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Wall Street Futures were upbeat Wednesday on less hawkish Powell testimony. On Thursday, on his 2nd day of ‘painful political grilling’ by U.S. lawmakers (House) on both sides of the aisle, although Powell didn’t say anything super hawkish, which the market didn’t know already, Powell indicated the terminal rate would be around 3.5 to 4.00% by Dec’22. Moreover, Fed’s Governor Bowman almost confirmed about +0.75% rate hikes in July, followed by +0.50% each in September, November and December.
On Thursday, on his 2nd day of Congressional testimony, Powell said in his Q&A session with the U.S. House:
· The effects of a shrinking balance sheet will be marginal compared to the impact of rising interest rates
· It is significantly more challenging to bring down inflation without impacting the labor market
· We're using our tools to affect demand
· The US has a very strong and well-recovered economy
· The labor market is overheated
· There is a risk that unemployment will move up, but remember, that's from a historically low level
· The challenge now is we are tightening, which should drive growth down
· It is possible to have a strong labor market while curbing inflation
· US inflation is a consequence of very strong demand
· With the benefit of hindsight, the Fed underestimated inflation during the summer of 2021
· The Fed pivoted (after Oct 21) when we saw that supply-side inflation didn't ease
· The path has gotten more challenging due to food and fuel prices
· We intend to achieve a soft landing, but the path to do that has gotten more and more challenging
· Financial markets have been functioning well; the banking system is very strong and well-capitalized
· We are not seeking new tools, though it's up to Congress if it wants to change the Fed mandate
· We think there's a job to do on-demand
· A big part of inflation won't be affected by our tools, but a big part of it will be
· Some of these wage increases are substantially bigger than what is consistent with 2% inflation
· Our tools affect inflation, not necessarily wage inflation
· In hindsight, inflation was not transitory
· Our judgment in real-time proved to be incorrect
· We thought supply shocks would be like oil shocks, where they come and go
· The US is not close to the point where servicing debt is an issue
· If there is a digital dollar, it needs to be from the Fed
· We don't want a private Stablecoin to become a digital dollar
· The time is coming for the regulation of stablecoins and digital finance, it is important to get it done quickly
· I would be reluctant to cut rates
· Growth this year should still be fairly strong
· The housing market is slowing down to some extent now due to higher mortgage rates
· The rate-hike pace to be orderly and data-dependent
· I don't see the US dollar as particularly under threat at the moment
· We haven't had a test like the current inflation situation; this reinforces our desire to move expeditiously on raising interest rates
· Inflation expectations are anchored, but that's not enough, because over time those inflation expectations will be under pressure
· The endpoint for the balance sheet would be roughly 2.5 to 3T smaller than it is now
· The Fed would not raise the inflation target
· Price stability is the bedrock of the economy, and we have to restore it unconditionally
· There would be supply effects from raising rates as well
· Core PCE inflation has tracked down from the hot levels of last year
· We would need an authorizing law for a CBDC
· I don't think a recession is inevitable (in line with Biden’s similar observation)
· Financial conditions need to be in a place where they are having the desired outcome for the economy
· Housing is one of the channels through which monetary policy works
· Fed rate hikes are leading to a slowdown in the housing market
· We expect inflation to move down over the next 2 years to the Fed’s goal of 2%
· The intention is a soft landing but the path has gotten more and more challenging
· We expect the present neutral rate would be 3.00 to 3.50% and the terminal rate between 3.5 to 4.00%, a range that would be moderately restrictive for the US economy--- these are rough estimates
· We expect ongoing rate increases over this year
· Fed is committed to having a mostly treasury balance sheet and the Fed is yet to decide on when it will be selling mortgage-backed securities (MBS)
· Inflation will move down, closer to the Fed's 2% target in the course of the next two years,
· The latest projections regarding inflation that individual Federal Open Market Committee (FOMC) participants submitted last week are reasonable
· We are doing a great deal of work exploring central bank digital currency, we should explore this as a country though
· We plan to work on the policy and technological side in the coming years on a CBDC and come to congress with suggestions
· The US is on an unsustainable fiscal path where debt is growing faster than the economy
· Liquidity in the treasury market has come down from where it was, I am looking at ways to address that
· Financial markets have been functioning well, the banking system is very strong and well-capitalized
“Inflation is the highest we have seen in the United States in 40 years and so far it shows little sign of moderating. At the same time, the economy is growing at a moderate pace, and the labor market is extremely tight, as indicated by a variety of measures including reports of many employers unable to find workers despite significantly raising wages. That tightness is contributing to inflation because labor is the largest input cost for producing goods and providing services.
Inflation is a significant challenge for everyone, but it hits lower- and moderate-income people the hardest since they spend a larger share of their incomes on necessities and often have less savings to fall back on. Inflation is also a burden for businesses that must somehow balance unpredictable costs while setting prices that aren't so high that they discourage customers from purchasing. Inflation that continues at these levels is a threat to sustained employment growth and to the overall health of the economy.
The inflation data show that, after moderating slightly for a short time, price increases for motor vehicles have picked up again, energy prices rose sharply in May, and prices for food have risen more than 10 percent from a year ago. The inflationary effect from the invasion of Ukraine has proven to be lasting for both energy and food commodity prices, with little prospect of the conflict or those price pressures abating very soon. More broadly, global supply chain issues continue, in part because of the effect of ongoing COVID-19 lockdown policies in China that have slowed production and shipping.
