Wall Street picking up what the Fed is throwing down

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by Glenn Dyer

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Wall Street has fallen in behind the US Federal Reserve’s hawkish approach to bashing inflation lower with a series of 0.50% rate rises.

Instead of throwing up their hands and selling shares, investors now accept that the Fed is deadly serious about controlling inflation and will cop whatever the central bank delivers over the rest of 2022.

The minutes from the Fed meeting at the start of May with its 0.50% increase confirmed that markets and investors generally can expect similar rises in coming months.

Investors appeared to welcome the certainty and seriousness of the central bank’s quite pointed commentary about the need for more big rate increases.

Even after the worse than expected estimate of first quarter GDP, markets bounced for a second day in a row.

The first estimate in late April showed the economy contracted 1.4% in the March quarter. Economists reckoned the second estimate would show a small improvement to a contraction of 1.3%. but the Commerce Department said gross domestic product fell at a 1.5% annual rate.

Normally that would trigger more doom and gloom but by the close, all three market measures were well and truly in the green with the tech heavy Nasdaq leading the way.

The two-day rebound even ignored weak earnings from leading clothing retailer, Gap which if they had been issued a week ago, would have triggered another sell off.

Reuters said Wall Street had risen solidly for two sessions because of “ebbing Fed fears”. That’s acceptance of the Fed’s now well-explained policy path for the next few months and heading into 2023.

The spirit of the minutes would have found support at the Reserve Bank of NZ which this week, with its second half a per cent rate rise in a row, made a similar declaration to local investors and markets – that inflation needs to be brought under control ASAP and if that involves slowing demand, so be it.

The Fed minutes showed that all members of the Open Market Committee not only backed the 0.50% rise (as was revealed in the post-meeting statement) but “most participants agreed to further increases of the same size.”

May’s 0.50% increase was the first in 20 years and the minutes make it clear that there will be a second and third in coming months.

“Most participants” judged that further hikes of the same magnitude would “likely be appropriate” at the Fed’s policy meetings in June and July, according to the minutes.

“All participants concurred that the U.S. economy was very strong, the labour market was extremely tight, and inflation was very high,” the minutes said, with risks of even faster inflation “skewed to the upside” given ongoing global supply problems, the Ukraine war, and continued coronavirus lockdowns in China.

In that context, “participants agreed that the (Federal Open Market) Committee should expeditiously move the stance of monetary policy toward a neutral posture … They also noted that a restrictive stance of policy may well become appropriate.”

“Many participants” also judged that getting rate hikes now “would leave the Committee well positioned later this year to assess the effects of policy firming.”

That is a dramatic change in policy and language from previous meetings and the acceptance by nervy wall Street traders was significant.

That begs the question, would we ever see the Reserve Bank of Australia heading down the 0.50% route? With our lower inflation rate (5.1% headline and 3.7% core) against 8.3% and 6.2% core in the US, the answer is not now.

But the big rise in electricity prices this week could very well see that change. It is the sort of rise that will seep into the rest of the economy and become embedded in the prices of a wide range of goods and services.

It is the type of price rise that worries the RBA because its the cost of an essential input across all parts of the economy.

That raises the chances of the RBA producing a rise of 0.50% down the track if inflation continues to rise past 6% on a headline basis and core inflation tops 4%.

Next week’s first quarter national accounts and growth data will not change thinking at the central bank – it is all very historical for the moment. But the data may well mark a peak in growth and demand with interest rates set to continue rising.

Like the rest of the world, the Fed is grappling with how best to navigate the US economy towards lower inflation without causing a recession or pushing the unemployment rate substantially higher – a task the minutes said “several participants” at the meeting this month said would prove challenging in the current environment (and don’t forget the continuing damage Covid infections are having).

From the minutes there seems to be a feeling that while inflation may have slowed, it was “too early to be confident that inflation had peaked.” That’s a view that is widely held in other central banks and markets.

The Fed’s preferred measure of inflation, the Personal Consumption Expenditures price index, is also rising, though not as rapidly, hitting an annual rate of 6.6% in March from a year earlier.

While the Fed and many economists had expected prices to ease as the economy reopened and snarled supply chains returned to more normal operations, that has not happened. Instead, prices have continued to rise, broadening to categories including food, rent and gas.

Price pressures may have weakened but for China’s Covid lockdowns and the war in Ukraine have exacerbated price increases for goods and (especially) food and fuel.

Data released on Tuesday showed new home sales in the US falling 16.6% in April from March, a sign perhaps that more expensive borrowing costs may be cooling the housing market.

Early business activity surveys for May by S&P Global on Tuesday also pointed to slowing activity at service businesses in the United States and elsewhere, and continued supply chain disruptions at global factories.

That could be a response to rising interest rates in the US, Canada, NZ, Australia and Scandinavia. Europe and Japan haven’t lifted rates and China is cutting rates, but the economy continues to slide.

Those early activity reports will be updated next Wednesday and Thursday and will give a clearer picture of the health of various economies as well as the globe. China’s won’t be pretty.

But the Fed minutes also contained a big reminder to markets and others that controlling inflation might be more difficult than simply making monetary policy adjustments and that the central bank (and others) might have to go beyond what might be considered normal policy moves.

The minutes noted that participants “noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook,” according to the minutes.

In this context, ‘restrictive’ means (as the RBNZ seems to have admitted this week) that slowing demand to the point (and its really household spending that we are talking about here) where a recession seems possible – ie going beyond a soft landing.

“There are huge events, geopolitical events going on around the world, that are going to play a very important role in the economy in the next year or so,” Fed chair, Jay Powell said last week.

“So the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control.”

And that’s the scary thing about this episode of inflation. The price pressures may not ease for quite a while because they are beyond the control of central banks and their governments and their monetary and fiscal policy levers.

Glenn Dyer

Glenn Dyer has been a finance journalist and TV producer for more than 40 years. He has worked at Maxwell Newton Publications, Queensland Newspapers, AAP, The Australian Financial Review, The Nine Network and Crikey.

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