DYNF - The Fed Needs To Send An Extremely Hawkish Message To Markets

Summary

• The Federal Reserve appears to be losing control of the market.
• Financial conditions have eased dramatically since the December FOMC meeting.
• The Fed needs to push back against the market before it is too late.

It appears that the Federal Reserve is losing control of the market. Financial conditions have eased to levels not seen since the spring of 2022. This easing has led to increases in commodity prices, drops in mortgage rates, a weakening of the dollar, and a rally in stocks.

The February FOMC will take on extra importance because the Fed will need to push back on the current easing of financial conditions. If the Fed truly believes that monetary policy is transmitted through financial conditions, then the Fed hasn't been successful. Conditions are currently at levels equal to when the Fed first started to raise rates. These conditions are accommodative to the economy and aid in its expansion, exactly the opposite of the Fed's desire to get the economy to grow at a below-trend rate.

Pushing back at this point in the game may be even harder than it was when Powell gave his Jackson Hole speech. The market knows the Fed is closer to the end of its rate hiking cycle than the beginning. The market also expects inflation to continue to drop. This means the Fed can either raise rates by 50 bps, which would be a big surprise to markets, or give guidance that financial conditions have eased too much, which will extend the rate tightening cycle.

Prices Are Rising

One effect of easing financial conditions is rising commodity prices. The average national price for regular unleaded gasoline increased by 9.4% in January, indicating that we may see a resurgence in the Consumer Price Index ((CPI)) on a month-over-month basis when the January report is released.

Also, copper prices have risen dramatically. Changes in copper prices can lead to changes in year-over-year changes in CPI. The recent increase in copper prices is due to two factors: the reopening of China and a weaker dollar. While the Federal Reserve cannot control the enthusiasm for a rebound in the Chinese economy, it can attempt to tighten financial conditions, strengthening the dollar and potentially slowing the copper rally.

Meanwhile, lumber prices have risen dramatically this month as new home sales begin to pick up again. This appears to be a result of the easing of financial conditions.

The Return of Inflation

These issues challenge Powell and the Federal Open Market Committee because the easing of financial conditions has increased inflationary impulses. According to the latest estimates from the Cleveland Fed, this is expected to result in a 60 basis point month-over-month increase in the headline Consumer Price Index in January. This would be the most significant increase in the monthly change of CPI since June.

Based on those estimates, the Consumer Price Index ((CPI)) could rise by 6.4% in January, showing no significant improvement compared to December. Inflation swaps for January have also been ticking higher in recent weeks, indicating that the market is also now expecting a higher reading in January.

This is a real risk for the Federal Reserve if the Cleveland Fed's predictions come true, as it would negate the progress the Fed has made since the summer peak in inflation and could call into question whether the downtrend we have witnessed in inflation has begun to reverse.

The bottom line is that the Fed cannot afford to have financial conditions ease any further and needs them to start tightening again to slow the inflationary impulses that appear to be coming back to life. According to the Bloomberg Financial Conditions Index, conditions have returned to levels seen in February 2022, before the Fed started raising rates and only discussed the possibility of raising rates.

Sufficiently Restrictive

Additionally, from a monetary policy standpoint, the overnight rate is roughly even with the core Personal Consumption Expenditures ((PCE)) inflation rate. The Fed has made it clear that it wants rates to be sufficiently restrictive, and for that to happen, rates will need to rise to a point where they are above the core PCE inflation rate.

Chris Waller, a Fed official, indicated what the Fed considers to be sufficiently restrictive in an interview last week when he noted that sufficiently restrictive rates are when real rates are 1.5% to 2% above the forecasted inflation rate. He said that if you look to the end of the year and market forecasts for an inflation rate of 2.5% to 3%, getting to a 5% rate would be sufficiently restrictive.

This may be the best indication yet that the Fed has given to the market about what it is thinking about when it comes to where it thinks rates need to be to bring the economy and inflation back into balance and why the Fed isn't going to back off raising rates before it reaches a 5% overnight rate at the lower bound.

Additionally, the key metric that the Fed is watching is the PCE core services ex-housing, and based on data from Bloomberg, that has been a stubborn number that hasn't come down and is hovering around 4.1%.

It Needs To Push Back

If the Fed doesn't act at this point and push back against the current easing of financial conditions, which it has repeatedly noted helps to transmit monetary policy through the economy, then all may be lost. Because at this point, the market does not believe the Fed when it says that it wants monetary policy to be sufficiently restrictive and wants to slow growth to below trend and is willing to endure these things to kill inflationary impulses that still clearly exist.

The Fed's options are limited at this point but can do this by going against the collective belief that the Fed will only raise rates by 25 basis points and instead raise rates by 50 basis points. Or, Powell will have to give a very forceful message, possibly more forceful than the one given at Jackson Hole, and threaten that rates may not go higher than what was thought in December due to unwarranted easing of financial conditions. Otherwise, he may need to raise the topic of potentially increasing the pace of quantitative tightening and the balance sheet run-off.

Anything else would suggest that the Fed is okay with the current easing of financial conditions and is willing to tolerate the market taking control and driving monetary policy, which seems like a disaster just waiting to happen.

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