THE FED'S "MEET ME IN THE MIDDLE" STRATEGY
The Fed is meeting this week, and we already know what they’ll do this time because Fed Chair, Jerome Powell, has already told us. But the long game is still uncertain. The market is pricing in seven 25 basis point increases this year. OK. That gets the Fed Funds target up to 1.75%, but if inflation stays where it is, the real rate would still be -4.75%, which could hardly be expected to slow inflation. In fact, it wouldn’t even be neutral, since the neutral rate is around 50 to 100 basis points above the rate of inflation. Yet the Fed’s stated goal is to remove stimulus, or “accommodation” as they prefer to call it these days. So what gives?
First, 25 basis point hikes are an artifact of the gradualist approach that goes with anticipating a rise in inflation. That’s clearly not what’s happening now. The Fed is reacting to inflation that has already arrived, and it needs to catch up. While the Fed will raise rates by 25 basis points this time, because of the Russian/Ukraine war, Chair Powell did not say that would continue. So accelerated rate hikes larger than 25 basis points are a definite possibility. Second, it is also likely that the Fed still believes, or hopes, that inflation will fall back as supply-related issues are resolved. If this is correct, they can still raise rates at a steady, though accelerated pace, and inflation will fall back to their 2% target by the time the Fed Funds rate gets up to that level later this year.
That seems like an unlikely scenario. In China, factory cities are shutting down due to continued COVID-19 outbreaks. The Eastern European geopolitical disruptions to energy and food supplies will not be resolved any time soon, even if peace breaks out. Labor shortages continue, as well. So while we can hope, along with the Fed, that their “meet me in the middle” strategy will work, we shouldn’t count on it. Even if inflation falls back by half to 3.9%, a neutral Fed Funds target would be around 4%. Interestingly, while this target is well above the current rate, it is actually close to the average rate before the Global Financial Crisis of 2008. That seems like a more likely outcome. Reversion to the mean reasserts itself.
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