Fed policy error looms large over market outlook

Strong data risks the central bank overheating the US economy

Tom Eckett

Federal Reserve

The Federal Reserve risks tipping the US economy into a sharp recession after chair Jerome Powell struck a more hawkish tone than market expectations last week.

The likelihood of a policy error from the Fed has been highlighted as the biggest risk for markets with commentators warning the central bank is moving closer to “panic mode”.

Earlier this week, Powell said the Fed would have to hike interest rates at a faster pace than market expectations in response to recent inflation and jobs data.

In particular, he pointed to the latest Consumer Price Index (CPI) reading in the US which hit 6.4% year-on-year in January, above market expectations of 6.2%, while US non-farm payrolls grew by 517,000 in January, far ahead of the 188,000 jobs predicted by economists. In February, the US economy created 311,000 jobs, once again above forecasts of 205,000.

These hot data points have left the Fed to deal with a stronger US economy than initially presumed, making the policy rate trajectory extremely uncertain.

At the Senate Banking Committee, Powell said: “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”

Powell’s comments have been interpreted as extremely hawkish – even for his standards – by the market with two-year US Treasury yields spiking to their highest level since 2007 at 4.97% while the 2-10 year yield curve is its most inverted since the 1980s.

As a result of Powell’s comments, traders are now pricing in a 55.7% chance of a 50bps rate hike at the Fed’s March meeting, up from 9.2% on 7 February, according to the CME FedWatch Tool. This has left a 19% chance the Fed’s funds rate could hit 5.75%-6% by December, miles away from the rate cut priced in at the start of the year.

“The Fed has clearly moved closer to panic mode indicating a willingness to push the policy rate higher than previously thought and for longer,” Peter Garnry, head of equity strategy at Saxo Bank, said.

“The outlook on inflation seems more uncertain and the policy rate trajectory is now leaning towards a new policy mistake where the Fed maybe gets too aggressive in their panic to lower inflation creating a recession.”

As a result, the market’s reaction to Powell’s comments could be overdone. Robert Minter, director of ETF investment strategy at abrdn, pointed to the warm weather in the US this winter, a factor that has skewed the non-farm payrolls data to give off the impression of an economy running hotter than expected.

“US non-farm payrolls and retail sales use a seasonal adjustment method to offset the large loss of jobs due to an average winter amount of snow, ice and low temperatures preventing work,” Minter explained. “The January adjustments are very large and add back three million jobs, in this case raising payrolls from 2,505,000 jobs lost, up to 517,000 jobs gained.

“In this case, we expect an average seasonal adjustment to overstate activity versus when winter weather is less severe. That leaves the macro and interest rate environments unsettled.”

After the turmoil in markets last year, investors have been waiting patiently to start adding risk to their portfolios, however, the latest data and subsequent statements from Powell have created uncertainty.

“Changes in interest rates take 18-24 months to have an impact but data-dependence implies a reliance upon backward-looking data at worst and concurrent data at best,” Russ Mould, investment director at AJ Bell, stressed. “That raises the risk of policy error.”

The Fed is keen to avoid the mistakes of the past. In the 1970s, the central bank’s policy of cutting rates to ensure growth before inflation was negated is viewed as an error today. However, if the Fed goes too far the other way then the Fed risks overheating the economy and sending markets tumbling with it.

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