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Wall Street slips as Fed Chair Powell sees no soft landing

calendar 22/09/2022 - 19:32 UTC

Wall Street Futures slips again in early U.S. sessions Friday and made a low around 33073, almost the same (33046) after Wednesday’s hawkish hike by Fed. The market is now only worried about higher borrowing costs, but also concerned about the stagflation-like scenario (lower economic growth, higher inflation, and higher unemployment rate) as being projected by Fed in its latest SEP/DOT-PLOTS. In fact, on Wednesday, in his presser, Fed Chair Powell also almost confirmed that the U.S. economy is on the way to all-out stagflation, if not recession.

Full text of Fed Chair Powell’s opening statement on 21st Sep’22 (Fed presser):

My colleagues and I are strongly committed to bringing inflation back down to our 2 percent goal. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.

Today, the FOMC raised its policy interest rate by 3/4 percentage points, and we anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. I will have more to say about today’s monetary policy actions after briefly reviewing economic developments.

The U.S. economy has slowed from the historically high growth rates of 2021, which reflected the reopening of the economy following the pandemic recession. Recent indicators point to modest growth of spending and production. Growth in consumer spending has slowed from last year’s rapid pace, in part reflecting lower real disposable income and tighter financial conditions.

Activity in the housing sector has weakened significantly, in large part reflecting higher mortgage rates. Higher interest rates and slower output growth also appear to be weighing on business fixed investment, while weaker economic growth abroad is restraining exports. As shown in our Summary of Economic Projections, since June FOMC participants have marked down their projections for economic activity, with the median projection for real GDP growth standing at just 0.2 percent this year and 1.2 percent next year, well below the median estimate of the longer-run normal growth rate.

Despite the slowdown in growth, the labor market has remained extremely tight, with the unemployment rate near a 50-year low, job vacancies near historical highs, and wage growth elevated. Job gains have been robust, with employment rising by an average of 378,000 jobs per month over the last three months. The labor market continues to be out of balance, with demand for workers substantially exceeding the supply of available workers.

The labor force participation rate showed a welcome uptick in August but is little changed since the beginning of the year. FOMC participants expect supply and demand conditions in the labor market to come into better balance over time, easing the upward pressure on wages and prices. The median projection in the SEP for the unemployment rate rises to 4.4 percent at the end of next year, a one-half percentage point higher than in the June projections. Over the next three years, the median unemployment rate runs above the median estimate of its longer-run normal level.

Inflation remains well above our 2 percent longer-run goal. Over the 12 months ending in July, total PCE prices rose 6.3 percent; excluding the volatile food and energy categories, core PCE prices rose 4.6 percent. In August, the 12-month change in the Consumer Price Index was 8.3 percent, and the change in the core CPI was 6.3 percent. Price pressures remain evident across a broad range of goods and services.

Although gasoline prices have turned down in recent months, they remain well above year-earlier levels, in part reflecting Russia’s war against Ukraine, which has boosted prices for energy and food and has created additional upward pressure on inflation.

The median projection in the SEP for total PCE inflation is 5.4 percent this year and falls to 2.8 percent next year, 2.3 percent in 2024, and 2 percent in 2025; participants continue to see risks to inflation as weighted to the upside. Despite elevated inflation, longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets. But that is not grounds for complacency; the longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.

The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people. My colleagues and I are acutely aware that high inflation imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials like food, housing, and transportation. We are highly attentive to the risks that high inflation poses to both sides of our mandate, and we are strongly committed to returning inflation to our 2 percent objective.

At today’s meeting, the Committee raised the target range for the federal funds rate by 3/4 percentage points, bringing the target range to 3 to 3-1/4 percent. And we are continuing the process of significantly reducing the size of our balance sheet, which plays an important role in firming the stance of monetary policy.

Over the coming months, we will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2 percent. We anticipate that ongoing increases in the target range for the federal funds rate will be appropriate; the pace of those increases will continue to depend on the incoming data and the evolving outlook for the economy.

With today’s action, we have raised interest rates by 3 percentage points this year. At some point, as the stance of monetary policy tightens further, it will become appropriate to slow the pace of increases, while we assess how our cumulative policy adjustments are affecting the economy and inflation. We will continue to make our decisions meeting by meeting and communicate our thinking as clearly as possible.

Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy. As shown in the SEP, the median projection for the appropriate level of the federal funds rate is 4.4 percent at the end of this year, 1 percentage point higher than projected in June. The median projection rises to 4.6 percent at the end of next year and declines to 2.9 percent by the end of 2025, still above the median estimate of its longer-run value. Of course, these projections do not represent a Committee decision or plan, and no one knows with any certainty where the economy will be a year or more from now.

We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply. Our overarching focus is using our tools to bring inflation back down to our 2 percent goal and to keep longer-term inflation expectations well anchored. Reducing inflation is likely to require a sustained period of below-trend growth, and there will very likely be some softening of labor market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run. We will keep at it until we are confident the job is done.

