What Does The Fed Do Now?
One Dollop Of Economic Good News Sheds Little Light On What The Fed Does Next
Wall Street’s bulls were positively ecstatic by yesterday’s surprise CPI print showing headline consumer price inflation declining to 8.5% in the month of July, rising sharply yesterday and continuing this morning.
On Wednesday, the Dow Jones Industrial Average DJIA, 0.89% rose 535 points, or 1.63%, to 33310, the S&P 500 SPX, 0.95% increased 88 points, or 2.13%, to 4210, and the Nasdaq Composite COMP, 1.04% gained 361 points, or 2.89%, to 12855. The S&P 500 is up 14.8% from its 2022 closing low hit in mid-June but remains down 11.7% for the year to date.
Wall Street is clearly celebrating the Fed’s “win” over inflation. But is it celebrating too soon? More than likely.
The Fed Is Still Pushing Rate Hikes
Although Wall Street is anticipating a softer Fed stance on interest rates, the Fed itself has been quick to downplay such expectations, with Chicago Federal Reserve President Charles Evans talking up further rate increases.
With consumer prices unchanged last month compared to June, but up 8.5% from a year earlier, inflation is still "unacceptably" high, and the Fed will likely need to lift its policy rate, currently in the 2.25%-2.5% range, to 3.25%-3.5% this year and to 3.75%-4% by the end of next year, Evans said.
With only three meetings left in 2022 in which to raise interest rates, for the Fed to reach Evans’ year-end rate target, at least one rate hike of 50bps or more is mathematically necessary, which reduces the likelihood of only a 25bps rate hike any time soon.
Even before the CPI Summary came out, Clevelend Federal Reserve President Loretta Mester cautioned against making too much of a drop in inflation over a single month.
So, again, we might see goods inflation and commodities inflation come down but at the same time see the services side--I said "supply side"--I meant services side of the economy, right, stay up and that's what we got to keep watching for. So, and that's when I say compelling evidence. It can't be just a one-month oil prices went down in July, that will feed through to the July inflation report, but there's a lot of risk that oil prices will go up in the fall. It's got to be sort of a sustained, several months of evidence that inflation has first peaked--we haven't even seen that, yet--and then, is moving down.
The cautionary notes arguably are somewhat prescient, as commodity prices, especially for oil and gasoline, rose on the day yesterday, along with gold, silver, and copper.
Are Rate Hikes Even The Answer?
However, the Federal Reserve is facing an even greater question about its rate hike policies, although it probably does not realize it—the rate hikes may not be having much if any influence on inflation at all.
That the Fed can corral inflation through interest rate manipulations is considered almost axiomatic in economic and finance circles, and is certainly taken as an article of faith by both the corporate and alternative media. So ingrained is this principle, that, with consumer price inflation running at 8.5% even Wall Street has conceded that there will be interest rate hikes still to come.
It will come as something of a surprise to many, therefore, to learn that the correlation between interest rates and inflation is a good deal less certain than the prevailing wisdom suggest.
A comparison chart between the Federal Funds Rate and Year-on-Year change for inflation shows a rather low level of correlation between the interest rate and consumer price inflation, particularly since 2020.
Nor is the visual representation deceiving. A computation1 of the correlation coefficient2 between the monthly measurement from 1997 through to the present of the Federal Funds Rate and year-on-year consumer price inflation yields a rather low value of 0.22516. The covariance3 between the Federal Funds Rate and inflation is similarly low at 0.325.
While there is a relationship between the Federal Funds Rate and inflation, it is far from a certain one.
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