What was Powell Thinking?

Words and Actions Follow Divergent Paths

To no one’s surprise, the Federal Open Markets Committee announced Wednesday that it would not increase the Federal Funds rate following ten hikes in as many meetings since March 2022. Despite not acting on rates, central bank officials signaled through their “dot plot” that there will be two more rate increases this year. They were pausing or skipping — a meaningless distinction in my opinion — in order to watch incoming data before deciding what to do at their next meeting July 25 - 26.

In reality, the decision does not mean that Chairman Jerome Powell and his colleagues will give undivided attention and spend the next six weeks deep in study of data before taking action. It suggests simply that they do not have a clue what to do now — to raise rates further and risk a severe recession; or not raise, follow in the footsteps of the 1970s Fed Chairman Arthur Burns, mimic Burns’ stop-and-go policies, and risk renewed inflation. For now, they have decided on the latter option.

The Powell press conference that followed the collective decision of the FOMC reflected this ambivalence. After the obligatory expression of concern that high inflation causes hardship “for those least able to meet the higher cost of essentials like food, housing and transportation,” Powell proceeded to justify not doing anything while inflation goals are far from being met. He would like to have the cake and eat it too — not act on rates now, but warn investors that more rate hikes will take place in coming months.

In addition to the Fed’s dot plot suggesting two more rate hikes before the end of 2023, Powell indicated that July will be “a live meeting,” signaling that the Fed may well hike on July 26. Nick Timiraos of the Wall Street Journal pointed out at the Q&A session that there is only one employment and one consumer price inflation data release before the next meeting. That being the case, what was the Fed going to gain by pausing / skipping last week? Powell did not have a convincing answer.

Markets were not convinced by the Chairman’s effort at tight-rope walking. Despite his assertion that interest rate cuts are far in the future — “we’re talking about a couple of years out,” he said — the S&P 500 index is up 15% so far this year and 2.2% this week alone. By comparison, the yield on 10-year Treasurys hardly budged, moving from 3.74% to end the week at 3.77%. The UST 2 10 yield curve inverted further from -0.72 percentage point at the beginning of June to close the week at -0.90 percentage point. The sustained and significant yield curve inversion is signaling recession in contrast to the euphoria in equity markets.

On the global front, the Fed’s wishy-washy approach to inflation mitigation stood out in comparison with the firm stance the European Central Bank took the following day. ECB’s deposit rate was increased by 0.25 percentage point to 3.5% with President Christine Lagarde stating that the central bank “is very likely to continue raising rates in July.” Eurozone inflation has slowed from 7% in April to 6.1% in May, but is still substantially above the target of 2%.

Notice that the decision taken by Lagarde and her colleagues came despite declining business sentiment in Germany, the region’s largest economy, as the country entered recession with two successive quarters of negative economic growth. She did not make a statement that the ECB would pause interest rate hikes after having raised them Thursday or, in any way suggest an easing of the pain of higher policy rates.

All this brings me to a key message: Credibility is a terrible thing to waste. I wrote in January about at least two instances when Powell either turned dovish when hit by a cratering stock market (December 2018), or persisted in forecasting “transitory” inflation to justify his vastly expansionary policies (2020 - 2022). Market’s belief that he is a soft touch when it comes to inflation reduction explains why equities have rallied despite his seemingly tough message at the press conference.

Last week may have been the last straw. Powell dropped the ball with his conflicting messages on Wednesday, and he will have to be a Houdini to escape this crisis of communication.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

June 17, 2023

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