Fed Minutes to Reveal Source of Inflation Angst Pushing Up Rates

(Bloomberg) — The Federal Reserve is set to shed more light on why it’s worried that strong inflation may linger as the US economy moves into the new year.

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At the conclusion of the Dec. 13-14 meeting of the Federal Open Market Committee, policymakers published new projections showing they expected inflation would end 2023 higher than they previously thought. That led to surprisingly widespread support in the projections for the notion that interest rates would need to rise above 5% in 2023.

The Fed will publish minutes of the meeting on Wednesday at 2 p.m. in Washington.

Officials saw inflation ending 2023 around 3.1%, according to their median projection, compared with 2.8% in the previous quarterly forecast released in September. The latest Fed outlook is at odds with that of Wall Street, which has generally become more sanguine in recent months as price pressures have started to moderate.

In his post-meeting press conference, Chair Jerome Powell linked the central bank’s inflation pessimism to ongoing strength in the labor market, pointing to services prices in particular.

“The inflation forecast being raised was surprising because it sounded like most economists on the street were expecting very little change there, and I was expecting them to cut their forecast,” said Kevin Cummins, the chief US economist at NatWest Markets in Stamford, Connecticut. “It seems that there is more of a consensus view that they’ve got to go above 5% than certainly I would have thought the numbers implied.”

The Fed is entering 2023 with plenty of resolve to make sure it wins the war on inflation, which in 2022 rose to the highest levels in four decades and then started to decline in the final months of the year.

The central bank began raising its benchmark interest rate from almost zero in March, which many outsiders criticized as a late start to the tightening cycle. It then picked up the pace with super-sized rate hikes for much of the rest of the year, bringing the federal funds rate to 4.3% — the highest since 2007.

At the December meeting, policymakers opted for a half-point rate hike, following four three-quarter-point moves. But they also signaled another 75 basis points worth of increases this year — more than what Fed watchers had been expecting, given the lower inflation readings in recent months.

The outlook for interest rates “was pretty hawkish,” and “much more than the market was pricing in,” said Priya Misra, global head of interest rate strategy at TD Securities Inc. in New York.

She said she will look for signs in the minutes that the committee had shifted its stance on trade-offs between inflation and employment, adding that the big question is: “How much of a rise in unemployment can they tolerate?”

Investors now expect the Fed to return to normal-sized quarter-point rate hikes at its next policy meeting on Jan. 31-Feb. 1, and see the federal funds rate peaking just below 5% around mid-year, according to futures contracts.

What Bloomberg Economics Says…

“Minutes of the Dec. 13-14 meeting will likely show that it was concern about the labor market not cooling fast enough that drove 17 of 19 FOMC participants to write down a terminal rate above 5% in the updated dot plot. That would be a sharp turnaround from the dovish November minutes, which showed several policymakers opining on the risks of overtightening.”

— Anna Wong (chief US economist)

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That expectation was bolstered by the most recent reading on price pressures published by the Commerce Department on Dec. 23, which showed so-called core inflation — excluding food and energy — rose just 0.2% in November. That was less than what was implied by the Fed’s latest projections, and monthly readings of a similar size going forward would be consistent with a return to the central bank’s 2% target.

But, as Powell made clear, the Labor Department’s monthly jobs report due out on Friday will also be an important factor in the February decision. Forecasters expect that report to show job growth moderated to 200,000 last month, according to a Bloomberg poll. Unemployment is expected to have remained unchanged at 3.7% and wage growth is seen as having ticked down to 5% on a year-over-year basis.

“No matter how you slice the labor market, it is strong. That is what got people exercised,” said Mark Spindel, the chief investment officer at Chicago-based MBB Capital Partners LLC.

Spindel also said he will be looking for clues about the Fed’s tolerance for the risk of even higher unemployment than the 4.6% rate it projected for 2023 and 2024, which is almost a full percentage point higher than the current rate.

“It’s going to be trickier” to achieve a soft landing for the economy in 2023 if the Fed follows through on its tightening plans, said Spindel. Given their blunt policy tool, “they are butchers, not surgeons.”