The risk of premature central bank celebrations on inflation

The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management

Markets are still parsing the implications of the early Christmas present delivered by Jay Powell during his December press conference with comments signalling a sharp shift in the US Federal Reserve’s stance on interest rates.

As the initial wave of excitement over the shift fades in the new year, there is now a considerable amount of head scratching regarding the change of heart that came just a few weeks after the US Federal Reserve chair was still warning of the possibility of even higher rates. Given the scale of the move in both stock and bond prices since the comments, this does warrant further examination.

The argument Powell has put forward is that the outlook for inflation has improved significantly, despite resilient activity. As such, the Fed is now increasingly convinced that economic growth can continue at trend, unemployment can stay low, and it will still sustainably meet its 2 per cent target. In contrast to what it thought earlier in 2023, a recession is no longer required.

Powell’s argument is then that without a need for economic weakness, interest rates don’t need to be as restrictive. They should instead be at what economists would term “neutral”. In simple terms, the Fed doesn’t need to keep its foot on the brake, so should shift gear and move to idle. 

The Fed is one of the few central banks that produce an estimate of what it believes ‘idle’ is. Its current estimate is 2.5 per cent, suggesting the current policy rate of 5.25-5.5 per cent is way above where it needs to be. If all elements of this argument are correct, the Fed would be right to not waste any time in bringing rates down. This is what the market is now pricing, with the first cut in March and rates 1.5 percentage points lower by the end of the year.

There are two elements of this argument that are worth questioning. First is whether too much weight is being placed on current inflation to assess medium-term inflationary pressure. It was acknowledged when inflation was at the highs of 9 per cent that the Fed should look through temporary spikes caused by distortions related to the pandemic. If it were working then on the basis that it needed to keep real interest rates close to 0.5 per cent, and deflated the policy rate using headline inflation, it should have taken interest rates to 8.5 per cent.

The Fed should be symmetric in how it reacts to deviations from target. It was right to look through the upside temporary distortions that came with the pandemic. In a similar vein, it should look through temporary weakness arising as supply chain distortions unwind.

The second element comes from its confident assessment that the neutral or “idle” rate of interest is 2.5 per cent. The fact the US economy has proved so resilient suggests it is significantly less rate sensitive than it was, and can sustain materially higher rates more easily than before the pandemic. In part, this is because fiscal policy is, and remains, much more stimulative than it was in the decade after the global financial crisis.

My concern is that the US economy is at, or very close to, full capacity. Falling energy and goods prices alone will provide a significant boost to consumers’ real income and spending power. It is a cost of living shock but, this time, of the good kind. The Fed cutting interest rates would then add further stimulus which risks reigniting inflationary pressures and undoing all its good work so far.

We have seen the problems caused by premature central bank celebrations in the past. This was well-documented in a paper by the IMF last summer titled “One Hundred Inflation Shocks: Seven Stylized Facts”. The key line was: “Most unresolved [inflation] episodes involved ‘premature celebrations’, where inflation declined initially, only to plateau at an elevated level or reaccelerate.” 

There is no doubt the inflation picture has improved globally. We are not facing a 1970s style wage-price spiral that requires a deep recession to stop companies and workers asking for higher pay. But central banks should also consider the risks of large, pre-emptive cuts, when so little is clear about sustained inflationary pressures or the neutral rate.

 If the Fed does deliver large cuts in the coming months, markets for “riskier” assets such as equities could initially do very well. But these gains may not be sustained. In such a scenario I would be more inclined to add bonds with inflation index-linked returns to my portfolio rather than long-term government bonds or risk assets.