Inflation Has Eased Somewhat, but There is Still Work to be Done

Jacob Hess

February 01, 2023

• Fed
• Monetary Policy

The Federal Reserve increased the target range of the Fed funds rate by 25 basis points to 4.5-4.75% in what many believe will be the second to last rate hike of this hiking cycle. This size was pretty much priced in by markets, and recent economic data had done little to sway the opinions of investors and Fed officials alike.

As a result, the bond market has already started to shape itself for a Fed pivot with the 2-year Treasury note looking to retest the 4% level, and the 3-year note moving comfortablely below it to around 3.8%. This represents about 50 to 75 basis points worth of cuts from the current lower bound of the target range. While these cuts may not come in 2023, there is very little pushback against the idea that a weak economy this year will preclude lower policy rates in 2024.

The Fed started off the press release with a slight acknowledgment of this sentiment by changing the brief phrase “inflation remains elevated” to “inflation has eased somewhat but remains elevated” which is an important admission that they are winning the fight against rising prices. This alone is a fairly dovish statement as the Fed has already positioned itself as “data-dependent” which means its actions are likely to be sensitive to observations like this. However, it does not necessarily mean that a pivot is coming soon.

Chair Powell in his press conference did everything he could to make sure that observers would not mistake the slowing of the pace in rate hikes and the slight admission that inflation has eased for a Fed pivot or even a Fed pause. In the speech, Powell made three very clear assertions that hiking is not over and that there is “more work to do.” The rhetoric is very clearly aimed at preventing the premature loosening of financial conditions which would soften the effects of tighter monetary policy. According to the Chicago Fed National Financial Conditions Index, the financial conditions have generally loosened since October 2022 which is counterproductive to the Fed’s intentions. Recent trends in short-term interest rates have been the culprit.

The moral of the story is that the job is not done yet. Powell did a good job of summarizing the work that still needs to be done to cool the economy to the desired level. “Labor demand substantially exceeds the supply of available workers, and the labor force participation rate has changed little from a year ago” which is importantly keeping wage inflation sticky. Some have pointed to some cooling in the Q4 2022 Employment Cost Index release as evidence that we can stop worrying about wage inflation, but there are way too many job openings, especially after we found out that 600,000 were added in December. The “higher for longer” narrative is the way that the Fed will likely go as it avoids cutting rates in 2023 despite growth challenges.