Fed half-yearly update says “All is Well”

6 Mar 2024 , 03:01 PM

FEDERAL RESERVE PRESENTS A ROSY REPORT TO CONGRESS

The US Federal Reserve routinely submits the half-yearly Monetary Policy Report to the Congress Under the Federal Reserve Act. This is the report that contains the updated on the various aspects of the US economy, recent steps in terms of monetary policy action and the outlook in terms of interest rates and inflation. In the current context, the discussion was also on the timetable for interest rate cuts in the US. Here are some key highlights of the half yearly report submitted to the Congress by the US Federal Reserve.

1. As per the report submitted to the Congress by the Federal Reserve, the PCE inflation (used as benchmark by the Fed) and the consumer inflation (CPI) continue to remain above the eventual FOMC objective of 2%. The CPI inflation is currently 90 bps above the target at 2.9%, while the PCE inflation is 40 bps above the target at 2.4%. 

    

2. However, as the Fed has underlined in its report, what is gratifying is that the tapering of inflation has occurred without a significant increase in unemployment. The labour market remains relatively tight, which means two things. Firstly, there are more jobs available than jobs sought, keeping the wages high. Secondly, the unemployment rate at 3.8% continues to remain very close to the recent lows. 

    

3. Fed has also underlined to the Congress that the Fed may have, perhaps, ensured a soft landing for the US economy. Here is the background. During the aggressive rate hike program by the US Fed between March 2022 and July 2023, the concerns were that growth would slow down. However, the real GDP growth rate continues to be robust at above 3.2% in Q4 and promising to be above 2.5% for full year 2023.

    

4. The Fed has also reported to the Congress that the FOMC has maintained the target range for the federal funds rate at 5.25% to 5.50%, since July 2023. It has been specifically reported to the Congress that the policy rate is likely at its peak for this tightening cycle, which began in early 2022. 

    

5. The Federal Reserve also reported that it has also continued to reduce its holdings of Treasury and agency mortgage-backed securities. Since the reduction of the bond book began in 2022, the Fed has cut the size of the bond book from $9.2 trillion down to the current levels of $7.5 trillion. This has sucked out a lot of liquidity from the system and has also help magnify the impact of the rate hikes intended to control inflation. 

    

6. The Fed has underlined that the sustained tightness in the labour market has resulted in substantial progress on inflation control. The Fed is confident that now it can achieve a sweet spot balance where inflation is almost fully reined in, unemployment levels continue to be manageable and GDP growth remains robust enough to avoid a hard landing of the US economy. However, the FOMC has underlined that it remains highly attentive to inflation risks. After all, inflation generally hits the vulnerable sections the hardest and past experience has been that the last mile inflation control is the toughest.

    

7. In terms of policy action, the Fed has report to the Congress that it may still be too early for the Fed to provide a timetable for rate cuts. The FOMC will continue to carefully assess incoming data, the evolving outlook, and the balance of risks. Any announcement on rate cut action and the timelines for the rate cut, will only be issued after the Fed is fully convinced that inflation was decisively moving towards the 2% mark.

In short, the report has presented a rosy picture of the US economy, with growth coming higher than expected and inflation now coming in lower than expected.

INFLATION CONCERNS STILL DOMINATE FOR THE FOMC

In the last few months, the Fed has consistently underscored the fact that its primary goal continues to remain on price stability followed by a robust labour market with low levels of employment. Fed also underlined that GDP growth would not be a key factor in the Fed decision, although they would still prefer to avoid a hard landing for the US economy. While the consumer price inflation has slowed considerably, it still remains well above 2%, with the risk of the last mile being very sticky. While the CPI inflation is 90 bps away from the target at 2.9%, the PCE inflation based on personal consumption expenditure is also 40 bps higher at 2.4%. However, since the peaks of 2022, both inflation readings are sharply down. 

In addition, the core PCE price inflation, which excludes volatile food and energy prices, has also been consistently falling. For the 12 months period, the PCE core inflation was down to 2.8% while on a six months basis, it was still lower at 2.5%. Unlike food and energy, core inflation is more stable and secular.  However, that also makes it relatively more structural and stickier. If core PCE inflation can be taken as a good barometer of future inflation, the trend is clearly lower. Even the longer term inflation expectations are sharply lower over the last one year as consumers have greater confidence in the Fed anti-inflation policies. 

UPDATE ON THE US LABOUR MARKET AND GDP GROWTH

In the US, the labour market has stayed relatively tight, with job gains averaging 239,000 per month since June. In addition, the unemployment rate is still close to its historical lows. However, the good news for inflation is that labour demand has eased as job openings have fallen in many sectors of the economy. However, for now, the demand for labour continues to exceed the supply of labour by a considerable margin. That is keeping wages still quite high, and to a large extent, these high wages have been neutralizing the effects of tight monetary policy by keeping demand robust. This has delayed the battle against inflation and also highlighted the risk of the last mile being the toughest. Compared to 2022, the year 2023 saw a better balance between the demand and supply of labour. As a result, nominal wage gains slowed in 2023 and the trend is likely to continue in 2024. However, the report also points out that the current labour demand and the low levels of unemployment is inconsistent with 2% inflation; at least if you go by anecdotal evidence. 

