Back in March, “the Fed is behind the curve” was the prevailing narrative of too little, too late when it came to containing inflation. The only problem was that the $30 trillion US bond market disagreed. The people who buy and sell Treasury securities around the world were obviously aware of the surging cost of living and bet their fortunes and reputations on the Federal Reserve fulfilling its data-dependent mandate to bring inflation, which peaked at 9.06% in June as measured by the Consumer Price Index from a year earlier, down to the central bank's target of 2% before spiraling prices became embedded in the economy.
To be sure, US debt of all types violently lost 13% in 2022 as the Fed raised its target interest rate on overnight loans between banks seven times, from 0.25% to 4.50%, in an unprecedented amount of tightening for the 109-year-old central bank in such a short period of time. Even so, US bonds still outperformed the benchmark for fixed-income assets globally as well as related securities issued by the Group of Seven developed economies, according to data compiled by Bloomberg.
The bond market's relative confidence in the Fed shows no signs of flagging even with the exogenous economic fallout from Russia's invasion of Ukraine and Vladimir Putin's war against its people. So when the US Labor Department said last week that the Personal Consumption Expenditures Price Index — the Fed's preferred measure of inflation — rose at a slower pace in each of the past three months, going from a 0.55% jump in August to a 0.46% rise in September to a 0.26% increase in October and finally to a gain of just 0.17% in November, no one at the central bank suggested ending the historic pace of credit tightening. Chair Jerome Powell made that clear when he said in a press conference earlier this month that wages -- a key driver of inflation -- are growing “well above what would be consistent with 2% inflation.”
J. Bradford DeLong, professor of economics at the University of California at Berkeley, former deputy assistant Treasury Secretary under President Bill Clinton and author of the just-published “Slouching Towards Utopia: An Economic History of the Twentieth Century,” never was among the crowd of economists scorning the Fed for being behind the curve. On the contrary, in his Dec. 24th Substack essay, DeLong extolled “ A High Five for Team The-Fed-Has-Got-This.”
“The Federal Reserve does not have to move slowly,” he wrote. “The past six months have demonstrated that there are very few downsides to the swift movement in monetary policy that 75 basis-point increases in interest rates every month and a half deliver. And a 75 basis-point increase at an [Federal Open Market Committee] meeting is not a speed limit. This suggests: Take advantage of optionality. When the situation is unclear, pause—and then move fast when the situation becomes clear.”
As persistent as inflation has been, it was 10th-slowest among 34 developed economies in the third quarter, as well as below the average for European countries, according to data compiled by Bloomberg. In the market for US Treasury securities, breakeven rates on five-year notes, which are a measure of what traders expect the rate of inflation to be over the life of the securities, narrowed to 2.17% from a high of 2.56% in April, according to data compiled by Bloomberg.
Zero-coupon inflation swaps, where one side of the transaction pays a fixed payment calculated on the inflation bet in exchange for the payment based on actual inflation, continue to endorse Powell's commitment to restore price stability. These trades, which the strategists at Credit Suisse Group consider the most liquid inflation derivatives, show consumer price inflation at 5.9% in the next month, 2.4% in six months and 2.3% within 11 months, according to data compiled by Bloomberg.
The resilience of the economy with unemployment at 3.7% and third-quarter gross domestic product growing at an annualized 3.2% amid unprecedented credit tightening may derive in part from the Fed's easier policy at the height of the Covid-19 pandemic in April 2020 when unemployment climbed to 14.7%, the highest since the closing years of the Great Depression eight decades ago. At the end of 2020, unemployment was still hovering 3.2 percentage points above 2019's 3.5%, with 2020 inflation 0.6 percentage point below the 1.9% of the prior year. Unemployment was 4.6% in October 2021 when the Fed was pilloried for keeping rates low with inflation at 6.2%, according to data compiled by Bloomberg.
No major economy rebounded as fast or recovered as much as the US from the pandemic. After the Fed dramatically reversed its easier stance, many pundits incorrectly predicted or declared a recession would occur this year. They continue to make the same forecast in the year ahead. Yet there is no average forecast for a contraction before at least mid-2024, based on the 56 economists contributing quarterly growth estimates to Bloomberg. The same economists who 12 months ago said fourth-quarter GDP growth would be 3.6% before they reduced it to zero in October, revised the final quarter to 0.2% growth in November, with similar upward revisions going forward, according to data compiled by Bloomberg.
“It's hard for me to define what recession would look like in 2023 as we sit here today,” Gene Seroka, executive director of the Port of Los Angeles, the largest in the US, said in an interview last month in his office overlooking a waterfront blissfully free of the supply-chain bottlenecks that bedeviled the economy a year ago. “We feel [higher prices] at the [gas] pump, we feel it at the grocery store. That's called inflation. That doesn't necessarily mean recession. The American consumer, which is 70% of our economy, continues to move with the pace that we've never witnessed before. July, August, September and now October spending, which was up 1.2%, seems not to be affected by higher prices.”
DeLong, for his part, doesn't rule out the foreboding consequences of the Fed's monetary moves in the months ahead. “This plague-ridden business cycle is one of the rare times that I do not envy the members of the FOMC,” he writes. “What they decide to do over the next six months will start to affect the real economy of demand, employment, and production starting one year from now, and start to affect the inflation news starting a year and a half from now. Many things good and bad will happen in the next eighteen months. And whatever the Federal Reserve decides to do, it is sure to regret it afterwards.”
So far, at least, the bond market isn't signaling any of the things that would put the Fed behind the curve.
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