From the U.S. Fed’s own mouth

U.S. Federal Reserve Governor Dr Chris Waller spoke at the UBS Australasia conference here in Sydney recently on Monday 14 November 2022. The financial media reported Waller telling attendees “to take a deep breath” after a lower-than-expected inflation print, of 7.7 per cent, the week before, triggered a near-record daily share market move.

But what else did he say? Our very own Dominic Rose was there and reported on Waller’s comments, some of which should be taken at face value and others which clearly fall under the important headline of ‘jawboning’. Much of Waller’s observations about what’s happened, what the response should be and what might happen next, we have discussed and reported on here at the blog over the year. Nevertheless, it’s always helpful to hear it direct from a Fed Governor.

• The better-than-expected CPI print was but one data point, and while it’s good to see some evidence of inflation easing, the U.S. Federal Reserve will need to see a trend of disinflation before taking its foot off rate hikes. Therefore, there is still some way to go.
• Importantly, the Fed is less concerned with the pace of hikes and more concerned with where they want rates to end up. The good news of moderation in prices of goods and some services will need to continue.
• Waller reminded attendees they thought inflation was easing in 2021, instead it exploded and the Fed was caught out. Waller said “a ways to go yet”.
• The market response is something the Fed is also watching. Equity markets have moved up, and the US dollar down, and the issue for the Fed is that back in July market celebrations led to a loosening of financial conditions which was unhelpful.
• Investors should remember there is a long way to go – rates will keep going up and stay high until inflation comes down from 7 per cent – it simply won’t happen overnight.
• Before the pandemic central banks were unable to generate wage inflation – Waller noted how remarkable it is that in a short period of time wage inflation has hit a 40 year high.
• One way to bring down wage inflation is raising rates to dampen demand – until the Fed sees evidence of it they won’t bring rates down.
• Unemployment in the U.S. is 3.7 per cent and there are now two job openings for every person unemployed. It’s a very tight market. While Waller sees some softening it’s not enough. Meanwhile, the strong labour market provides some optimism for a soft landing. The Fed is simply not seeing the impacts of policy on the labour market they would have expected.
• Why so resilient? Inflation is driven by supply and demand – excess savings, then reopening spending surges, and durable demand exploded. Production couldn’t reopen quickly enough causing COVID-related supply shocks. Add fiscal stimulus and loose monetary policy – which should have been tightened earlier, then the Ukraine war blew up energy markets, and here we are..
• Waller thinks stimulus fades, excess savings fade, supply chain issues fade but he worries about inflation expectations being built in, so it’s critical to get inflation down now.
• Current inflation expectations show people do expect inflation to come down, which is good. TIPS spreads (Treasury Inflation-Protected Securities) and break evens ­– where people are putting their money – show lower inflation expectations.
• The big worry is if households and firms start building in 5-6 per cent in their expectations – that’s a big problem. Given the current inflation rate, interest rates are not that high – therefore not that tight. One year-out real rates are only one per cent.
• Reflecting on Fed policy to date, Waller noted the 75 basis point hikes were needed. They got rates up fast and they have not crashed the economy, nor broken markets. Given rates have quickly arrived at a level acceptable to the Fed, the central bank can now start to think about a slower pace of hikes.
• If real rates are not yet restrictive then they’re not breaking anything yet. After the first 75 basis point hike, the rest were expected. 400 basis points of hikes in seven months and the economy hasn’t broken.
• Waller again noted he’d like to see labour market ease. This and the need to get inflation down require higher rates.
• On the state of the housing market, Waller noted after COVID housing exploded and over two years prices rose 40-45 per cent. At seven per cent mortgage rates even a 15 per cent pullback would have house prices still 30 per cent higher than where they were.
• Obviously, for those who purchased at the peak with very little deposit/money down there will be some trouble. Waller noted the Fed is starting to see some softening of rents but the housing market will be ok. Seven per cent mortgage rates won’t break the market, because household balance sheets are in good shape, and the labour market is still strong. Waller does not see a GFC-esque 2007-08 market crash.
• The real rates of about one per cent a year reflect the fact markets are expecting inflation to come down.
• After the last FOMC meeting there was an initial dovish reaction by investors to the change of pace message. Then Chairman Powell was hawkish at the conference. Jawboning. It is always going to be a challenge to signal a slowdown in the pace of hikes – slowing from 75 basis points to 50 basis points per hike. Investors are being asked to remember rates are still going up by 50 basis points. It’s not a softening in the Fed’s resolve, just moving at a slower pace. The Fed’s hawkishness comes not from the pace, but the level rates need to go to. Investors are being asked to pay attention to the endpoint – until inflation comes down to target the Fed will not be bringing rates down.
• In terms of Quantitative Tapering (QT) – the Fed has announced the pace and is fulfilling expectations. Eight per cent of GDP in reserves is the number. As the Fed approaches 10 per cent of GDP in Reserves they will slow the pace of QT. They are keeping an eye on it and not looking to cause problems in financial markets. Here at Montgomery, back in August, we reported on the importance of watching the Fed’s balance sheet actions here.
• Inflation is determining the Fed Funds Terminal Rate. And the Fed will keep doing what’s necessary to get inflation down.
• The transmission impact on the economy from higher rates is slower in the US because a large number of borrowers have fixed-rate mortgages.
• While the Fed cares about income equality they have but one blunt instrument – monetary policy. Price stability, max employment and financial stability is the mandate of Congress. So that is the focus.

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