The Federal Reserve made it clear Tuesday that it is more concerned about the recent acceleration in inflation than in the recent slowdown in the economy.
The Fed statement clearly suggests that it does not believe that it is finished raising interest rates. Accordingly, the bond market is now priced for near 100% odds of a 25-basis-point hike at the June 29-30 FOMC meeting, and for about 75% odds of a 25-basis-point hike at the Aug. 9 FOMC meeting. The market is priced for the federal-funds rate to end the year at 3.75%, up from 3% currently.
The news shouldn't be a major surprise to the markets, given recent indications suggesting that the Fed remains confident in the economic outlook. Moreover, in light of the Fed's March 22 expression of concern about the recent acceleration in inflation, and given the subsequent release of sobering news on inflation, to expect anything less than a show of resolve from the Fed would be to misinterpret the nature of the Fed's mandate.
If the Fed wanted to indicate that it was either finished or nearly finished raising interest rates, it easily could have done so with only mild changes in its policy statement. Instead, the Fed chose a different route by indicating that, if anything, the need to raise interest rates had been reinforced by recent developments with respect to trends in inflation.
Perhaps the clearest signal that the Fed could have sent would have been the removal of the word "accommodative" as its reference to the current stance on monetary policy. Yet, it remained:
"The Committee believes that, even after this action, the stance of monetary policy remains accommodative..."
The inclusion of the word accommodative is critical because its removal would widely be seen as a signal by the Fed indicating that it believes that the federal funds rate has reached a neutral level, meaning a level that neither acts as a stimulant to economic activity, nor as a drag. The inclusion of the word is seen by most market participants to mean that the Fed will continue to raise interest rates, at least until the federal funds rate has reached a neutral level.
Inflation Risks Still Dominant Concern
The policy statement makes it clear that the Fed's concerns about inflation risks are outweighing concerns about the soft patch that the economy has fallen into. The Fed gave only a passing glance at the slowdown, similar to last August when the Fed had to address a soft patch with similar qualities. Here is the Fed's only reference to the latest soft patch:
"Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices."
Interestingly, the Fed said that the slowing in spending was because of an earlier rise in energy prices. In 2004, the Fed referenced the effect of energy on the economy in all four policy statements from August through December, but it wasn't until the December statement that the Fed put the energy-price rise in the past tense. That's because it took until November before energy prices had any meaningful pullback. By describing the oil-price rise in the past tense makes it even clearer that the Fed believes the impact of the recent rise in energy prices will be temporary.
Job Market Highlighted Again
The Fed's characterization of the economy continued to include a statement about labor market conditions, pointing our attention to the importance of the labor market in the current formulation on monetary policy. The Fed's characterization of the labor market was quite favorable and the Fed is apparently banking on fairly good employment figures in the months to come:
"Labor market conditions, however, apparently continue to improve gradually."
Inflation Concern Elevated Slightly
The Fed strongly signaled that it would continue to raise interest rates by showing heightened concern about inflation:
"Pressures on inflation have picked up in recent months and pricing power is more evident."
In and of itself, the inflation comment is not new, as it was included in the March 22 FOMC statement. What is important, however, is the Fed's mitigating remark that was included in the March 22 statement:
"The rise in energy prices, however, has not notably fed through to core consumer prices."
The removal of these remarks fits with the recent inflation data, which has shown an acceleration in core inflation. Recall that, excluding food and energy, the consumer price index rose 0.4% in March, the most since August 2002, and that the deflator for core personal consumption expenditures rose 0.3% for the second time in three months and the largest quarterly average since 2001.
With the inflation rate accelerating, and after having expressed concern about inflation risks, it would be very unbecoming for any central bank to backpedal and consider anything other than a further show of resolve. It is therefore fitting that the Fed showed greater concern about inflation than growth. Only after several more months of decelerating economic activity would the Fed likely change its tune.
One way to guess whether the Fed might be done raising rates is to consider the impact on the markets and its subsequent effect on the economy. If it seems that a stoppage in the rate hikes would cause a substantial loosening of financial conditions and hence cause all of the factors that brought about the recent acceleration in inflation, then one should expect the Fed to continue to raise interest rates.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of
The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback and invites you to send it to
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