50 and 6?
The Credit Strategist Blog
Markets are having trouble digesting Jay Powell’s sobering message that more work needs to be done to tame inflation. Talk of a 50-basis point hike in March is now back on the table (i.e., getting priced into derivatives markets) after markets convinced themselves that 2023 would only see a handful of 25 basis point hikes and then clear sailing after that. But the data isn’t cooperating, leading Mr. Powell to warn that “We’re looking at a reversal, really, of what we thought we were seeing to some extent…nothing about the data suggests to me that we’ve tightened too much.” Rate hikes have yet to fully impact the economy as seen in January’s 0.6% rise in PCE inflation (the highest since last June and up from 0.2% in November and December), and January’s 3.4% unemployment rate (though January’s jobs increase of 517,000 was a statistical fabrication). It simply takes time for the economy to feel the effects of higher interest rates because the contracts that set interest rates on all types of financial obligations establish different timetables to adjust those rates. Some of those timetables are very short (i.e., floating rate debt contracts) and some are much longer and may require the debt instrument to mature and be refinanced at a higher rate (i.e., fixed rate debt contracts).
Accordingly, interest rate hikes take time to tame inflation which contributes to the complexity of policymaking. Concerns that the Fed will “overshoot” derive from the lagged effect of interest rates. “Overshooting” occurs when the Fed sets a terminal rate that constrains economic growth too much because it didn’t give the economy sufficient time to react to higher rates. The result is a sharp economic slowdown. If that occurs, the Fed then has to lower rates which the economy still has to take time to process, suffering the effects of a slowdown or recession until the economy starts growing again. Politicians are particularly averse to recessions and therefore very vocal about the risks of “overshooting.” Needless to say, after economists, politicians are the last people to listen to about economic policy (or any policy for that matter).