Let us now turn to the reporting of the economic growth as demonstrated by real GDP. For the full year 2023, the real GDP increased 3.1%, which is much quicker  than the growth in 2022. However, the third and final estimate of Q4 inflation will only come in the end of March 2024, but it is unlikely to deviate to much from this number. Ironically, despite higher interest rates and tighter monetary conditions, the consumer spending grew at a solid pace, and housing market activity started to turn back up in the second half of 2023. However, the spending on consumption has shown a robustness that is not matched by the pace at which the US companies are creating inventories or at the pace at which the US housing market is picking up momentum. That could follow, more, as a lag effect.

WHAT ABOUT BANKING AND FINANCIAL STABILITY?

The FOMC report to the Congress has highlighted that the banking system remains sound and resilient. The acute stress in banking seen in March 2023 with the implosion of mid-sized banks, has abated.  However, there are still some pressure points for the US banks. The first risk is the upward pressure on asset valuations; with real estate prices elevated relative to rents and high P/E ratios in equity markets. Secondly, the borrowing from non-financial businesses and households continued to increase at a pace slower than that of nominal GDP, and the combined debt-to-GDP ratio is near its 20-year low. 

There are also some leverage issues. While risk-based bank capital ratios stayed sedate, the problem is in the declines in the fair values of fixed-rate assets. This refers to the depreciation in the valuation of the bond holdings of banks, in the light of sharply higher bond yields. The recent experience has been that most of the banks maintained high liquidity and stable funding, while bank funding costs continue to increase. This has resulted in unnecessary cost loading on borrowers; including corporate and individual borrowers.

UPDATE ON THE GLOBAL MACROECONOMIC SCENARIO

Monetary policy, even for the most power economy in the world, rarely operates in a vacuum. Economic growth has been particularly weak in several advanced foreign economies like the UK, parts of EU and Japan. The second largest economy in the world, China, is struggling with its pile of real estate debts and a sharp downturn in valuations. Across the board, there has been an erosion in real household incomes in most of the developed world. In addition, Europe is making structural adjustments to higher energy prices, especially after they were drawn into imposing sanctions on Russia. The good news is that global headline inflation has fallen, but many of these economies are still quite vulnerable to a spike in energy and food prices. 

There is another challenge of monetary divergence as far as the policies of central banks are concerned. The US has hinted at a peaking of interest rates, although the Fed continues to be ambivalent on the timing of the rate cuts. However, many of the advanced economies are likely to rapidly start cutting interest rates in the current year and if the US does not response fast enough, there is the distinct risk of monetary policy divergence. In the past, such monetary divergence has resulted in a lot of volatility in global financial markets. If the US continues to remain ambivalent, there is also the risk that the dollar may strengthen further. To add to these risks, there is the worsening geopolitical crisis in the Middle East and West Asia, which threatens to spike oil prices higher.

WHAT DOES ALL THIS MEAN FOR US MONETARY POLICY TRAJECTORY?

Between March 2022 and July 2023, the US Fed had tightened the monetary conditions by raising the repo rates from the level of 0.00%-0.25% to the current level of 5.25%-5.50%. While the Fed is yet to make an open commitment, the recent Fed statement, Fed minutes and the speeches by the various Fed governors appears to underline the fact that rate hikes may be done and dusted in this cycle. The FOMC estimates that the risks to achieving its employment and inflation goals are moving into better balance, but the FOMC remains highly attentive to inflation risks. 

In terms of the monetary policy outlook, the FOMC is unlikely to reduce the rate of interest until it has total confidence that inflation was moving sustainably toward 2%. This will be judged by incoming data on inflation, labour data, economic growth etc. As Christopher Waller recently summed up; when the Fed had achieved a sharp lowering of inflation through aggressive rate hikes with robust GDP and labour indications, there was no tearing hurry for the Fed to embark on rate cuts. That is a space the FOMC has left open.

HOW THE FED PLANS TO DEAL WITH ITS BALANCE SHEET

An important part of the report submitted by the Fed to the Congress also includes how the Fed plans to significantly reduce its holdings of Treasury and agency securities in a predictable manner. Reduction of the Fed balance sheet tightens the financial conditions and can magnify rate hikes or even act like a rate hike in terms of impact. Between early 2022 and early 2024, the Fed balance sheet has gradually come down from $9.2 trillion to $7.5 trillion, hinting at a substantial unwind of the bond book of the Fed.

For now, the FOMC has reported that it will maintain securities holdings at amounts consistent with implementing monetary policy efficiently and effectively in its ample-reserves regime. That would mean that in the coming months, we could not only see reduction in the aggression with which the bond book has been unwound, but also possibly a temporary halt to the bond book unwinding. Clearly, the Fed wants to achieve its monetary goals, without disrupting growth or liquidity conditions in the economy.