Welcome to our Unhedged newsletter, delivered straight to your inbox every weekday morning. Today, we’ll be discussing the market reaction to the Federal Reserve press conference, including insights from Fed chair Jay Powell. If you have any questions or comments, feel free to reach out to us at [email protected] and [email protected].
Yesterday’s market reaction to the Federal Reserve press conference was rather uneventful. Stocks and the bond market remained largely unaffected. The only notable movement came from the two-year yield, which experienced some zigzagging but ultimately ended up 5 basis points higher. We’ll delve into what Powell had to say in more detail below.
We’ve mentioned before that inflation has reached an inflection point and is now on the decline. It’s reassuring to know that Fed chair Jay Powell shares this view. During the press conference following the decision to hold rates steady, Powell acknowledged the need for continued improvement in supply-side conditions, particularly in the goods sector. He also noted that new rents and leases in the housing services sector are coming in at low levels. The main challenge lies in non-housing services, which make up more than half of the core PCE inflation. Powell recognized early signs of disinflation in this sector. He also acknowledged that loosening labor market conditions can help bring down inflation rates. However, he admitted the uncertainty surrounding the speed at which inflation will fall.
It’s interesting to juxtapose Powell’s realistic acknowledgement of uncertain inflation projections with the Fed’s practice of providing detailed economic projections. When you can’t predict how quickly inflation will decrease, it becomes difficult to determine the fed funds rate six months from now. This inconsistency can be frustrating for commentators. However, it’s important to view the Fed’s economic projections as a holistic image rather than precise calculations. According to this image, the Fed now expects higher near-term growth and inflation, as well as lower unemployment, compared to its previous outlook. As a result, policy will tighten for a longer period, leading to slightly lower medium-term growth. The decision to hold rates steady may appear odd in this context, but it allows for some margin of error in an uncertain environment. While the Fed is generally supporting a tighter policy path, there seems to have been a notable shift in recent meetings. Powell, who previously saw labor market strength as a problem driving non-housing services inflation, now views it as a support to economic growth rather than a risk for inflation.
This shift in attitude is backed by empirical evidence. In the past year, headline inflation has decreased while unemployment has remained low. The Phillips curve, which suggests an inverse relationship between inflation and unemployment, hasn’t been applicable recently. However, Powell’s transition to a less stringent view of the Phillips curve seems incomplete, as he still emphasizes the importance of loosening labor market conditions in bringing down services inflation. This tension was pointed out by a questioner during the press conference, and Powell’s response was equivocal.
According to a paper by Ben Bernanke and Olivier Blanchard, high wage growth has played a role in sustaining inflation. While tight labor market conditions currently contribute only a small share to excess inflation, this share is expected to grow and won’t naturally subside. Reversing the inflation resulting from labor market overheating will require policy actions that balance labor demand and supply. This suggests that targeting the labor market alone isn’t sufficient in combating inflation. It also implies that we may not need years of recession-like unemployment levels to address the issue. Powell’s recognition of the positive aspects of a resilient labor market is a promising sign. It lowers the risk of over-tightening monetary policy.
Throughout this process, Powell has consistently expressed a desire to bring down inflation without triggering a recession and significant increases in unemployment. However, his previous beliefs regarding the role of the labor market in services inflation left little room for this possibility. His new attitude allows for a more flexible approach. This intellectual openness toward understanding inflation mechanisms is good news for investors.
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