The financial markets have been on a tear since early November when the Fed decided to keep its key policy rate unchanged for the third consecutive rate-setting meeting. Whether that means the rate-hiking campaign is over remains to be seen. The Fed did not change its forecast of one-more increase it predicted over the summer. But recent comments by Chair Powell as well as many of his colleagues strongly suggest that the final hike is now in the rear-view mirror unless the inflation decline stalls out or, worse, reverses.
The most interesting aspect of the Fed’s decision to put rate hikes on hold is that it comes on the heels of a gangbuster growth rate for the economy, as GDP surged by an eye-opening 4.9% annual rate in the third quarter, the strongest since 2021 and way above the economy’s potential growth rate of roundly 2%. Historically, when the economy grows faster than its output capacity, inflationary pressures increase and spur the Fed into demand-curbing rate hikes. That backdrop stoked the inflation surge in 2021 and 2022 when trillions of dollars in stimulus payments boosted demand while global supply constraints suppressed output. Although demand is slowing now, consumer inflation expectations are rising, and actual inflation remains higher than the Fed’s 2% target. So, what’s behind the Fed’s newfound patience?
The answer is that the Fed thinks the economy has undergone a significant transformation that allows inflation to continue to recede even if growth exceeds its long-term trend. Indeed, that’s precisely what occurred in the third quarter when, to the surprise of many, torrid growth did not prevent inflation from falling. Simply put, the economy’s potential growth rate – its speed limit – also ratcheted up, more than matching the surge in demand. That’s because the supply constraints that restrained output and growth is unraveling as labor shortages eased, people returned to the workforce, bottlenecks cleared up, product shortages improved and productivity increased. These conditions remain in place and could well act as a brake on inflation for a while longer.
Soft Landing Hopes Improve
The recognition that the economy’s increased growth potential could suppress inflation is a striking about-face by the Fed. Until recently, policy makers thought only a severe cutback in growth and, by extension, a weaker job market would bring inflation down. Although not explicitly stated, it was generally assumed that Fed officials would accept a recession as collateral damage in the anti-inflation fight, with the hope that any downturn would be mild. The Fed was not alone in this thinking, as Wall Street and most economists looked at the historical record of Fed tightening cycles and were just as convinced that a downturn was inevitable, particularly given how aggressively rates were driven up since March 2022.
However, following a record 13 consecutive months of declining core inflation a consensus is forming that the Fed can conquer inflation without causing a recession, thanks in good part to the economy’s expanded output capacity, which allows supply to accommodate a sustained increase in demand. This prospect, known as a soft landing or, more recently, immaculate disinflation is also gaining acceptance in the financial market, spurring a strong rally in stock prices and decline in bond yields. Even the Fed has come around to this thinking, with chair Powell noting that a recession is no longer the default option. But he also notes that wringing the last mile out of inflation – getting it from 3% to 2% — will be more of a struggle unless wage increases slow more sharply. Still, the inflation doves argue that if price increases can be slowed from 9% to 3%, there is no reason another percentage point can’t be wrested out of the system without inducing more economic damage than necessary. In their eyes, since the unusual pandemic-related shocks that suppressed output and boosted demand are unwinding, it is only a matter of time before inflation returns to pre-pandemic levels. This group understandably believes that the Fed should start cutting rates soon, before the pain on housing and other rate-sensitive sectors intensifies and sends the broader economy into an avoidable recession.