Weekly Inflation Outlook: Fed Hikes To Slow, But Inflation Collapse Still Elusive

 | Oct 31, 2022 05:34AM ET

  • The market has been pricing in a relatively rapid pivot by the Fed after this week’s expected 75bps hike
  • However, given the persistency in inflation and the Fed’s firm stance, I believe a pause is more likely
  • Monetary conditions remain more likely to damage the economy than inflation per se

    • We are only a couple of days removed from the next FOMC meeting when the U.S. Central Bank will almost certainly raise the overnight rate by 75bps to a full 4%.

    Last week, there was tremendous market optimism that the Fed will clearly signal that they will begin to taper the size of their rate hikes going forward, probably peaking at 5%. That has been my view for a little while, but it is now fully reflected in market prices, so that’s not worth any more. Indeed, it seems to me that the market is pricing a relatively rapid pivot to cutting rates.

    Admittedly, a year ago, I, too, thought the Fed would rapidly lose its nerve once something broke. So far, though, nothing has broken, and the Fed has surprised many of us with its resolute hawkishness. I don’t think the Fed is eagerly waiting to cut interest rates once they achieve their ultimate target, and in fact, I think the pause is likely to be a year or more.

    Partly, that’s because inflation will be declining, but only slowly—so the Fed will be frozen between tightening because inflation is still too high and lowering rates because of weak growth and inflation that is at least heading in the right direction. This, of course, remains to be seen, but my point is that the market is pricing in a very optimistic path for rates and inflation, and most of the ways that can be wrong are bad for markets.

    The Fed’s progress on breaking the economy has proceeded nicely. In my article last week, I noted that the Fed’s tool for decelerating economic output is not the same as its tool for restraining inflation. They were once joined because the level of required reserves (which influences the money supply) also influenced interest rates. These are now sundered since banks are not reserve-constrained. So the real question is, why does the Fed want to slow economic output?

    The strongly-held belief is that recessions cause disinflation, but they don’t. I’ve probably run this chart before, but it’s worth looking at repeatedly. In the two largest contractions of the last 100 years, core inflation never went negative and, in fact, barely slowed at all and not for long. Of course, this is so—if it were not, stagflation would never happen.

    Get The News You Want
    Read market moving news with a personalized feed of stocks you care about.
    Get The App