Markets Doubt Fed Resolve After Reading July Minutes

The Federal Reserve released the minutes from its meeting in July at 2:00 p.m. today. The reaction of the market was more skepticism about the Fed’s commitment to keep raising rates to fight inflation.

The Fed hiked its target for the overnight Federal Funds borrowing rate three-quarters of a percentage point at the July meeting, but the markets interpreted the Fed chairman’s comments as indicating that perhaps the Fed believed it was close to a rate that would successfully stifle inflation. In particular, a perhaps off the cuff reference by Chairman Jerome Powell that the current 2.25 percent to 2.50 percent range was near neutral seemed to buoy hopes that the Fed would back off of hikes and begin cutting rates again next year.

Stocks have rallied, recession fears have faded somewhat, and both bond and derivative markets imply rate cuts next year. This is the opposite of the tightening of financial conditions that the Fed has been seeking to bring about through its interest rate hikes. Credit spreads have narrowed. Even mortgage rates, the most direct pass through from Fed policy rates to the real economy, have tumbled. After peaking at 5.81 percent, the average 30-year mortgage fixed rate has fallen to 5.22 percent. One of the first rules of investing is supposed to be: Don’t Fight the Fed. For the past month, however, fighting the Fed’s tightening has worked out just fine.

As we’ve explained, the market is really expressing doubts about the credibility of the Fed’s commitment to bringing down the rate of inflation to two percent. Investors putting their money into trades that loosen financial conditions by making riskier activity less pricey—and therefore tend toward a higher level of economic activity and more inflation—do not really think they are fighting the Fed. They think the Fed simply is not going to fight them. The Fed will lose resolve sometime next year, perhaps because unemployment ticks up a bit from the record low 3.5 percent hit in July, and begin cutting rates.

Federal Reserve Board Chairman Jerome Powell speaks during a news conference in Washington, DC, on July 27, 2022. (MANDEL NGAN/Getty Images)

The Fed minutes released on Wednesday did little to shake the market from this view. The minutes told us that the Fed does think it will keep tightening rates but that it would “become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation.” The dovish interpretation of this is that the Fed already seems to be losing its nerve even though employment is still soaring, unemployment is falling, and the inflation rate had—at the time of the meeting—hit the highest point in over 40 years. What’s going to happen when unemployment starts moving up, jobs growth slows to a trickle, and the economy contracts for a third or fourth or fifth consecutive quarter?

How would the Fed justify backing off on inflation? In many ways, it has already laid the groundwork. Many Fed speakers have said there is little the Fed can do to directly fight inflation caused by problems of supply. They’ve pointed to the war in Ukraine as a source of inflation unlikely to be influenced by monetary policy. It’s easy enough to imagine Fed officials noticing unemployment rising without having much of an influence on inflation and deciding that perhaps we just have to live with higher inflation for the duration. There are lots of analysts and investors already talking about the Fed deciding to settle into three percent inflation until global supply constraints have eased.

There’s good reason to believe that unemployment may have to go much higher than Fed official expect in order to tame inflation. According to the version of economic theory widely subscribed to within the Federal Reserve and the economics profession, there is a “natural rate of unemployment.” This is often called NAIRU, which stands for the non-accelerating inflation rate of unemployment. It is the rate of unemployment at which inflation does not accelerate. When unemployment goes below NAIRU or the natural rate, inflation picks up.

One problem, of course, is that the natural rate cannot be directly observed, and it likely changes over time. Economists can make guesses at it, but no one really knows what the natural rate is. For a long time, economists thought NAIRU might be between four and five percent or even higher. In the Trump years, however, we dropped far below that with no sign of inflation accelerating, so economists had to lower their estimates of what the natural rate might be. The economic projections of Fed officials tell us that they think the long-run unemployment rate will be four percent and that this is consistent with long-run inflation at two percent. So it’s safe to say that the Fed thinks the natural rate is four percent.

At a minimum, this means that the Fed probably thinks the unemployment rate needs to go above four percent to tame inflation. Indeed, the minutes show unemployment at 4.1 percent at the end of 2024 and inflation at 2.2 percent. That may be overly optimistic. If four percent is the natural rate, the decelerating inflation rate of unemployment is likely higher than one-tenth of a point above that. What’s more, there are reasons to suspect that the natural rate is higher than the Fed projections show. A recent note from analysts at Bank of America argued that all the geographic and economic dislocations from the pandemic have pushed up the natural rate of unemployment. An essay by Olivier Blanchard of the Peterson Institute for International Economics and Harvard’s Alex Domash and Lawrence H. Summers argued that the natural rate is probably as high as 4.9 percent. That likely means the Fed needs to push unemployment above five percent to tame inflation.

The market does not believe the Fed will do anything like this. Next week, when Fed officials gather for their annual boondoggle in Jackson, Wyoming, we will look for clues about whether they think they have the monetary policy fortitude to actually restore price stability.

Larry Kudlow of Fox Business had us on his 4:00 p.m. show on Wednesday to talk about Jerome Powell’s credibility problem. He appeared to largely agree with our point that the Fed has not yet established itself as a reliable narrator of its own plans. Be sure to check it out. We were on toward the end of the program, but we recommend watching the whole thing because the earlier segments, largely about the problems with the fraudulently named Inflation Reduction Act, were the best we’ve seen on the subject.

Alex Marlow & John Carney
Breitbart News Network

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