- Fixed Income Analyst
United States, Institutional
Change
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As expected, the Federal Open Market Committee (FOMC) raised interest-rates by 25 basis points, to a target range between 5.25% and 5.5% at its July meeting. The FOMC made no changes to balance-sheet normalization or the relative levels of administered money market rates. Its economic outlook hasn’t changed significantly since the June meeting, though the committee described the expansion of economic activity as “moderate” rather than “modest.”
US Federal Reserve (Fed) Chair Jerome Powell adopted a balanced tone during the press conference. He kept open the option for further rate hikes, possibly as soon as September, but acknowledged repeatedly that he believes monetary policy is in restrictive territory. What matters now for investors is the pace and magnitude of further tightening, which will depend on the answers to three questions:
- How long is the lag between changes in financial conditions and changes in the real economy?
- To what extent has disinflation been caused by supply chain normalization rather than policy?
- How sustainable is decoupling of US economic data from global economic data?
“Long and variable” lags vs financial conditions easing
Monetary policy famously operates through financial conditions with “long and variable” lags. Chair Powell expects those lags to affect economic data in the coming months. There are several reasons to believe lags between changes in financial conditions and the real economy may be longer than in previous cycles. These include the extraordinary levels of fixed-rate debt that corporations have issued at low rates and the pervasiveness of low fixed-rate mortgages. Both suggest that corporations and consumers may not “feel” higher rates for some time.
What’s more, the reduction of global central bank balance sheets is in its initial stages. The Bank of Japan and the Bank of England initiated asset purchases in 2022 to offset currency depreciation and financial instability, respectively. Additionally, the Fed created its Bank Term Funding Program (BTFP) and saw increased borrowing at its discount window amid banking stress earlier this year, all of which offset initial balance-sheet reduction.
Despite this backdrop, financial conditions have eased in recent months, as optimism about artificial intelligence (AI) and resilience of economic data have bolstered risk appetite. If the lag between financial conditions and the real economy is shorter than in previous cycles (which could be the case due to technological advances and the FOMC’s adoption of “forward guidance” as a key tool), the incremental effects of monetary policy tightening to date may be limited. For example, home prices, which are an expected source of disinflation in the coming months, appear to have troughed at levels above FOMC expectations.
Chair Powell dismissed a question about recent easing in financial conditions, suggesting that short-term fluctuations are not a concern for the FOMC, but continued moves in this direction may prove unsustainable.
Sources of disinflation and the coming base effects
Inflation has declined steadily in the past few months, but it’s unclear how much disinflation is the result of moderating supply chain problems and how much is due to the change in monetary policy. Chair Powell believes both have contributed. The Fed’s Global Supply Chain Pressure Index suggests that disruption in supply chains peaked in December 2021. The lag between supply chain normalization and disinflation is unclear, but the forward disinflationary effects from correction in supply chains is likely to be limited.
In the coming months, the Fed’s disinflationary goals will face headwinds from so-called “base effects.” This means that inflation, measured as a year-over-year change, will be measured against lower figures than have recent Consumer Price Index (CPI) annualized changes, which were measured against prints highly influenced by supply chain aberrations. This mathematical reality, combined with the risk of higher energy prices and the loss of disinflationary forces from supply chain normalization will make the Fed’s job more difficult.
Economic resilience in the US vs slowing global data
In the US, many economic data series, such as inflation data, wage data, and manufacturing data, have started to roll over. However, most economic data in the US has been surprisingly resilient. Labor market strength and consumer confidence appear robust.
Economic data in the rest of the world has slowed notably more. In Europe, Purchasing Managers’ Indexes (PMIs) have declined considerably, and economic growth is in contractionary territory. Similarly, China is nearing disinflation and struggling with youth unemployment around 20%. Messaging from the Politburo suggests incremental fiscal support is likely.
Global cycles may be less correlated now than in recent history for several reasons. Differentiated housing market structures — particularly the 30-year fixed mortgage structure in the US — have created massive amounts of wealth for US consumers, most of whom own their own homes and have secured low financing rates. Changes in trade dynamics amid a tense US-China relationship allow for greater economic decoupling. Differences in the magnitude and details of fiscal responses to the COVID-19 crisis continue to affect economies differently. However, global economic cycles are usually correlated over the medium term, which suggests global economic weakness may pose headwinds to growth in the US.
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