To conclude, we understand that our actions affect communities, families, and businesses across the country. Everything we do is in service to our public mission. We at the Fed will do everything we can to achieve our maximum employment and price stability goals. Thank you, and I look forward to your questions.

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Highlights of Powell’s Q&A session: Fed Presser (21st September 22)

·         It will eventually be prudent to slow the rate of rate increases

·         Expectations of inflation seem to be firmly grounded

·         It is also dependent on changing perspective

·         Incoming data will determine how quickly rates increase

·         We will be seeking convincing proof that inflation is moving

·         The rate of increase will be determined by data and the outlook

·         In the coming months, we'll be looking for compelling evidence that inflation is declining

·         Participants still perceive inflation as being at risk of rising

·         We continue to see inflation risks as being skewed to the upside

·         Inflation is still substantially above our 2% target

·         Price pressure is visible across a wide range of goods and services

·         The labor market remains unbalanced

·         Wage growth is elevated

·         The labor market has continued to be quite tight

·         The labor market is still out of balance

·         We expect supply and demand conditions in the labor market to improve over time

·         Meeting by meeting, we shall continue to make decisions

·         We will probably require a tight policy approach for some time

·         History warns against premature rate cuts

·         Dot plot projections do not represent a plan or a commitment

·         We are moving swiftly and forcefully

·         Since Jackson Hole, my main message has remained the same

·         Labor-market conditions may soften

·         It seems anticipated that a prolonged period of below-trend growth will be necessary to reduce inflation

·         There is now little evidence of a cooling labor market

·         We won't stop working till the project is done

·         We need to get inflation down, to do that, we believe we will need a softer labor market and slower economic growth than usual

·         My main message is that FOMC is strongly resolved to bring inflation down. To do so, we believe we will need labor market softening and below-trend economic growth

·         We believe we will need to raise the fund's rate to a restrictive level and maintain it there for a while due to the strong rate of inflation

·         Given the high inflation, we believe we will need to raise the Funds Rate to a restrictive level and keep it there for some time

·         It will take some time to see the full effects of changing financial conditions on inflation

·         We would need to be quite convinced that inflation will return to 2% before we can begin lowering rates

·         Before lowering rates, the Fed would like to be very confident that inflation will return to 2%

·         Hikes may be slowed at some point to assess the effects

·         There is a chance that we will reach a particular rate and remain there, but not yet

·         There is no way to predict how the economy will perform, thus policy must be tightened up

·         It will take some time to see the full effects of changing financial conditions on inflation

·         Rates have a long way to go

·         We have recently entered the most restrictive levels that are now available

·         We see the current situation as being outside of historical norms

·         Job openings may decrease without causing as much of an increase in unemployment

·         Hence the unemployment rate may not increase as substantially as it did during previous recessions

·         We see the current situation as being outside of historical norms

·         Supply shocks contributed to some inflation

·         This cycle's longer-term inflation expectations have remained mostly well-anchored, which will also make it easier to bring inflation down

·         Commodity prices appear to have peaked

·         If supply shocks also subside, it might help relieve inflationary pressures

·         Restoring price stability while achieving a soft landing is difficult

·         Soft landing is incredibly difficult, and no one can predict whether it will result in a recession or how severe it would be

·         But not lowering inflation would cause far more pain

·         If a policy needs to be more restrictive or restrictive for a longer period, the likelihood of a soft landing is also likely to decrease

·         No one knows if we will have a recession or how severe it will be

·         We believe we need to raise the policy stance to a restrictive level

·         Vacancies and job opportunities are strong labor market indicators

·         You want real rates to be positive across the yield curve

·         I use the term restrictive to refer to applying real downward pressure to inflation

·         If we followed the rate path implied by the dot plot, we would see positive real rates across the Yield Curve

·         There is a sizable group that would see 100 bps by the end of the year

·         Despite modest supply-side healing, inflation has not decreased

·         We are currently figuring out what level we need to reach

·         Median policymaker views 125 bps hikes by year-end

·         If you examine the inflation rate for this year, you will discover that it is too high

·         You never want to overreact to a single data point

·         I don't anticipate thinking about MBS sales in the foreseeable future

·         Major US bank CEOs have told Congress that they expect to pay higher deposit rates shortly

·         We are highly conscious of what is happening in other economies throughout the world, and the opposite is also true

·         The labor market, in particular, has been very strong

·         Other economies and policies incorporated into our projections

·         Exports, imports, and interest-sensitive spending are all impacted by us

·         Growth may be stronger than expected, which is a good thing

·         Substantial savings can still be seen on people's balance sheets

·         The economy is robust

·         US states are very flush with cash

·         We must succeed in reducing inflation, for now, that has to be our overarching focus

·         I don't know what the odds are of a recession

·         Quite likely to see a period of substantially slower growth

·         Slow growth can lead to an increase in the unemployment rate

·         I still believe we can have a slight increase in the unemployment rate while lowering inflation

