What are the independent variables in the Fed decision making?
Current CPI
Current employment
CPI trend
Employment trend
Current Fed mandate that Fed is focusing on: one out of three:
Fight high CPI
Fight low employment
Protect the system from breaking
Why?
Current CPI: high or low with respect to 2% target
Current employment: target full employment, unemployment not more than 5%
CPI trend: up or down last few months
Employment trend: up or down last few months
Current Fed mandate that Fed is focusing on: one out of three mandates:
Fight high CPI
Fight low employment:
Protect the system from breaking
At different times, the 3 mandates (CPI, employment, system intact) are behaving differently. Hence, Fed focuses on what mandate depends on the situation. This is what Fed refers as “data dependent”
What does it mean now?
Reading of these variables as of Nov 2022:
Current CPI: Core PCE 5.15%. Fed targets to bring this down to 2%.
Current employment: high, with unemployment very low (3.7%) -> tight labor market
CPI trend: going down from peak (9.1%) in Jun 2022 (headline CPI). Core PCE is going up in the last 3 months though
Employment trend: softening since Apr 2022. Unemployment is about to pick up.
Current Fed mandate that Fed is focusing on: one out of three:
Fight high CPI: focusing on this one since it’s high
Fight low employment: not focusing on this one since it’s high. As long as the unemployment rate is less than 5%, it’s good for the Fed.
Protect the system from breaking: system still intact.
Outlook:
Moving forward, the Fed will tighten further. Fed will stop until one of these conditions hit:
CPI 2%, unemployment less than 5%, system intact
CPI higher than 2%, unemployment is more than 5%, system intact
CPI higher than 2%, unemployment less than 5%, system breaks down
Commodity prices falling -> reduced pressure on CPI and people are not worried about Ukraine war
Weak global economic activities -> reduce pressure on CPI
Recession is coming. Initially, it’ll reduce pressure on CPI. Later, when unemployment picks up, pressure on CPI will rise again since supply will fall (more bankruptcies)
Which condition does the market expect to hit first?
Employment normally lags.
To reach 2% Core PCE, it needs to be 2024.
Hence, the third condition will hit first because of Powell's determination to bring down CPI growth and super high leverage in the system. Liquidity crisis will probably happen in Q3 2023. After that, the Fed will print money to rescue.
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