Last Wednesday’s press conference fatally undermined the Fed’s credibility. It’s a remarkable development for a central bank that staked so much on its ability to guide expectations. The days of forward guidance are gone.
It wasn’t just Powell’s most explicit dovish statement that did it – when he ruled out a 75 basis points rate hike. That was the least of it, in my view. Two other aspects of the press conference did much greater damage to the Fed’s credibility:
First, Powell de facto acknowledged that the Fed has not done its job: at different points in the conference he said that (i) the Fed’s job is to keep demand and supply aligned; (ii) demand has been running strong with supply unable to catch up; and (iii) policy interest rates are a long way from neutral. In other words, the Fed kept monetary policy way too loose exacerbating excess demand and fueling inflation. We already knew it; to hear the Fed’s Chairman recognize it as the opposite of “the Fed’s job” is refreshing, but does not exactly inspire confidence.
Second, Powell stressed that keeping inflation expectations anchored is of paramount importance, but he spoke as if a rise in inflation expectations were a risk, not the reality we see all around us. He claimed there are no signs of a wage-price spiral but noted that (i) the labor market is very strong; and (ii) companies have pricing power and are using it. Worker compensation is rising at the strongest pace in a long time, even if it lags behind even faster consumer prices. That’s a wage-price spiral already in the making. (The latest jobs report recorded a mild deceleration in wage growth, but it also showed labor supply weakening further, which should increase wage pressure).
None of this inspires confidence.
Powell insisted that by raising policy rates gradually to a supposed 2-3% neutral range the Fed can bring inflation back to target. He insisted a soft landing is possible, though not guaranteed. He hinted that stabilizing inflation somewhere below current rates (8.5%) in the coming months should already be seen as a partial victory.
After you’ve allowed inflation to surge close to double digits, after you have misjudged its rise as temporary, you don’t build credibility by professing hope that a little bit of tightening will do the job.
The market’s reaction bears this out: after a brief rally, equity markets tanked. Investors wanted to buy Powell’s story – but they just could not believe it.
The silence of the doves did not last long. This last press conference suggests that wishful thinking still drives the Fed’s strategy.
The Fed has lost its “street cred”: neither investors on Wall Street nor ordinary people on Main Street will have much confidence in its willingness to break the back of inflation. Without credibility and with only a gentle monetary tightening, curbing price growth won’t be easy. The Fed may get lucky, of course. But unless luck comes to the rescue, the most likely outlook is high inflation for longer, followed by a Volcker 2.0 and a hard landing.