Federal Reserve Chairman Jerome Powell apparently figured out that the market had not quite got the message that he intends to be tough on inflation. Stocks were up every day last week, not exactly what you would expect in the face of a Fed determine to tighten enough to overcome 40-year high inflation. Bond market indicators of inflation expectations kept rising to new highs.
So Powell on Monday put on his hawk costume and told the market that inflation was not just high but “much too high.” He argued that the Fed would hike rates faster than the 25 basis point per meeting pace that markets were expecting, if doing so was necessary to fight inflation. “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability,” Powell said in a speech delivered to the annual policy meeting of the National Association of Business Economists.
Stocks sold off after the text of the speech was released, which was presumably part of the point. A decline in equity values is a form of tightening financial conditions, so talking down the market is one of the ways that the Fed can try to bring about those “restrictive” conditions it might need to tame inflation. The problem, however, is that stocks did not actually decline by all that much. The Dow Jones Industrial Average lost six-tenths of a percentage point, and the S&P 500 was more or less flat for the day. Powell is going to have to try a bit harder if he really wants to signal that he’s serious about inflation.
Things were even worse in the bond market. The five-year breakeven rate, a measure of expected inflation derived from 5-Year Treasury bonds and 5-Year Treasury Inflation-Indexed bonds, actually moved up to the highest level in a decade, indicating that inflation is expected to average 3.52 percent over the next five years. The 10-Year breakeven rate at 2.90 percent is just four basis points below its recent record high.
And then there is the yield curve. The most important part of the curve, the difference between 2-Year Treasury bonds and 10-Year Treasury bonds, remains right side up, but everything else is has flatlined. The 3-Year yield ended Monday at 2.30 percent, the 5-Year at 2.34 percent, the 7-Year at 2.346 percent, and the 10-Year at 2.297 percent. The distance between 2s and 10s shrank to just 18 basis points. Economists swear that we do not need to be scared of a recession until the 2s and 10s actually invert, but at less than 2-tenths of a percent, the firewall against inversion is looking mighty thin.
Part of the problem here is that Powell remains unconvincing. “We are committed to restoring price stability while preserving a strong labor market (emphasis added),” Powell told those assembled business economists. That’s a bit like having your cake and eating it too. If history is any guide, Powell is going to have to choose between letting the labor market weaken or letting inflation run hot. Right now Powell is in denial that there is any tradeoff. So markets seem to be predicting that we’ll end up with both inflation and recession, the opposite of the “soft landing” Powell says he can achieve.