The Fed’s June interest rate meeting announced that it would raise the target range of the federal funds rate by 75BPs to 1.50%-1.75%, a rate hike larger than the forward guidance (50BPs) given by the Fed in May. In order to curb inflation, the Fed is forced to accelerate the process of raising interest rates, and the risk of a hard landing in the US economy is rising. How to solve this dilemma will be the biggest challenge for the Fed to implement its policy in the second half of the year.
U.S. inflation is more difficult to manage
The first signs of runaway inflation in the United States appeared in early 2021. In April 2021, the year-on-year CPI growth rate in the United States exceeded the 4.0% mark for the first time. In May, the unemployment rate fell below 6%. inflation target of 3 percentage points.
Since the Fed established “average inflation targeting” as the new monetary policy framework in August 2020, the Fed’s tolerance for inflation overshoot has increased. The Fed believes that the main reason for the rise in inflation is the supply chain disruption caused by the epidemic, monetary policy is helpless to supply shocks, and price increases will subside on their own as the epidemic eases and the economy restarts.
Federal Reserve Chairman Jerome Powell insisted that “inflation is temporary” and extended an accommodative stance to support economic growth. It was not until the December 2021 interest rate meeting that the Federal Reserve gave up the expression of “inflation temporary theory” in its statement, but at this time, the year-on-year growth rate of the US CPI has soared to 7%, exceeding the long-term target of 2% for 10 consecutive months.
With the passage of time, this round of inflation has shown more and more obvious demand-driven characteristics, mainly reflected in the following two aspects. First, during the epidemic, the income of US residents rose instead of falling, and consumer demand increased significantly. During the 2020 epidemic, the U.S. Treasury Department issued a large amount of cash subsidies to residents. Before the pandemic (end 2019), the U.S. Treasury Department’s personal transfers to residents were about $3.1 trillion (annualized), and the subsidy amount in 2020-2021 rose to $40,000-8 trillion (annualized). Personal disposable income and total savings have grown rapidly during the epidemic, and personal consumption expenditures are still above the long-term trend before the epidemic.
Second, the job market is extremely tight, and we need to be wary of the wage-price spiral. The labor force participation rate increased by 0.1 percentage points to 62.3% in May, still 1.1 percentage points lower than before the epidemic (February 2020). In April, the number of job vacancies in the United States was as high as 11.4 million, but the number of unemployed was only 5.94 million, and the gap between supply and demand in the labor market was as high as 5.45 million, far higher than the normal level before the epidemic. Workers adjust their salary requirements according to inflation expectations, and the “labor shortage” further pushes up wages, which in turn exacerbates inflationary pressures. Since the second half of 2021, the year-on-year growth rate of non-agricultural average hourly wages has continued to climb with the expansion of the labor market gap, and it is necessary to be vigilant about the formation of wage-price spiral inflation.
This round of inflation is triggered by a shortage of supply, but the over-expansion of aggregate demand has provided a solid foundation for the continued rise in prices. Now the Federal Reserve must also use a strong demand contraction in exchange for a fall in inflation. It is precisely because of the Fed’s misjudgment of the cause and nature of this round of inflation that its policy response lags behind, and its rate hike action is far behind the interest rate curve and inflation level.
Different from short-term shock supply-based inflation, demand-based inflation is more persistent and widespread. In fact, the market and the Fed have consistently underestimated inflationary pressures in the U.S. over the past year. From March 2021 to the present, the month-on-month growth rate of U.S. CPI has been in line with market expectations 3 times, 1 time is lower than market expectations, and the remaining 11 times are higher than market expectations. The Fed continuously raised the growth forecasts of PCE and core PCE at the rate meeting at the end of each quarter in 2021, but still underestimated the actual inflation level in 2021. In March and April 2022, the year-on-year growth rate of overall and core inflation in the United States dropped, and the market’s inflation worries eased for a time. However, the year-on-year growth rate of U.S. CPI rebounded to 8.6% in May, hitting a new high in more than 40 years, and the expectation of “peaking inflation” was once again falsified.
The breadth of this round of inflation also exceeded market expectations. Core inflation after excluding energy and food can more clearly reflect medium- and long-term price trends. Specifically, U.S. inflation exceeded expectations in May. On the one hand, it came from the recent rapid rise in food and energy prices, and on the other hand, from the core inflation that has continued to be high since 2022. In May, the US core commodity prices rebounded strongly compared with April, and the inflation pressure of durable goods was more persistent than expected. Among them, the prices of new cars and used cars rose by 1.0% and 1.8% month-on-month respectively. Core service prices maintained a strong month-on-month growth rate. Among them, housing prices, which contributed more than 30% to core service inflation, increased by 0.6% month-on-month, a further increase from April, indicating that inflationary pressures have penetrated into more viscous service industry items.
In the short term, US inflationary pressures may continue to rise in the third quarter. The conflict between Russia and Ukraine has fallen into a long-term stalemate, which may lead to high and volatile energy and food prices this year. With the lifting of travel restrictions and the arrival of the summer travel peak, the demand for services such as transportation, catering and entertainment is strong, and the prices of core services in the CPI sub-item may continue to rise. In addition, the month-on-month growth rate of the US CPI and core CPI from March to June 2021 is relatively high, and the base effect has brought about a “peak and fall” of inflation in the second quarter of 2022. The base effect gradually faded in the third quarter, and there is a possibility that the US inflation reading will continue to deteriorate.
