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US inflation, the Federal Reserve and markets

Market participants can relax over Christmas and the New Year about the Federal Reserve after soothing comments after its latest meeting.

Markets participants can relax over Christmas and the New Year about the Federal Reserve after soothing comments after its latest meeting.

by
John Redwood

in Features

12.12.2019

This week’s statement from the US Federal Reserve was liked by equity markets. Fed chairman Jerome Powell confirmed that the central bank had reset policy earlier this year when it realised a world slowdown was also going to affect the US. It switched from putting rates up to cutting rates. He now thinks the outlook is good, forecasting continued growth around the 2% mark, with inflation on his preferred PCE measure below target. Core inflation is at 1.6%.

Earlier fears that wage inflation would accelerate once unemployment fell below 4% have been replaced with reassurances that inflation expectations are well anchored at under 2% for the future, confirmed by the run of PCE numbers. The official Fed forecast is for core inflation on their measure to rise to 1.9% next year, still slightly below target. It expects unemployment to fall a little more to 3.5% in 2020.

Inflation measures

We also saw the CPI figures, the more normal way that inflation is talked about in world economic and market circles. On this measure, inflation is slightly over target at 2.1%, with core inflation at 2.3%. Within the total services, inflation has risen to 3% reflecting faster US wage growth, and housing costs are also on the rise well above the 2% overall target. Mr Powell is right, however, about expectations, with the bond market expecting just 1.8% future average inflation if you compare the real interest rate on inflation-linked Treasuries with the interest rate of ordinary Treasuries with no inflation protection.

The Fed promised us a review of how they set interest rates. One of the issues they needed to think through was why there isn’t more inflation now unemployment has fallen to well below 4%. Its old models implied that tight labour markets led to wage inflation which, in turn, led to general inflation.

Today we are told that the current high employment levels will not cause such an inflationary spurt. Maybe the Fed is now giving more weight to excess capacity elsewhere in the world and to the competitive pressures particularly on goods prices from global overcapacity and internet competition. Maybe they expect more people to join the workforce to moderate wage rises. The Fed clearly was shocked late in 2018 when their view and the market’s view of the future was so different, forcing the Fed to admit that there was then no inflationary threat but the danger of too big a slowdown in activity.

Keeping liquid

The most reassuring thing for equity markets the Fed said this week was its willingness to supply more cash to the Treasury Bill end of the bond markets, as they have been doing recently. The Fed clearly signalled its wish to keep interest rates low, and its ability to enforce the rates by buying Treasury Bills itself if necessary. It looks as if the Fed can live with bit more inflation on the CPI in order to sustain the recovery. It points favourably to upwards movements in wages in low-paid employment, in line with the President’s strategy. Markets can relax over Christmas and the New Year about the Fed. It does not want to stop the party.

In 2020 we might need to look again at how much inflation there actually is, bearing in the mind the gap between what the two measures of inflation now say. Meanwhile, from time to time the President will chide them for not cutting rates more, as he wants 3% growth and looks enviously at zero rates in the Euro area and Japan. US policy remains positive for shares.

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