Inflation fears, rate expectations and chair changes: Takeaways from the Fed meeting

Welcome to Beyond the Benchmark, the EFG podcast with Moz Afzal.

Daniel Murray:

Hello, my name's Daniel Murray. I'm the Deputy Chief Investment Officer of EFG, and I'm very pleased to welcome you to today's episode of Beyond the Benchmark. Also, very happy to have with me today our chief economist, Stefan Gerlach, who's a former deputy central bank governor of the Bank of Ireland, former very senior employee at the BIS, and our general expert know on all things related to central banks. Against that background, very happy to have Stefan with us. Interesting time for central banks, given all that's going on in the world, sticky inflation, wars in the war in the Middle East, sharp rises and energy prices and so forth. And on that note, we had the most recent Fed meeting. Stefan, what are your immediate thoughts about the outcome of the Fed meeting?

Stefan Gerlach:

Well, I was actually not surprised at all. I don't think really anyone was surprised. I mean, the Fed is facing the same situation as it has for quite some time. Inflation is a little high. It came down quite a bit towards the Fed's target, but it remains a little bit high and economic activity remains quite strong, although there is growing evidence that the labour market is slowing down. So why not just continue what you've been doing before? And I think that's pretty much what the FOMC decided to do. Of course, we've had this massive increase in oil prices in the last couple of weeks, but it's not really clear yet what its outcome here will be. Uncertainty, I think, is extreme. Oil prices could be $20 a barrel higher in 10 days time, or there could be $20 a barrel lower in 10 days time. So I think there isn't enough for the Fed there to respond to.

Daniel Murray:

Obviously, there have been hopes over the past few months that the Fed would adopt a more dovish path, particularly with the new incoming chair of the Federal Reserve, the Trump appointee. But the dot plots actually showed that there was one more individual who preferred higher rates than there was last time, although the median was the same. But the longer term expectation for rates was up very slightly. And of course, there was quite a decent uplift to the Fed's growth forecast. So how do you put that together and define the path for Fed policy over the next 12 months?

Stefan Gerlach:

So I think the FOMC members, they will not have liked President Trump's intervention and they will have been worried about growing pressure on the Fed. I don't think one should be too focused here on the midpoint of these dot blots or the average view or for that even sort of the average rate that the markets are pricing in right now. As I said, uncertainty is extreme. And you could imagine something happening this afternoon or tomorrow or next week that leads to a radical change in the outlook for US monitor policy. So I think these are sort of the best estimates or the best projections the FOMC members can come up with. Their house, they have to come up with something, but I'm not sure they believe or have a lot of faith in these projections right now. I think they feel like anything could happen.

Daniel Murray:

Yeah, I think that's right. And certainly Chairman Powell noted in his comments how there's a great deal of uncertainty at the moment that's been elevated by events in the Middle East, and that's both upside and downside risk, I think. So certainly very interesting. I thought also interesting, Powell made a point of highlighting the dual dimensions to the Fed's mandate being stable prices and also full employment. And in that context, he mentioned how inflation was above target and the labour market remains very tight as indicated by the unemployment rate. And so on those purely objective grounds, and then obviously there's little basis for the Fed to cut rates at the moment. So it's going to be an interesting year as that plays out. And I think something else, of course, we've forgotten about is that there's potentially still going to be a delayed impact from tariffs. So lots of moving parts here, lots of potential range of outcomes, but with inflation sticky and the labour market's still tight, I think the Fed's reaction totally justified.

Stefan Gerlach:

Yes, I think that's right. But I do think it is important in general now not to overinterpret things and to have too firm in view about what might happen and what policy may be. We are in uncertain times, and I think things could change a lot in a week or two. So I wouldn't be too firm in my views about where interest rates will end up at the end of the year.

Daneil Murray:

No, absolutely. And as we've seen, those rate expectations can be hugely volatile in response to events and incoming data. Something we just sort of touched on was the independence of the Fed and the new incoming chair. Obviously, Trump has nominated Kevin Warsh to take over, and I think he's a credible and decent candidate, but it's not given that he'll be approved. And comments that I think were overlooked a little bit last night from Powell related to the fact that once his term ends, if there's no chair, he could possibly stay in place. And also, of course, his term as governor doesn't end until 2028. So lots of moving parts and lots of possibilities in the way that that could play out. What do you think of that?

Stefan Gerlach:

So I suspect that Warsh will be appointed or he will sail through the Senate. Central bank needs to have an acting governor at any point in time. So I was not surprised at all, but the Powell said that something is needed to ensure continuity. I thought it was quite instructive that he said that he would stay around as a governor as long as his legal case is active and that he hadn't decided what he would do after that. I think this is a very strong signal that he would like to do what he can to safeguard independence of the Fed. So yeah, this is an important statement, I think. I also think it's instructive that at the end of the day, Trump went in appointing or in nominating Warsh, he went for an experienced central banker. There were people who were perhaps closer to him or to his outlook politically and so on, but much less experience and much less likely to carry weight in the FOMC. And had he appointed, or had he nominated someone else, you could have imagined the market reaction could be very strong. So I think this was a good sign. You may not agree with everything Warsh has said about monetary policy in the path, but you cannot doubt his experience and his background, and he's certainly a highly credible candidate.

