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  • Writer's pictureJoe Carson

Risky Business: Is The Fed Sending the Wrong Message About the Promise of Lower Rates?

Updated: May 14

Policymakers often proclaim their reliance on data (i.e., a data-dependent policy approach), indicating uncertainty about the economy's future growth and inflation. However, they also assert that monetary policy is restrictive and promises lower rates in the future. This raises a crucial question: How can policymakers confidently assert these policy assertions if unsure about the economy's trajectory? Policymakers need to move beyond the focus of day-to-day statistics and grapple with the more significant challenge of understanding the cyclical dynamics of growth and inflation cycles.

Business cycles are not linear. Yet, policymakers often view growth cycles in a linear fashion, assuming that if growth is fast, it will inevitably slow. However, the history of business cycles tells different stories- quarterly growth patterns are often random and, in most cases, unforecastable. This unpredictability should serve as a reminder for policymakers to adopt a more flexible approach. 

Look at the quarterly growth patterns over the past two years. In 2023, the second half GDP growth was 4% annualized, twice that of the first half. Yet, nothing in the first half suggested a significant acceleration was a possible outcome. 

In 2022, the difference between the first and second half was more dramatic. GDP contracted slightly in the first half but expanded at a 2.75% annualized rate in the second half. Was that forecastable? 

Mid-way through Q2, the Federal Reserve Bank of Atlanta GDPNow model estimates GDP rising an annualized rate of 4.2% in the current period. How can monetary policy be restrictive when economic growth in Q2 is running twice that of Q1 and double the Fed's estimate of potential?

Inflation cycles are not linear or straightforward, either. They fluctuate, with some months experiencing faster inflation than the average and others witnessing slower inflation. Moreover, they rotate, with some products experiencing price hikes each month and others occasionally declining for a few months before bouncing back. This multifaceted nature of inflation cycles should prompt policymakers to address the issue comprehensively and not single out one or two items. 

Policymakers seem obsessed with the rental price cycle, which they view as the "last leg" to getting inflation back to the 2% target. Fed Chair Powell spent much time discussing the rental inflation issue at the recent press conference following the April 30-May 1 FOMC meeting. 

Admittedly, the owner's rent index has a big weight in the CPI. But the owner's rent series is an odd item in the CPI. CPI components are weighted by people's expenditures. Yet, two thirds of people own their home, so the majority of households don't ever experience rental inflation.

However, anyone who has studied inflation cycles knows inflation is never limited to a single item. In the past twelve months, consumer service inflation has risen 5.3%; without the shelter component, it's 4.8%. In other words, there is a lot of service inflation outside of the rent index. In the first quarter of 2024, the service ex-shelter increased at an annualized rate of 8%. 

So, statistically, if rental inflation slows somewhat in the coming months, core inflation might temporarily move closer to 2%. But underneath the "hood," there is still an inflation issue the Fed needs to deal with.

One of the Fed's most powerful tools is the ability to shape market expectations of future policy through public statements. The downside, of course, is sending the wrong message. Policymakers made a mistake when they initially argued that the surge in inflation was "transitory."

Are policymakers too confident that inflation will slow on its own? History says yes. Last week, April's Michigan consumer sentiment survey showed inflation expectations jumped to 3.5%, the highest reading in six months. 

If economic growth is strong and people's inflation expectations are on the rise the Fed, by promising lower rates, is making a policy mistake that could prove to be more damaging to the economy and financial markets than the "transitory" policy mistake of 2021.

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