The Fed refuses to celebrate

Good morning. Stocks liked, but did not love, yesterday’s very encouraging inflation report. The S&P 500 rose less than 1 per cent. Perhaps the market’s animal spirits were suppressed by a rather hawkish Federal Reserve meeting (see below). But I suspect that the issue is that a lot of good news is already priced in. Email me: robert.armstrong@ft.com.  

The Fed is not being too cautious

Well this is good:

Using the metric Unhedged prefers (month-over-month change annualised), core CPI inflation fell to the Fed’s 2 per cent target in May. Huzzah. The three- and six-month averages are not there yet, and neither is the official year-over-year figure (3.4 per cent). But for one month, at least, the news is excellent.

All the more so because it was not housing inflation that accounted for the decline. Housing services inflation, for reasons that are now well rehearsed, is a lagging indicator which has trailed for longer than everyone expected. This continued in May, which saw a 0.4 per cent monthly increase in housing costs, the same as the previous three months. Instead, the disinflationary work was done by other services (airfares, car insurance and repairs, hotels) as well as goods (cars, clothes). This means that, as Steven Blitz of TS Lombard points out, services inflation ex-housing was close to zero in May. And this is the flavour of inflation that the Fed has said it is the most concerned about:

Blitz thinks sustained services disinflation will be hard to achieve if wages continue to grow at their current pace. This thought was echoed by Fed chair Jay Powell in his press conference yesterday, when he noted that while he did not see wage growth as a principal cause of inflation, wages’ current pace of growth (4 per cent or so) is probably inconsistent with inflation staying at target.  

It’s not just wages that Powell and his colleagues are cautious about. Right from the first sentence of the May meeting press release, the monetary policy committee struck a sober tone that was at odds with the giddy news in the CPI report. Last month’s dour comment that “in recent months, there has been a lack of further progress towards the committee’s 2 per cent inflation objective” was leavened only slightly to “there has been modest further progress”. No victory laps here.

The summary of economic projections (SEP) reinforced the committee’s caution:

It was not just that two rate cuts came out of the committee’s projection for the year-end policy rate (red box lower left), leaving the forecast at one cut. The expectation for the long-term neutral rate ticked up (lower right). A naive reader of the SEP might conclude that, since March, the committee has become less optimistic not only about inflation this year, but inflation forever.

What is more, the committee’s aggregate expectation is that core PCE inflation will end the year at 2.8 per cent. But that’s where core PCE was in April, and the May reading is likely to be lower. At the press conference several journalists asked why, if the committee thinks that inflation is still too high to cut rates now, and it does not expect inflation to get better by December, why it expects to cut rates at all this year. In response Powell talked in a general way about being conservative. Omair Sharif of Inflation Insights made the same point differently, writing that the inflation projections suggested that some committee members have “inflation PTSD” from the rough first-quarter number.

Part of this quite conservative and apparently inconsistent outlook can be put down to the fact that the SEP is just a collection of individual opinions, which is not a formula for perfect coherence. It also reflects the fact that the 2024 rate outlook was a close call: eight members foresaw two cuts, seven saw one, and four saw none. Powell noted, too, that for many individual members it was a very close call. The SEP simply should not be taken too seriously.

But to the degree the Fed is projecting caution, they are quite right. Perceptions of this meeting were coloured by the fact that a very good inflation report landed just hours before. But that report reflects only a single month of data. The long history of inflation says that it never falls smoothly. The recent experience of inflation suggests that none of us can predict its path very accurately. For all of Powell’s talk about the better balance between the risks to employment and price stability, the labour market is where it should be and inflation is not. The Fed is not merely striking a hawkish posture. They are genuinely cautious, and they should be. 

One good read

Knowing when to fold ’em.

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