Can the Fed break the dynamics of inflation in the short term?

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Federal Reserve Chairman Jerome Powell is aiming to try and on Tuesday expressed confidence that the central bank will aggressively persist in its quest to solve its biggest inflation challenge in four decades.

“If this involves going beyond widely understood levels of neutrality [interest rates] we won’t hesitate to do so,” Powell Told The Wall Street Journal yesterday. “We will go until we feel we are at a place where we can say financial conditions are in an appropriate place, we see inflation coming down.” Underlining the Fed’s intention, he insisted that “there will be no hesitation about it.”

Estimating neutral rates – a level that supports growth while effectively fighting inflation – is a mixture of art and science. There are many models that attempt to estimate this rate and, unsurprisingly, the results vary by more than an insignificant degree. Recent Fed estimates point to a neutral rate in the 2% to 3% range, well above the current target federal funds rate of 0.75% to 1.0%.

The Fed’s hawkish pivot is now over, at least rhetorically. But that still leaves some key uncertainties to wrestle with in the weeks and months to come. First, what exactly does the Fed’s commitment imply in terms of the duration of policy tightening? Will he really raise rates to fight inflation for as long as it takes, even to the point of pushing the economy into recession to do the heavy lifting? Powell seems to agree with this drug, even to the point of recently invoking the name of Paul Volcker, a former Fed chairman who raised rates sharply in the early 1980s to kill inflation, although at the prices of two recessions in the first half of this decade. But earlier this month, Powell appeared to back down from expectations that he would go full Volcker.

The other big question is how will the price of the bond market factor into expectations for the Fed’s monetary plans going forward? Although interest rates have skyrocketed in recent months, the market appears to be reassessing how far rates can rise from current levels. A key variable in the calculation is the slowdown in economic growth. As rates rise, the risks of economic contraction may increase in the current climate if the central bank goes too far too fast with policy tightening. Although economic activity in the second quarter appears to be starting to rebound from the contraction in the first quarter, a number of economists predict that the risk of recession is increasing.

Perhaps sensing this shift, the benchmark 10-year Treasury yield recently retreated after topping 3% earlier this month for the first time since 2018.

Rendement du Trésor américain à 10 ans (<a href=

The policy-sensitive 2-year rate – widely seen as a proxy for Fed policy expectations – also paused in recent days after a long run up.

Rendement du Trésor américain à 2 ans (<a href=

Fed funds futures currently estimate an 87% chance that the Fed will raise rates another 50 basis points to a target range of 1.25% to 1.50% at the FOMC meeting on Tuesday. June 15. Beyond that point, the outlook becomes cloudy, largely due to uncertainty about how the economy reacts to higher rates and what the change means for Fed policy.

Powell’s comments yesterday imply that the Fed will err on the side of breaking inflation momentum, suggesting that the central bank will tolerate more deterioration in economic momentum than recently expected.

“The Fed will tighten financial conditions until it sees clear and convincing evidence that the economy is on the path to price stability,” advises Tim Duy, chief US economist at SGH Macro Advisors, in a statement. note to customers on Tuesday. “The Fed knows this path may require a recession.”

The main variable that will determine how this all plays out is the path of inflation in the near term. Consumer prices for April showed a slowdown in the annual pace – the weaker first impression since last August, the 8.3% year-on-year increase continues to show that inflation is on the rise. rise.’s Inflation Trend Index (ITI), a multi-factor estimate of price pressure, suggests that May doesn’t look set to offer much, if any, relief. The ITI’s median estimate for this month came in at 5.4%, reversing (slightly) April’s slowdown.

Inflation trend index: range of estimates over 1 year

What is clear is that the Fed now seems determined to reduce inflation. “What we need to see,” Powell explained yesterday, “is clear and compelling evidence that inflationary pressures are coming down and inflation is coming down. And if we don’t see that, then we’ll have to consider acting more If we see this, then we can consider moving to a slower pace.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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