July FOMC: Dancing with Our Hands Tied

Executive Summary:

• In a forgone conclusion, the Federal Open Market Committee (FOMC) increased interest rates by 25 basis points to 5.5 percent.
• After putting themselves in a difficult position by pre-committing not to hike at the June meeting, the Committee now recognizes the limited usefulness of forward guidance.
• This lack of forward guidance colored Chair Powell’s answers during the press conference as he focused on forward-looking data dependence despite acknowledging the positive progress on inflation.
• The focus for markets is shifting to the Committee’s reaction function for cuts. In figuring that out, we need a better understanding of whether the Committee is revising their model of the world as disinflation occurs without a material increase in unemployment.

Beyond the hike, the changes to the policy statement were minimal with the Committee slightly upgrading their assessment of economic growth from modest to moderate. Chair Powell’s opening statement expanded on the improvement in growth, noting that the housing market is picking up somewhat. On the labor market, demand still substantially exceeds the supply of available workers despite some signs of additional slack. He noted the positive surprise in the form of the lower-than-expected June Consumer Price Index (CPI) print but was loathe to extrapolate from one print. In a line, we did not gain any insight from the Federal Reserve’s (Fed) characterization of the recent past. Nor did Powell indulge us with his thoughts on what ticket prices for Taylor Swift’s concert tour and moviegoers’ Barbie enthusiasm say about the state of the U.S. consumer.

Going from Asymmetric to Symmetric

Reporters, rightly, spent the press conference preoccupied with attempting to understand how the Committee will transition from their asymmetric focus on further hikes to a balanced risk posture. This is not to say that the hiking cycle is over necessarily, but rather that the progress on inflation is such that it is likely that rates will be lower a year from now than higher. We think the path forward depends on the Committee’s answers to the following questions. First, how is the Committee’s view on the transmission of monetary policy evolving, if at all.

We think it’s fair to say that the Committee shares our surprise about the limited effect of 500 basis points of tightening on the labor market. The best explanation that we can fit into the Fed’s existing framework relies on the premise that the distortions of the pandemic, more so than an increase in aggregate demand, increased prices which consumers were able to offset in real terms through lower savings rates and higher household net worth due to fiscal transfers and asset price increases. The slow increase in interest rates kept policy below restrictive territory for some time further supporting growth and the lagged effects of past policy changes are still to come. At the same time the relationship between inflation and aggregate demand steepened resulting in the need for less labor market slack to achieve a given change in inflation.

Insofar as this change is persistent, the Committee should expect a limited increase in unemployment to reach their 2 percent goal. An alternative view is that the pre-pandemic view that inflation is not very responsive to aggregate demand remains the case and that the increase in inflation attributable to aggregate demand will be more costly to unwind.

Second, insofar as we understand policy transmission, how long are the lags from policy tightening to the real economy and when did we reach restrictive territory. To the former, Powell noted that financial markets anticipate the Fed’s response earlier than in previous hiking cycles, which argues for shorter lags. We are nearly 16 months out from the first rate increase although the pace accelerated in the second half of last year, making it difficult to argue against either view. This uncertainty around the length of policy lags leaves us unable to answer question one. As to whether we are in restrictive territory, the border is only obvious in hindsight. Our understanding of the Committee’s reaction function is that the answer to these two questions is that policy is in restrictive territory with lagged effects still to come, and that the last mile on disinflation must come from slower aggregate demand.

The sacrifice ratio is another way of articulating question one, i.e. how much does the unemployment rate need to increase for a given decline in inflation. Taking the sacrifice ratio as a given, our third question is what is the FOMC’s tolerance for labor market pain, should it be required, relative to the level of inflation. The June Summary of Economic Projections suggests the Committee would tolerate a 1 percent increase in the unemployment rate by 2025 to reach 2 percent inflation. Delivering a 1 percent increase in unemployment in practice may prove less palatable than forecasting it. So, for now, we know the questions, but it will take a few more months before either we or the Committee know the answers.

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Important Information

The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.

This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

A basis point is one hundredth of 1 percentage point.

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