participation rate — the percent of working-age population that is actually in the work force — remained unchanged at 62.5. In other words, the lower unemployment rate was not achieved by throwing workers off the labor force. Any of these suggest that the labor market is weak as Powell had suggested to justify a full percentage point of rate cuts between September and December?

On the inflation front, the University of Michigan’s preliminary January survey released yesterday indicated that US consumers expect an annual inflation rate of 3.3% over the next five to ten years, up from 3% that they had expected as recently as December. And when consumers / workers anticipate faster inflation, they typically react by demanding larger wage increases. In turn, that would increase inflationary pressures — a phenomenon known as a wage - price spiral.

Furthermore, minutes of the FOMC meeting held on December 17 and 18 suggested that members of the Committee were increasingly concerned about the inflationary impact of the proposed Trump tariff and immigration policies. Recall, however, that by contrast, Chairman Powell had repeatedly asserted in his public speeches during November and December that the Fed does not anticipate what the future tariff and tax policies are likely to be in setting its policy. Go figure!

Markets reacted in predictable fashion to developments in employment and prices. The combination of labor market strength and higher inflationary expectations pushed long-dated Treasury yields sharply higher. The 10-year yield rose by 8bp yesterday alone ending the week at 4.76%., the highest in over a year. The yield on 30-year Treasury obligations approached 5%, also the highest in a year.

The surge in Treasury yields attracted capital to the United States, in turn pushing the dollar to year’s highs. The euro, which fetched $1.116 as recently as September, fell to below $1.03. The DXY index, a measure of dollar strength against major global currencies, rose to over 109, a level not seen since late-2022.

These movements were prompted by growing concern that Powell, who has cheerled equity markets with his approach to monetary policy, will not be able to cut the interest rate later this month. It would be difficult, even for the Chairman, to explain at his press conference January 29 that employment continues to be the problem and that inflation has been contained.

What is my expectation for 2025? Economic conditions will not allow the Fed to cut rates even once this year, assuming that the central bank operates with a modicum of interest in attaining its inflation target rather than backstopping equity holders. But having been surprised by the 50bp reduction in rates in September, I wouldn’t be shocked if Powell believes that the takeaway from recent data is that the FOMC should reduce the rate by 75bp!!

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

January 11, 2025

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