Fed chair Jerome Powell at last week's press conference. Photo: Samuel Corum/Getty Images
The Federal Reserve is in risk management mode and is more worried about the possibility it will do too little to quash inflation rather than too much. Meanwhile the economy, and especially the job market, is proving surprisingly resilient.
- That tension looks likely to shape markets and the economy in 2023.
Why it matters: It creates a meaningful risk of new disruptions to financial markets — and the possibility of a hard economic landing — as the Fed tries to wrestle inflation to a place where it's persistently low.
- Fed officials have envisioned raising rates above 5% this year, in contrast to markets that have priced in rate cuts later in 2023.
- But another possibility is that they're both wrong, and the "terminal rate" will be even higher than the Fed or markets project. That would mean a repeat of the kind of market repricing, rise in recession fears and economic ripple effects seen over the past year.
Flashback: When Fed chair Jerome Powell took questions from the media at his news conference last Wednesday, markets seized on his acknowledgment that a "disinflationary process" is underway.
- Traders took that as affirmation that the Fed will back off rate increases and could cut rates later this year. That drove a bond market rally and a sharp drop in interest rates.
- But if you focus on a different aspect of Powell's remarks, it becomes clear that this path is by no means assured.
Powell's full comments emphasize a risk management approach. He and his colleagues see the risks of overdoing rate hikes and as less worrying than the risk that higher inflation gets baked into the economic outlook.
- "I continue to think that it's very difficult to manage the risk of doing too little and finding out in six or 12 months that we actually were close but didn't get the job done, inflation springs back, and we have to go back in," Powell said.
- "I think it would be premature, it would be very premature to declare victory or to think that we've really got this," he added.
- If you're Powell, a world where there are a few bumpy quarters for growth, or a mild recession in the second half of 2023, is tolerable. Inflation staying high is not.
State of play: Those were Wednesday's thoughts. On Friday morning, the jobs numbers surely intensified the sense of those risks, with the unemployment rate hitting a new five-decade low, combined with more than half a million net new jobs.
- And don't sleep on Friday's blockbuster ISM-Services survey that showed strong growth in non-manufacturing businesses.
- Those developments have now more than reversed the slump in bond yields that took place after the Fed meeting. Two-year Treasuries were yielding 4.41% this morning, up from 4.10% just before the Friday jobs report.
- Some analysts think that robust growth and continued price pressures will necessitate an even more aggressive path of rate hikes than now implied in Treasury yields.
What they're saying: "I think the data overran the Fed last week, and Powell and his colleagues are falling behind the curve again," said Tim Duy, chief U.S. economist at SGH Macro Advisors, in a note.
- "It's time to start looking for a higher terminal rate," he added. "I think we are just waiting for the Fed to get there."
What's next: Powell speaks tomorrow at the Economic Club of Washington, followed by colleagues including New York Fed President John Williams and Governor Christopher Waller on Wednesday. We'll be watching for any change in tone.