The Fed paused, of course….

The outcome of Wednesday’s FOMC gathering of U.S. Federal Reserve governors had been known for weeks.

Pause. And there was literally less than a 2% probability of a rate cut in the lead up. So, the federal funds rate (FFR) remains at 5.25% to 5.50%.

The Fed reiterated that the current level of the FFR is probably at the peak of restrictive territory, it will remain on pause (probably until May unless the data changes materially), the balance sheet run-off will continue ‘as is,’ and any changes to balance sheet policy won’t be discussed until March.

At the post-meeting presser, Chair Powell said that U.S. growth, unemployment and 6 months of lower inflation was good data, but that the Fed is not confident to make any rate cuts until more good data comes to hand and points to inflation going/staying down sustainably, at the 2% target.

Cutting rates too soon could result in a return of inflation which would require tighter policy (i.e., rate hikes again) whereas cutting rates too late could result in undoing productivity and employment gains.

But most of all the Fed wants to ensure inflation does not stabilise sustainably above 2% which could easily result if the Fed is premature in cutting rates and inflation comes back.

Both have happened before

Inflation recurring in waves happened in both the 1940s and the 1970s as I wrote in “Will inflation come in waves like the 1940s and 1970s”.

But it’s the oil shock fuelled 1970s experience of Fed Chair Arthur Burns that this Fed is keen to avoid.

Arthur Burns served as Fed Chair from 1970 to 1978 and tried to control inflation from oil shocks and the activities of the Nixon Administration.

By July 1974, Burns had raised the FFR to 13%. When Gerald Ford replaced Nixon, Burns cut rates to 9.25% despite 12.2% inflation. That was in September.

By April 1975, his Fed had managed down the FFR to 5.25% despite recurring inflationary waves challenging that sort of accommodative policy.

Still, in 1976, The Burn Fed reduced the FFR a further 500 basis points to 4.75% despite inflation ripping.

Fed Chair William Miller's brief term followed, and in an attempt to counter Burns’ dovish policy he raised the FFR to 10% in December 1977 as inflation hit 7.8%.

But the Miller policy response wasn’t anywhere near enough to combat the inflationary forces already baked into the global economic landscape. About the only relief for mums and dads at that time was ABBA in Concert…

As a result, Fed Chair Paul Volcker faced a challenging eight-year battle when he took the helm in 1979. In April 1979 he increased the FFR from 10.25% in big increments to a peak of 20% in March 1980, marking a tough period remembered for egregiously high mortgage rates in the 20s. As we often say, it’s about the rate of change, not the level.

And by 1987, in his 8th and final year in the chair, the Volcker Fed had successfully quashed inflation to 1.9%.

Higher for longer until confident for longer

Back to the Powell Fed - they say the current economic data is good – but the governors want good data for longer to be confident that inflation is firmly under control - and to avoid another 1980s, which global markets could not withstand given today’s debt levels (and government deficits).

And there are still risks on the horizon that could contribute to a resurgence in inflation.

These primarily include extreme weather events and hostilities in multiple countries both causing fuel and food shortages and disruptions to shipping lines - all supply side issues causing higher prices and goods inflation.

Remember, it was the supply side that started this bout of inflation, with over ample liquidity (demand side) extending it for longer.

The possibility of resurging goods inflation continues to lurk in these geopolitically charged waters, but luckily low unemployment and economic resilience (so far) are allowing Powell to continue with restrictive rates for longer without material fallout at the household level. While some banks still have underwater investment portfolios, there is a fix for that, if needed.

Importantly, Chair Powell did say on Wednesday in a response to a reporter that his Fed will probably dial back rates this year, but that cuts are unlikely to start in March. And that means May, at the earliest.

In fact, according to fixed income traders as reported by CME Group, there is a lot more weight being given to a pause/no cut in March (65% probability) followed by a 60.1% probability of a first rate cut in May.

Cuts are moving further out as expected, but even so 10-year yields and equities have traded sideways and down only ever so slightly and that tells me markets are still not properly pricing risk.

Looking at equities this morning - it’s had almost no effect - off to the races yet again.

Oh well, in the meantime, big hugs to whichever Fed Governor convinced Chair Powell to resist another premature victory lap on Wednesday, for a job that’s far from done. Kudos, even though it didn’t really help….

And just quickly before I go, yesterday the UK followed suit with the BOE pausing for the fourth month in a row. The ECB is also on pause. The RBA will meet next week to no doubt talk about our so-called cost of living crisis. No hints there.

See you in the market.

Mike