In the medium term, we need to be alert to the risk of de-anchoring of US inflation expectations. The long-standing low inflation expectations of U.S. residents have reversed as inflation continues to rise more than expected. In May, the University of Michigan’s 5-year inflation forecast reached 3%. As of June 17, the 5-year breakeven inflation rate was about 2.9%, and the 10-year breakeven inflation rate was about 2.6%, both significantly higher than the 2% rate. Long-term goals and medium- and long-term inflation expectations show a certain risk of de-anchoring. Inflation expectations are self-fulfilling, and a positive feedback is formed between actual prices and inflation expectations, making it more difficult for the Fed to curb inflation, and the inflation turning point may come later than market expectations.
Risk of hard landing for U.S. economy rising
Federal Reserve Chairman Jerome Powell said that despite the Fed’s resolute stance on curbing inflation, it is still possible to achieve a soft landing in this case, that is, to reduce inflation without causing a recession. With the steep path of interest rate hikes and severe inflation, the recent US economic activity has begun to cool down, the hidden dangers of financial stability have begun to emerge, and the risks of economic recession and even stagflation are accumulating.
Despite the current US economic resilience, the current investment and consumption outlook are showing signs of weakening. In business and real estate investment, the Philadelphia Fed said factory activity in the mid-Atlantic region contracted for the first time in two years in June. The number of new housing starts in the United States in May fell by 14.4% month-on-month to 1.55 million units (annualized), the largest month-on-month decline since April 2020. Building permits, which reflect future residential construction, fell to 1.7 million (annualized), the lowest level since September 2021. In terms of consumption, the U.S. Department of Labor said that although nominal wages continued to rise, after excluding inflation, the actual average hourly wages of employees in May fell by 0.6% month-on-month and 3% year-on-year. The decline in real income will erode consumption momentum. The University of Michigan’s consumer confidence index fell further to 50.2 in June from 59.1 in May, the lowest level since April 1980.
Economic forecasts within the Fed are also relatively pessimistic. On June 16, the latest forecast of the US GDP growth rate by the Atlanta Fed showed that the US GDP growth rate in the second quarter was only 0% (the actual GDP growth rate in the first quarter was -1.5%), and the growth rate of private investment fell to -8.5%. (The real growth rate of private investment in the first quarter was 0.5%). On June 17, the New York Fed released a working paper showing that the DSGE model predicts that the US GDP growth rate will be -0.6% in 2022 and -0.5% in 2023, achieving a soft landing (GDP growth will continue to be positive in the next 10 quarters). ) is only 10%, and the probability of a hard landing (GDP growth below -1% at least once in the next 10 quarters) is as high as 80%.
The National Financial Conditions Index (NFCI) released by the Federal Reserve Bank of Chicago includes three dimensions: Risk, Credit and Leverage, which are used to describe the overall financial conditions of the United States. A positive index means current financial conditions are tighter relative to the historical average, and a negative index is more accommodative. As of June 10, U.S. financial conditions have risen from -0.74 in the most accommodating period to -0.26, which is significantly higher than the pre-pandemic level (about -0.6). The specific manifestations are the strengthening of the US dollar index since 2022, the rise in US bond yields and home loan interest rates, the sharp decline in US stocks, and the widening of corporate bond credit spreads.
With the accelerated tightening of the Fed’s monetary policy, U.S. financial conditions will continue to contract in the third quarter, and the possibility of returning to above 0 from the current negative range cannot be ruled out, and the risk of violent fluctuations in the U.S. financial market will rise. Since American residents have a large amount of assets allocated in the financial market, once the liquidity crunch triggers a coordinated decline of various risk assets, it will inevitably lead to the shrinking of the wealth of the private sector and the crisis of economic and social stability.
Interest rate hikes will continue in the second half of the year
Facing severe inflationary pressures and political demands for mid-term elections, the Federal Reserve will accelerate the policy tightening process in the second half of the year. The dot plot released by the Fed’s June meeting on interest rates shows that all officials expect the Fed to raise the federal funds rate above 3% by the end of 2022, and the median forecast reaches 3.4%, which means that in the remaining 4 interest rate meetings A total of 150BPs-175BPs of interest rate hikes were raised at the meeting, and 75BPs, 50BPs and 50BPs of interest rate hikes in July, September and November have become the benchmarks for market forecasts. But even if the Fed has raised interest rates sharply to 3.4% in a row, there is still a big gap compared to the inflation level. The Fed predicts that the year-on-year growth rate of PCE and core PCE will still be as high as 5.2% and 4.3% in 2022, significantly exceeding the federal funds rate of 3.4%, while the Fed’s inflation forecast has always been low. According to a Reuters survey, market institutions predict that the year-on-year CPI growth rate in the fourth quarter of 2022 will still be as high as 6.2%, and the year-on-year CPI growth rate for the whole year will be 7.4%.
The current inflation outlook is highly uncertain, especially the wage-price spiral and the spillover effect of inflation expectations on the price level is difficult to accurately predict. In addition, the monetary policy itself is lagging behind. The Fed’s policy tightening rhythm shown in the June dot plot It still lags the interest rate curve and inflation levels. The Fed’s effectiveness in fighting inflation remains to be seen, and it is expected that the US inflation level will continue to peak at a high level in the third quarter.
At present, the Federal Reserve has made combating inflation the primary goal of its policy, but it still faces multiple constraints such as maintaining economic growth and maintaining financial stability. If inflation continues to exceed expectations in the third quarter, the urgency of the Fed to raise interest rates will be further enhanced, which may release more hawkish policy signals to suppress inflation expectations. In the process of aggressive interest rate hikes, if the US financial conditions tighten rapidly, leading to a drastic adjustment in financial markets, or if the unemployment rate starts to pick up earlier than expected, the Fed may slow down the policy tightening process.