·         Softer labor market conditions are required

·         Inflation eats away at salary increases

·         Consider price stability as a resource that benefits the public

·         Currently, the housing market has been quite hot nationwide

·         To return to normal price growth in the housing market, we must have a correction

·         For some time, housing expenses will remain high

·         Rates are projected to reach their peak in a summary of expectations

·         The course we take will be sufficient to bring back price stability

·         We have outlined a likely course for the Fed Funds Rate, and the actual course will be sufficient to reduce inflation

Conclusions:

On Wednesday, all focus was on the Fed policy meeting and SEP (Summary of Economic Projections) or dot plots for the Fed’s thinking about rate actions in 2023. As unanimously/highly expected, Fed hikes all key rates by +0.75% and projected terminal rate +4.50% (~4.4: median 4.50-4.25) in Dec’22 and +4.75% (~4.6: median 4.75-4.50) at Dec’23. Thus, as per September SEP, Fed may hike another +125 bps to reach a +4.50% terminal rate by Dec’22; i.e. Fed may hike another +75 bps in November and +50 bps in December. This is more hawkish than the market expected. But Fed also projected only +25 bps hikes in the entire 2023, which is less hawkish than the market assumption.

During his presser/Q&A, Powell eventually acknowledged fading hopes of a safe & soft landing and the high probability of a hard landing; i.e. all-out stagflation/recession for the U.S. economy in 2023 led by housing and labor market slowdown. As usual, Powell also downplayed longer-term SEP of more than 3/6/12 months. Thus the market got some hints that if inflation does not come down meaningfully, then Fed has to again go for rate hikes for a positive real rate by H1CY23, even at a slower pace.

Fed may continue to hike either at +50 or +25 bps (slower pace) to reach a positive real rate by H1CY23 at least wrt core PCE inflation, which was +4.6% in July’22. Assuming core PCE inflation around +4% and core CPI inflation +5% by H1CY23, Fed may hike to at least +5.00/5.25% by H1CY23, so that core PCE inflation goes down to +2% levels by H1CY24, ahead of Nov’24 U.S. Presidential election without causing an all-out recession.

As per Taylor’s rule:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.50+2+ (1.25+0)*(4-2)

=0.50+2+1.25*2=0.50+2+2.5=5%

Here for the U.S.

A=desired real interest rate=0.50; B= inflation target =2; C= permissible factor from deviation of inflation target=1.25 (2.5/2); D= permissible factor from deviation of output target from potential=0; E= average core CPI (PCE inflation) = 4

As per Taylor’s rule, which Fed policymakers generally follow, assuming U.S. ideal real interest at 0.50%, the Fed repo/interest rate should be +5.00% against the present +3.25%. Thus Fed has to hike another +1.75% by Mar’23; i.e. +75 bps in Nov’22, +50 bps in Dec’22, and then +25 bps each in Jan-Mar’23.

In his presser Wednesday, Powell pointed out the positive real rate of interest wrt 1Y inflation expectations or core PCE inflation (rolling 3-months average), both of which are now around +4.8%; i.e. ~+5.0%. Fed will publish the next SEP on 14th Dec’22 and if core PCE inflation continues to move around +5.0%, then Fed may project at least a 50 bps rate hike by Jan-Mar’23. Further rate actions will depend on the inflation trajectory in Q1CY23 and subsequent Mar’23 SEP. If core PCE inflation stabilizes around +5.0%, then Fed may pause further rate hikes after March-June and wait for the actual rate hike transmission effect on the overall economy (inflation, employment and growth).

Fed may keep the real rate of interest (wrt average core PCE inflation) between 0-0.50%; i.e. if average core PCE inflation turns out to be around +5% in CY22/Q4CY22, then Fed may keep the terminal rate around 5.00-5.50% in Q1CY23 and so on.

As a central bank, Fed can control the demand side of the economy so that it can match with the currently constrained supply side and bring inflation down to some extent. Although, mostly supply issues are now causing higher inflation, amid Russia-Ukraine/NATO war/proxy war, as a central bank, Fed must act to control demand and inflation; otherwise higher inflation will affect discretionary spending and economic growth in a more durable way.

Inflation will not come down meaningfully unless the resolution of supply chain disruptions caused by lingering Russia-Ukraine/NATO/U.S. war/proxy war. As of now, there are no signs of any resolution of this geopolitical conflict. Moreover, Russia/Putin is seeing the supply chain disruptions, subsequently elevated inflation, and resultant stagflation/recession as a golden opportunity to end ‘western supremacy’.

On the other side, Biden is also not ready to make any compromise with ‘killer’ Putin for domestic political compulsion (until at least Nov’22 mid-term election). Thus Wall Street is now bracing for an all-out recession in the coming days and plunging. White House/Biden admin can now make some compromise with Russia/Putin and also Ukraine to stop this war and reverse various economic/commodity trade sanctions. Only then inflation may come down meaningfully due to lower commodity prices (food, fuel, fertilizer, and various metals).

 

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