Economy & Policy
This week’s inflation numbers were mostly positive and benign for the U.S. economy as well as for the Federal Reserve (Fed) and confirms our view that, at least for now, the Fed is done increasing interest rates for this monetary tightening cycle. However, the data also confirmed our concern that while better and on a disinflationary path, the speed of this disinflationary process continues to be less than stellar. This means that any pivot in interest rates by the Fed is going to remain highly uncertain compared to what markets are expecting. Furthermore, as we have argued for some time, the market’s misreading of the Fed’s intentions regarding interest rates could result in the Fed having to continue to increase interest rates in the future.
Recall that the Fed determines only one interest rate in the markets, the federal funds rate, while the rest of the rates are determined by market forces. That is, if market forces believe the Fed is going to reduce the federal funds rate in the near future because market participants think the U.S. economy is heading toward a recession, then this may prevent the Fed to continue to bring down inflation going forward. That is, if interest rates, other than the federal funds rate, move lower because markets think a recession will be enough to make the Fed relax monetary policy, then the Fed’s monetary policy campaign is going to be put at risk.
We saw some of this happening during the first quarter of the year when the yield on the 10-year Treasury declined and thus pushed mortgage interest rates lower, which improved the state of the U.S. housing market during the first quarter of the year as existing home sales, as well as new homes sales, increased during the period (see graph below). Fortunately for the Fed, home prices have continued to decline on a year-over-year basis during the first quarter of the year, but if interest rates on mortgages continue to decline or remain as low as they were during the first quarter of the year, quantity demanded of housing may increase enough to start pushing home prices higher again, which will threaten the efforts by the Fed to lower shelter costs and keep them contained until inflation stabilizes close to the 2% target over the longer term.