Inflation report on Tuesday was good. Actually, it was pretty great: headline inflation fell to 7.1 per cent last month, lower than the 7.3 per cent forecast by economists and down from 7.7 per cent in October. It is now at the lowest level since December 2021. That gave the Fed cover to reduce the rate of hikes to a “mere” 50 bps. So why did stocks drop?
The post-meeting press conference on Wednesday is where things started to go wrong for the bullish crowd. If Fed chair Jay Powell was relieved by the previous day’s inflation report, it was not on display. Even as the US central bank slowed the pace of rate rises, the man donned his Grinch outfit.
The key insight into Fed’s thinking was the quite literally named “dot plot.” The dot plot is a graphical representation of where Fed officials see interest rates going over the next several years. Each dot represents the interest rate prediction of one Fed official.
After the initial exuberance over the rate pace reduction, it took markets only a second to realize that officials expected the hiking cycle to go longer, and end higher.
Source: Financial Times
This was despite the fact that the Fed’s economic projections actually deteriorated since their last publication in September. Growth lower, and unemployment higher.
So why the hawkish rhetoric?
We discussed this a number of times but it’s worth saying it again: the Fed has to both act tough, and talk tough.
The “act tough” is impacting the short term rates. But that’s not the only channel that impacts the economy. Consumers’ sense of wealth – and therefore confidence to spend – derives from their houses and financial portfolios.
That makes long-dated mortgages, and stocks, pivotal to the overall financial conditions in the economy. The “talk tough” is a form of forward guidance where they try to prevent markets from loosening financial conditions by rallying stocks and bringing down mortgage rates.
Source: Federal Reserve bank of Cleveland
Ok, again – why?
They worry that inflation will become entrenched if they don’t. One look at the inflation picture above shows you that while headline inflation (CPI) has declined nicely, the Fed’s preferred measures (that excluding most volatile items + energy) is only just starting to decline.
The Fed is gearing up for a longer fight.
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Originally Posted December 19, 2022 – Inflation drops. Then market drops.
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