The flattening of the US yield curve will depend on the persistence of core inflation and on the impact of monetary tightening on growth. The more resilient the US economy proves to interest-rate hikes, the more aggressively the Fed will have to tighten monetary policy, thereby increasing the risk of recession.
We have gone from ‘bad news is good news’ to ‘good news is bad news’.
For the Fed it is still all about inflation. The Fed remains much more concerned about the risk of inflation expectations becoming unanchored than about downside risks to growth. The Fed is determined to act to bring inflation back to target:
- The committee sees resilient underlying growth and persistent inflationary pressures. According to the Fed, “this is a strong, robust economy.” Despite the growth slowdown, the labour market has proved tight, with the unemployment rate near a 50-year low, job vacancies close to historic highs, and wage growth elevated. Inflation is running hot. At their September meeting, FOMC members revised up their median core inflation forecast for 2022 and 2023 by 0.2pp to 4.5% and by 0.4pp to 3.1%, respectively. They left their 2024 forecast unchanged at 2.3%.
- The committee sees a higher terminal rate and a longer hiking cycle and warned that “restoring price stability will likely require maintaining a restrictive policy stance for some time.” As such, no rate cuts are foreseen before 2024. The median dot now shows a Fed Funds target midpoint at 4.375% at end-2022 and 4.625% at end-2023. Almost a third of the committee members see a peak target range of 4.75- 5.0% in 2023 as appropriate.
- The Fed wants to continue its restrictive monetary policy. Restrictive territory means positive real rates across the curve, which seems consistent with the Fed’s new willingness to push Fed Funds rates above 4.5% in 2023. “Restrictive means that you will have a positive real Fed Funds rate adjusted for short-term inflation expectations which could be 1 percent or so… it would be significantly positive”.
- Jerome Powell is willing to risk a recession in order to bring inflation back down to 2.0%. Indeed, “the chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive or restrictive for longer”. The true policy mistake would be to fail to restore price stability, Powell said, but reducing inflation will require “a sustained period of below-trend growth” as well as weaker labour markets, which will cause “some pain” for households and firms. A soft landing scenario implies a rebalancing of supply and demand on the labour market, which does not require an excessive slowdown in economic growth. The soft landing scenario would mean inflation expectations remaining anchored, and a greater supply of labour. “It’s plausible that job openings could come down significantly, and they need to, without as much of an increase in unemployment as has happened in earlier historical episodes”.