Fed chief Jerome Powell, shown at a May 4 press conference, has said the central bank remains committed to bringing inflation down to 2%.
Al Drago/Bloomberg
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Signs of economic weakness are piling up, but many economists and strategists are holding fast to their soft-landing predictions. A new inflation target may be the only way they can be right—and it would come at an underacknowledged price.
Data over the past week included a worse-than-anticipated drop in pending home sales, to the lowest level since 2014 and signaling more pain because they lead existing-home sales. Households saved at the slowest rate since 2008, purchasing manager indexes showed bigger-than-expected slowdowns in both manufacturing and services activity, jobless claims’ four-week moving average rose for the eighth consecutive week, and the Federal Reserve Bank of Atlanta’s GDPNow tracker for the second quarter fell to 1.9% from a previous estimate of 2.4%.
All of this is as business inventories rise, layoffs mount, and the revised first-quarter gross-domestic-product report showed that corporate profits fell for the first time since late 2020. Based on forward-looking company statements, profits will decline again in the current quarter, says Nancy Lazar, chief global economist at Piper Sandler. Her firm’s daily consumer confidence tracker fell to a new cycle low over the week.
Yet much of Wall Street remains sure that the U.S. economy will continue to grow as the Fed tightens monetary policy to combat a four-decade high in consumer price inflation—even if soft landings are rare and despite Fed Chairman Jerome Powell recently shifting from “soft” to “softish” and then to “bumpy” and involving “some pain” when describing how the economy will land.
There is one way to square tightening Fed policy—where balance-sheet shrinkage starts in June as interest rates rise another half-point amid already flagging growth—with recession-avoidance. Inflation would remain high because the Fed stops fighting it.
Consider analysis from Solomon Tadesse, head of quantitative equities strategies North America at
Société Générale
,
about what it would take for the Fed to achieve its target. To arrest inflation, he says, it could take overall monetary tightening of up to 9.25%, with the main policy rate rising to 4.5%. The balance would come from quantitative tightening of about $3.9 trillion—reversing two-thirds of the emergency bond purchases the Fed conducted over the past two years and cutting the Fed’s balance sheet by almost half.
But that probably won’t happen. “They keep talking about 2%, but the price might be too high,” says Ed Yardeni, president of Yardeni Research, referring to the Fed’s longstanding inflation target. He predicts that when price inflation cools to about 4%, the central bank will signal that it will lift its target and thus stop tightening sooner than many investors believe.
Rent is a main driver of Yardeni’s view. While housing demand is falling as mortgage rates jump, prices are still rising. Shelter makes up about a quarter of the personal consumption expenditure index, the Fed’s preferred inflation gauge, and 40% of the consumer price index. Rick Palacios, director of research at John Burns Real Estate Consulting, says existing-home and new-home prices will still rise 8% and 6% this year, respectively. Since rents lag behind home prices by 12 to 18 months, those forecasts suggest that rents will remain high even as housing cools. Other than causing a “severe recession,” there is little the Fed can do about rent inflation at this point, Yardeni says.
So far, Fed officials past and present say the 2% target is sacrosanct. Treasury Secretary and former Fed Chairman Janet Yellen recently dismissed the idea of a higher inflation target. Powell has expressed a commitment to bringing inflation back down to 2%, and formal policy statements reiterate that objective.
But Yardeni isn’t alone in his view. In a Bloomberg TV interview earlier this month, New York University professor Paul Romer said the Fed would be better off at a stable 3% to 4% inflation target.
Allianz
chief economic adviser Mohamed El-Erian told CNBC in April that the Fed might be forced to raise its target, given how far behind the inflation curve it had fallen.
Persistent shelter inflation isn’t the only reason to suspect that a higher inflation target is on the table. Tim
McDonald
,
partner at Pennant Investors, points to the green-energy transition as well as potential moves by U.S. manufacturers to bring supply chains closer to home. On the former, he says there is going to be a yearslong supply-demand disconnect before a green system can replace the current one. On the latter, McDonald (who says his views don’t represent his firm’s) notes that even a partial reversal of globalization would lift a decadeslong inflation lid as companies face higher labor costs and other expenses associated with moving production.
The point, McDonald says, is the U.S. economy is in a period of higher structural inflation, rendering the 2% target outdated. “As I look at it as an investor, I look at it like we are in a transitional period. I don’t know how long it will be, but I can tell you it’s not in quarters.”
Data on Friday showed that the PCE excluding food and energy cooled to a 4.9% year-over-year pace in April, from 5.2% a month earlier and representing the slowest rate this year. That is well behind the 6.2% rise in April’s core CPI and not far off the 4% that Yardeni and others flag as a possible new target. Critics say the PCE is problematic. Healthcare is heavily weighted in the PCE, and Medicare and Medicaid reimbursement rates that are set by the government and thus artificially depressed make up most of that, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. Criticism aside, the reality is that the Fed uses the core PCE to set policy, and it may cool to 4% faster than appreciated.
It is unclear how a higher inflation target would affect the economy and markets because there are various moving pieces. Tadesse of Société Générale says raising the target would be negative for both stocks and bonds because doing so would dislodge inflation expectations, in turn lifting prices and potentially setting up more pain later. McDonald of Pennant notes that higher inflation benefits borrowers at the expense of creditors. Then there is the idea that a higher inflation target would mean lower interest rates, which, in a vacuum, should boost the present value of companies’ future free cash flows and bolster growth stocks especially.
If the U.S. economy is to avert a recession, something will have to give. It may well be the Fed’s inflation target.
Write to Lisa Beilfuss at [email protected]
Source: https://www.barrons.com/articles/fed-inflation-recession-51653687426?siteid=yhoof2&yptr=yahoo