The Fed Is Upside-Down on Inflation and That's a Big Risk

The last time the U.S. suffered a nasty bout of inflation, in the 1980s, the economic emergency was seen as so dire the Federal Reserve, then led by Paul Volcker, jacked up interest rates by as much as three percentage points.

That's about six times the pace seen in a more typical rate-hiking cycle, where the Fed moves in 0.25 percentage-point increments.

“Unless we respond to the increase, which could be quite large in this period, we're going to have a real credibility problem,” Donald Winn, former senior official of the Federal Reserve Board, told Volcker at the Fed meeting in March 1980, according to the meeting transcript.

Eventually, the U.S. central bank's main interest rate was some five percentage points over the inflation rate. The increase induced a sharp recession, but the intent worked: Inflation soon subsided.

Now, there's a similar gap between inflation and the federal funds rate, but the relationship is upside-down.

Inflation surged to a fresh four-decade high of 9.1% last month, and Fed officials are worried although several governors of the U.S. central bank have talked down the prospect of a 1 percentage point rate hike, expressing their preference for a 0.75 percentage point hike.

Such a move would raise the federal funds rate to a range between 2.25% and 2.5%, which would still be at least 6 percentage points below the current headline inflation rate.

Last month, Fed officials published their fresh quarterly economic projections, or “dot plot,” and members of the rate-setting Federal Open Market Committee (FOMC) expect the federal funds rate to be at 3.4%, while inflation is forecasted to be at 5.2% by year end.

The point is Fed officials aren't moving with anything close to the urgency seen in the Volcker era. That's a risk, some top economists say.

“We're as close to an inflation emergency as we've been anytime in the past 40 years,” said Michael Feroli, chief U.S. economist at JPMorgan. “The only thing that's keeping it from being a full-blown, no-holds-barred emergency is that longer-term inflation expectations still seem reasonably well anchored.”

The dynamic is being closely watched in the bitcoin (BTC) market, partly because the price performance of the largest cryptocurrency by market capitalization has recently been correlated with U.S. stocks. Faster interest-rate hikes will make bonds more attractive to investors. Higher borrowing costs will eat into corporate earnings and slow the pace of investment, which could affect stock prices.

The bitcoin price is down about 49% this year, currently around $23,351.

Dan Morehead, CEO of Pantera Capital, recently wrote that the difference between inflation and the federal funds rate is larger than at any point in history. The rate currently sits where it was before the coronavirus pandemic, when inflation was at 2.3%.

On Friday, a University of Michigan survey showed that consumers see inflation running at 2.8% over a five-year horizon, down from an expected 3.1% in June.

However, currently inflation is still running at a four-decade high, and Fed Chair Jerome Powell has admitted that the U.S. central bank underestimated the pace of consumer-price rises and was wrong about calling it "transitory." He also repeatedly said the economy, thanks to a very hot labor market, is very strong, which is why many market participants predicted a 100 basis-point (one percentage point) hike in July.

The Fed’s current target is to get the federal funds rate to a longer-run neutral rate of 2.5%, but minutes of the last FOMC meeting show that officials plan for rate increases that would take the rate to 3.4% this year.

“I think there's good reasons for 100 or 125 basis points, but I think one of the strongest reasons for 75 basis points is that two 75 basis point hikes get you to neutral and then you can start calibrating from there,” Feroli said.

But these measured calculations are a far cry from the swift, emergency action the Federal Reserve took to slash rates during the market crash of March 2020 because of the pandemic's expected economic impact, or during the financial crisis of 2008.

Vincent Reinhart, a former Fed official who's now chief economist and macro strategist at Dreyfus and Mellon, says that it’s hard to understand how the Fed will bring inflation down if the federal funds rate remains negative throughout the year, as shown in officials' own projections.

Reinhart noted that the Fed risks violating the Taylor principle.

According to the Taylor principle, the real interest rate should be raised “more than one-for-one” when inflation increases, but the rate is currently negative because it is lower than inflation.

“That's a complaint you can have about the Federal Reserve right now,” Reinhart said.

Fear of losing credibility

Another risk of the Fed's light approach could be the fear of losing credibility.

The Fed's use of forward guidance to prepare and control markets for coming rate hikes – an innovation of recent decades – only works as long as investors believe that officials will follow through.

“Powell really, really hates surprising markets,” Reinhart said. “He wants to control the narrative, and he wants to make sure there’s no surprise.”

Last month, Fed officials changed their minds about the level of rate increase at the last minute after a higher-than-expected inflation report. This time they may stick to their initial plan. Fed officials at the end of May signaled that they would likely raise interest rates by 75 basis points in July, given that inflation was expected to accelerate slightly in June. But even though the CPI came in much stronger than forecast, the Fed stuck with its plan.

“I think they probably got some blowback from what appeared to be a bit of choppiness in the last meeting,” JPMorgan’s Feroli said of the Fed. “It didn't appear that there was a steady advance, and I think to go from 75 to 100 basis points may appear choppier. More unstable, perhaps.”

Consistently making decisions before the FOMC meetings even take place also undercuts the importance of the two-day, closed-door discussions.

“The FOMC wants to do multiple things, and they're not all mutually consistent,” Dreyfus and Mellon’s Reinhart said. “You want guidance, you want to convey what you're going to be doing with rates to investors so they can price it in advance. On the other hand, you also want to be responsive to incoming information. If you give guidance that is not described by the incoming information, what do you do?”

“If you change the plan between meetings, are you respecting the consultations of the committee?” he said.

If all goes according to the Fed's plan, inflation will decelerate notably in the fourth quarter, according to Feroli, and if the officials' projections prove accurate, the federal funds rate will be as high as 3.5% by year end.

“So at least in quarterly sequential annualized terms, you will get back to a positive real fed funds rate by the fourth quarter, if not sooner,” he said.

That's a gradual return to normal. It assumes emergency actions aren't needed.