Market and Policy Commentary - July 2023

Markets continue to try to infer the next rate move by central banks. Succeeding at this requires both a keen understanding of macroeconomic conditions and anticipating the central banks’ response to those conditions. Most recently, the ECB raised rates by 25 bps, the BoE surprised markets with a 50-bps hike, and the Federal Reserve paused its hiking pattern in June but announced more hikes should be expected.

The impact of such a steep increase in rates has been to reverse the normal upward slope of the term structure of interest  rates. Long-term rates are lower than short-term rates to an extent unseen since the early 1980’s (see Exhibit 1). Since  banks generally fund longer-dated lending from shorter-dated deposits, their business model is challenged when they  earn less on the former than they pay on the latter. The potential for any pullback in lending is going to play out over the  remainder of 2023 if central banks stick to their announced inflation fighting plans. While past is not prologue, the last term  structure inversion of this magnitude (1981) did not have a happy ending. 

Helpfully, central bankers have recently offered considerable commentary to shed further light on their actions. At the recent ECB Forum roundtable in Sintra on June 28, Chair Powell remarked that “quite a strong majority (of FOMC members) wanted two or more rate hikes,” a comment he repeated the next day at the Banco de Espana conference. In response, the moderator asked Chair Powell an insightful question: “So I don’t get why you didn’t raise rates at the last (June) meeting, especially I think it was a surprise that it was a unanimous decision to hold rates steady when you said a majority think that they still need to go farther to raise rates?”

Indeed, it is hard to comprehend, based purely on inflation-fighting goals, why the Fed chose to communicate its conviction  of two more rate increases on the heels of the Fed “maintaining the level of the federal funds rate at its current level for this  meeting” (its terminology for the pause). In contrast, when at the same roundtable discussion the BoE governor was asked why the BoE raised its rate by 50 bps, his response was that “if we were really of the view that we were going to do 25 (bps)  and then we were baked in for another 25 based on the evidence we had seen, it was best to do the 50.” 

The most likely and unspoken reason for the Fed’s pause is the potential conflict between prudential supervision (safety  and soundness of banks) and inflation objectives. Due to the inverted term structure, financial stability risk arises from  banks having little ability to earn their way out of negative carry on their assets. Greater near-term rate hikes would likely  steepen the negative carry, at least in the short run. While some monetary policy observers regard financial market  supervision and monetary policy as logically separable (believing vigilant supervisors should be able to spot troubled  banks before disaster strikes, allowing inflation fighters to do their job independently), a lesson from the Spring 2023 bank  failures is that, in practice, this is not the case. And because financial stability fundamentally depends on public confidence  in the banking system, regulators’ concerns about it are not easily shared publicly.  

However, there is good news on the inflation front for two reasons. First, Chair Powell announced in November 2022 a framework for fighting inflation that emphasized that the Fed looks carefully at the labor market as an indication of how  much pressure there might be on core services inflation. The level of job openings per unemployed is often cited by Chair  Powell as a metric for labor market tightness. According to the so-called Beveridge curve (a plot of the rate of job openings  against the rate of unemployment), job openings fall in connection with increases in unemployment. But what if openings  can fall without greater unemployment? Indeed, the Beveridge curve, and its close relative the Phillips curve (a plot of 

inflation against unemployment), have been vertical in graphic terms (see Exhibit 2) indicating there has been little trade off between job openings, unemployment, and lower inflation. This increases prospects for a so-called“soft-landing”,  inflation reduction without large increases in unemployment, provided restrictive monetary policy is not prolonged  excessively. If so, job openings may not be an informative metric for gauging wage pressure, and the Fed’s focus on it may  be misplaced in the current environment. 

There is a second reason for inflation optimism. The Fed often emphasizes the 12-month measure of the Consumer Price Index (CPI), and in fact, the Bureau of Labor Statistics highlights it in the last column of its data release, as indicated below. Twelve-month CPI contains the last 12 months of monthly inflation– and hence much of the data comprising it is old history. For example, the CPI print for the month of June 2022 alone was 1.2%. This was scheduled to roll out of the June 2023 12-month CPI calculation (because it would become 13-months old). Even if the June 2023 CPI print had been the same level as the prior three months’, simply dropping

June 2022 from the 12-month calculation would have reduced 12-month CPI from 4.0% to 3.1%, a near 25% reduction in 12-month inflation without any reduction in 3-month inflation. Exhibit 3 plots the 3-month CPI as compared with the conventionally reported 12-month CPI. While 12-month inflation has been trending down slowly, 3-month CPI has been consistently lower, and much nearer to the Fed’s target. The recent July 12 CPI release brought the two measures much closer together, simply because older, high prints dropped out of the calculation. Despite this being entirely predictable, markets seemed surprised, with the March 2024 Fed Funds futures contract rising 15 basis points in the aftermath of the July 12 announcement. 

We have previously expressed the view that the road from 9% inflation to 4% would be relatively easy to achieve. That a  3% headline (all items) level has arrived so quickly is welcome news, even if core inflation lags. The quick drop in headline  inflation also suggests that the Fed should revisit progress against its stated framework for evaluating inflation in terms of three components: goods inflation, services inflation less rent of shelter, and rent of shelter. The first two have dropped  meaningfully, with rent of shelter inflation still high but impaired by stale measurement inputs. We are interested to see  how the Fed will reconcile the strong statements made in June by FOMC members that two more hikes are forthcoming  with the sensible application of data-dependent policy.

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