Why the US Fed changed its view in February 2023?

3 Mar 2023 , 01:40 PM

Back in December 2022, the Fed had moderated its stance. It had even indicated that growth was slowing and inflation should react faster. Hence the argument was that the Fed would cut its rate hike intensity from 75 bps to 50 bps, which is what it did in December. In the subsequent Fed meeting in early February, the Fed further reduced the intensity of the rate hike to 25 bps, but what surprised the markets was the hawkishness in the language. While that has been an enigma for the markets, there is finally a detailed explanation from Governor Waller.

What Governor Waller said about the economic situation

Speaking at the conference of mid-sized banks, Governor Christopher Waller, admitted that they were wrong in getting too optimistic about the economic data too soon. In fact, Waller admitted that the January 2023 data had seriously challenged his own perception that inflation and economic activity were moderating. Waller also admitted that he was not the only FOMC member whose views had shifted in January, but there was a consensus among the FOMC members that they may have, perhaps, expected the moderation too soon in the backdrop of such a prolonged phase of growth and inflation.

How US Unemployment rate has been on a consistent downtrend
Jan-21	Feb-21	Mar-21	Apr-21	May-21
6.4%	6.2%	6.0%	6.0%	5.8%
Jun-21	Jul-21	Aug-21	Sep-21	Oct-21
5.9%	5.4%	5.2%	4.8%	4.6%
Nov-21	Dec-21	Jan-22	Feb-22	Mar-22
4.2%	3.9%	4.0%	3.8%	3.6%
Apr-22	May-22	Jun-22	Jul-22	Aug-22
3.6%	3.6%	3.6%	3.5%	3.7%
Sep-22	Oct-22	Nov-22	Dec-22	Jan-23
3.5%	3.7%	3.6%	3.5%	3.4%

Data Source: Bureau of Labour Statistics, US

The data that really spooked FOMC members like Governor Waller was the unexpected tightness in the job market. Tightness here refers to the number of job openings far in excess of the supply of workers. This leads to as situation when wages continue to remain high and that acts as a roadblock for the transmission of higher rates into lower inflation. Between November and early January, the Fed had noticed too much tightness in the job market and had hence slowed the pace of rate hikes to loosen the job market. However, the February data showed that the exact opposite was happening. In fact, the January report showed that a stunning 517,000 new jobs had been created even as unemployment at 3.4% was at a 50-year low. That was the data point that directed the view shift.

Inflation was another factor driving this change in view

Governor Waller has pointed out that it was not just the labour market tightness that urged the FOMC members to change their perspective on the rate stance. Even inflation moves came as a surprise. It must be reiterated that the FOMC still looks at PCE inflation rather than CPI inflation to formulate its view on interest rates. However, CPI inflation gets announced in the second week while PCE inflation is announced in last week of the month. Hence CPI has some predictive value for PCE inflation, which is why the FOMC also looks at the CPI inflation too. The January inflation report and the revisions to 2022 data showed that not only had inflation stopped declining in January, it also slowed a lot less in the second half of 2022 than previous reported by the Bureau of Labour Statistics.

Later, this picture was also ratified by the consumption spending data that came in. In the US personal consumption represents almost 70% of the gross domestic product (GDP); being a largely domestically driven economy. It needs no reiteration that sustained progress on inflation control depends substantially on lowering demand and moderating economic activity. However, the indications coming from the retail sales data and the spending data suggest that progress on reducing aggregate demand may have stalled. This data is all the more surprising because the fiscal stimulus of the government is almost wound up and even the supply chain constraints imposed by the lag effect of pandemic are gone. At this stage, strong consumer spending and tight labour market complicated the path to price stability.

As Governor Waller says, the devil is in the detail

Even as the FOMC has been patting itself in the back for bringing down inflation, it had bigger concerns, as outlined by Governor Waller. Look at some of the revisions for the second half of 2022. For instance, core CPI inflation for the last quarter of 2022 was revised up from 3.1% to 4.3%. At the same time PCE (personal consumption expenditure) inflation for the December 2022 quarter also saw headline inflation being raised from 2.9% to 3.6%. This led Waller and other members of the FOMC to believe that the fight to bring inflation down to the 2% target will be slower and longer compared to what they had expected just a couple of months back. These revisions also played a part in the change of view.

The one factor that really worries people like Governor Waller is that consumer spending was not slowing that much. One reason could be that the  labour market continues to remain substantial under-supplied resulting high wage levels. When wages are high, the interest rate hikes are more than offset by wage hikes. Hence, the higher rates do not translate into lower consumption and hence do not manifest in the form of lower inflation rates. That is the complex mechanism that the US economy is seeing at play right now. As Waller puts it rather defensively; it is hard to say if the data for January 2023 and the last quarter of 2022 are the exceptions or the rule. That would only be ratified by future data flows. However, the bottom line is that the FOMC members did expect quick results.

Still, a silver lining in the cloud

Governor Christopher Waller has also highlighted an optimistic angle. He has underlined that the progress in reducing inflation cannot be questioned. For example, 3-month inflation rate is running well below the 12-month rate. That is a clear signal that the inflation is structurally heading lower, even if 2% may appear to be a distant target at this juncture. Also, data points coming in like the sharp deceleration in rent increases since the middle of last year are a positive signals that there is cooling of the economy. However, these numbers would be meaningfully captured in inflation statistics only in the coming months.

A lot will, therefore, predicate on the March 2023 Fed policy slated to crystallize during the March 21-22 meeting of the FOMC. Ahead of the meeting, the members of the FOMC would be armed with the most current jobs and CPI data, which would give them enough ammunition to take a more informed decision. That is when the precise view on the terminal Federal Funds rate could also crystallize. The RBI would certainly be keenly watching this data point as it would influence the view of the RBI Monetary Policy Committee also.