One important factor that we often point to in driving today's spending decisions and inflation outlook are expectations of future inflation. Near-term expectations tend to rise as current inflation increases, but when inflation expectations over the longer-term—the next 5 to 10 years—begin to rise, it may indicate that consumers and businesses have less confidence in the Fed's ability to address higher inflation and return it to the Federal Open Market Committee's (FOMC) goal of 2 percent.
If expectations move significantly above our 2 percent goal, it would make it more difficult to change people's perceptions about the duration of high inflation and potentially more difficult to get inflation under control. As we see surveys like the Michigan survey report higher longer-term inflation expectations, we need to pay close attention and continue to use our tools to address inflation before these indicators rise further or expectations of higher inflation become entrenched.
As I mentioned earlier, one force driving inflation is the extremely tight labor market. The benefits of a tight labor market are easy to see—the U.S. economy continued to add jobs at a pace of 400,000 per month for the past three months, which is remarkable considering the low number of people looking for work. Today, most people who want to work can find a job, and wages and salaries have risen faster than they have in decades. Even with these gains, wages have not kept pace with inflation, which has made it much more difficult for many workers to make ends meet in the face of soaring housing, energy, and food costs.
Job creation signals strong labor market demand, particularly in the current environment, with a large number of available jobs and fewer job seekers. In addition, the tightness of the labor market is exacerbated by a labor force participation rate that remains far below the pre-pandemic benchmark, representing millions of workers sitting on the sidelines. Many of these are early retirees, some incentivized to retire during the pandemic, and those with family caregiving challenges including very high costs for childcare. While the strong job market has brought some of these workers back into the workforce, it seems that many are still waiting or may not return, meaning that labor shortages will likely persist in many sectors of the economy.
I've laid out many of the challenges, so now let me talk about what the Federal Reserve is doing to get inflation under control. In the face of inflation that continues to be much too high and in light of the recent high readings, the FOMC raised the federal funds rate by 75 basis points at our most recent meeting last week. That increase followed two rate hikes totaling 75 basis points earlier this year, and we indicated that further increases will likely be appropriate in the months ahead. On June 1, the Fed took a separate step to tighten monetary policy by beginning to reduce its large balance sheet of securities holdings.
I strongly supported the FOMC's decision last week, and I expect to support additional rate increases until we see significant progress toward bringing inflation down. Based on current inflation readings, I expect that an additional rate increase of 75 basis points will be appropriate at our next meeting as well as increases of at least 50 basis points in the next few subsequent meetings, as long as the incoming data support them.
Depending on how the economy evolves, further increases in the target range for the federal funds rate may be needed after that. The case for further rate hikes is made stronger by the current level of the "real" federal funds rate, which is the difference between the nominal rate and near-term inflation expectations. With inflation much higher than the federal funds rate, the real federal funds rate is negative, even after our rate increases this year. Since inflation is unacceptably high, it doesn't make sense to have the nominal federal funds rate below near-term inflation expectations. I am therefore committed to a policy that will bring the real federal funds rate back into positive territory.
While I expect that the labor market will remain strong as the FOMC continues to tighten monetary policy, these actions do not come without risk. But in my view, our number one responsibility is to reduce inflation. Maintaining our commitment to restoring price stability is the best course to support a sustainably strong labor market. The Fed's credibility, earned over decades of low inflation, is a powerful policy tool that is critical to our long-term success. If that credibility erodes, it must be re-earned.
As a step toward that goal, I also supported the Committee's action to begin reducing the Fed's balance sheet, which is providing unneeded economic stimulus and making inflation worse. The current balance sheet is composed of Treasury securities and a significant amount of agency mortgage-backed securities (MBS). Since the longer-term goal of the balance sheet reduction plan includes a Treasuries-only balance sheet, it would make sense to eventually incorporate MBS sales into the plan so that reaching this goal does not take too long. My longer-term goal would be to get the Fed out of the business of indirectly intervening in the real estate market.
In his post-FOMC presser last week, Fed Chair Powell already indicated about +0.50 or +0.75% rate hikes in July. On Thursday, Fed’s Governor Bowman made it almost clear about not only +0.75% rate hikes in July, but also +0.50% rate hikes in subsequent rest 3-meetings in 2022 (September, November, and December). Additionally, Bowman also talked about real positive rates; i.e. FFR must be above 1Y inflation expectations.
If we take the latest UM inflation expectation data (outlook) for 1Y forward, the June reading was +5.4%. Assuming some easing, if it stays around +4.5% in early 2023, the Fed rate should be around 4.75% to be real positive. As per Bowman’s hawkish narrative, by Dec’22, the Fed rate should be at +4.00%. This means that Fed may hike by another 75 bps in early 2023 to make the FFR real positive to help anchor inflation expectations and actual inflation data subsequently. Bowman also talked about active QT (selling) of MBS, while Powell is still fumbling.
In any way, Bowman’s jawboning is more hawkish than the current market expectation and thus Dow and Gold slip. Also, subdued Composite PMI and jobless claims data indicate some economic slowdown already in the U.S. Although, Fed may eventually launch QE-5 by early 2024 to bring out the economy from a recession caused by ‘Putin’s aggression on Ukraine, if inflation does not fall towards 2%, it would be difficult for Fed to launch QE-5 too.
Eventually, Wall Street recovered from Bowman’s panic low and closed in the deep green after Powell’s testimony, as overall, Bowman’s projections of rate hikes were almost in line with the market expectations.
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