Market participants returned from their summer vacation apparently undaunted by the consistent and persistent message from central bank officials that short-term interest rates must be raised significantly to reduce inflation.
US stocks snapped a three-week losing streak with
the index added 3.65%, although the probability of a 75 basis point hike in the federal funds target at the Federal Reserve’s Sept. 20-21 policy meeting rose to 90% by Friday from just over even money a week earlier , According to CME FedWatch site. It followed a similar-sized boost from the European Central Bank last week and expectations of a further 50 or 75 basis point increase in the Bank of England’s key interest rate at its September 22 meeting, which was postponed by a week due to the death of Queen Elizabeth II. (A basis point is 1/100 of a percentage point.)
Markets appear relatively upbeat despite the possibility of an additional 50 basis point increase in the Federal Reserve’s funds rate at its Nov. 1-2 meeting and 25 basis points at its Dec. 13-14 conference call, according to CME futures. The latest move would bring the prime rate to an “end” range of 3.75% to 4%, from the current 2.25% to 2.50%.
But even an interest rate of 3.75% or 4% may not bring inflation closer to the Fed’s long-term goal of 2%. Inflation is well above the top 4% rate expected by federal funds futures. This means that money is worth less than nothing after inflation. To contain inflation, money must be expensive in real terms.
For clues as to whether the inflation wave is subsiding, stock and bond markets will be closely watching the consumer price index for August, which is scheduled to be released this coming week. Mainly due to the big drop in retail gasoline prices, economists forecast a 0.1% drop in the overall CPI. That would cut its 12-month increase to 8.1 percent from 8.5 percent in July and a four-decade high of 9.1 percent in June. Excluding food and energy prices, the “core” consumer price index is expected to have risen 0.3% last month, lifting its annual increase to 6.1% from 5.9% a month earlier.
Also, wages are not keeping pace with rising prices. Tracking Atlanta Fed Wage Growth showed wage growth at a 6.7% annual clip in August, the same pace as July. That’s well above the Fed’s inflation target, but less than the rise in CPI.
According to Douglas Peta, chief U.S. investment strategist at BCA Research, these numbers suggest that a trailing federal funds rate above 4% will be needed to stem inflation. The pace of price increases will slow to 4% on its own regardless of what the Fed does, he predicted in a telephone interview. Even beyond energy and food, other prices have risen, especially those of used cars, a huge driver of inflation during the worst of the pandemic.
Getting inflation down to 2% from 4% will be more difficult, Peta added. Once markets realize that this will require a higher terminal fed funds rate than the 4% they expect, stocks and bonds tend to correct. This is likely to be an event in 2023 as markets and the Federal Reserve play chicken as tighter money takes its toll on the economy.
Of course, the federal funds rate does not fully reflect the degree of policy tightness. Lisa Beilfuss Interview with a former Fed trader explains the impact of shrinking the Fed’s balance sheet. Jefferies chief financial economist Aneta Markovska also estimates that the rising dollar effectively raises the fed funds rate by 100 basis points.
But that still leaves that rate below the rate of inflation. While Fed spokesmen insist the central bank won’t budge until inflation is under control, its own forecasts predict that this will be achieved without a significant increase in unemployment. Which is to say, this time is different.
Write to Randall W. Forsythe c [email protected]