Daniel Murray:

Absolutely, Stefan. I think there were certainly less credible candidates that Trump could have chosen who would've been more challenging for markets to accept. And I think given Warsh's prior experience as the Fed governor, I think he's certainly a wise choice and hopefully there won't be any difficulties in getting him approved. I think Powell also said words to the effect that even once his legal case is over, that he retains the possibility of perhaps staying on as governor until his term ends if he thinks it's in the best interest of the institution. And that also hints at the sensitivity to the Fed's independence and that if he believes that there'll be any challenge, that he would do what he thinks is right for the Fed as an institution. So interesting times I don't think there's any precedent for that. If you're a central bank watcher and you like all things to the central banks, this is an incredible week. It doesn't get much better than this. We've got 18 central banks that are reporting this week, including the Fed, Bank of England, ECB, this National Bank, Central Bank of Brazil, Bank of Japan, and so on, and this goes on. What do you think are the common features that central banks are looking at at the moment?

Stefan Gerlach:

So I think there are four important things that impact on all these central banks. And instead of thinking of each central bank as being its own animal, I think one should sort of take a step back and think about the similarities across central banks. So the first similarity is that they are experiencing the same shock, of course, the oil shock that is clear. But also they have experienced pretty much the same situation in terms of the business cycle. Inflation has been generally high in all these countries, a little too high, not far too high, but a little too high. And similarly, labour markets have been a little bit, or is tending to become a little bit softer. And that of course means that they are probably going to respond in the same way. Secondly, what really matters for policy in the short term, I think is not a shock right now because no one knows what this shock actually will end up looking like.

But what really matters, I think, are initial conditions. The Reserve Bank of Australia tightened monetary policy, and I just saw that the Central Bank of Iceland tightened monetary policy. And in both cases, it was something they probably would've done anyway, because both have experienced relatively strong or growing inflation pressures for some time. So much not disregard initial conditions. In fact, I think those are sort of more important. Third, I think uncertainty is just extreme. And we've already spoken to that, so let me skip that. I think the fourth point is that I think all central banks would like to avoid the repetition of the surge in inflation in 2021 and 2022. As a senior central banker, this is not something you want to put on your resume. This was hugely costly in terms of central bank credibility, and they want to avoid that. And I think the way they will avoid that is that they're going to signal much more strongly that we are on the ball this time.

We're going to make sure this doesn't happen. And in doing so, they hope to prevent long run inflation expectations from rising. The risks, however, is that they overdo it, and they are a little bit too tough and financial markets could take fright. And you could see short-term market determined interest rates rise in response to they think there will be a surgical strike on inflation. And actually, let me add a fifth point, which is very important. And that is, of course, the likelihood that inflation could take off now is much lower than in 2021. Then we had negative interest rates in some countries. We had some central banks continuing with QE. We had quite tight labour markets as the economy was coming out of Covid. We actually still had government support for spending for consumers coming out from Covid and had pent up demand from the Covid period.

So this was sort of a little bit of taking a match to dynamite or something like that. Now the situation is very different. Monetary policy has been much tighter recently. Fiscal stimulus is nowhere close to where it was. And then labour markets are weaker. There's a less risk of a wage price scandal spiral. So one has to have that in mind. So in fact, there are some common themes that really affects on all of these central banks, and that is why we're going to get very similar results out of all these central banks.

Daniel Murray:

I think that's absolutely right. I think as well, one thing we learned from 21, 22 is that central banks have an incentive to, in the short term, at least prioritise fighting inflation over activity just because if they think they let inflation get out of controlled, then the longer term consequences will potentially be more painful. And I think you highlighted a very important point at the beginning, which relates to your recent comments as well, which is that your starting point is incredibly important. We were starting from a position where real interest rates are in negative territory and you've got lots of potential for inflation to feed through. That's a very different situation potentially to where we are today. So I think that's very interesting. Just as a final sort of comment, are there any other points that you think are relevant and that perhaps are being clouded by all the noise around situation in the Middle East?

Stefan Gerlach:

The one thing I'm just a little concerned by, and I mentioned it already, is that people may be a little too quick to draw firm conclusions about what's going to happen next. I don't think ... We certainly don't know what's going to happen to oil prices. We don't know, therefore, what's going to happen to inflation. And consequently, we don't know what's going to happen to central bank policy rates. And worse, the same thing is true for all central bankers. They don't have more information than we have. They may have a clearer view about their own sort of concerns and so on and so forth, but by and large, they are reacting to the same dramatic changes in data as we are. So I would not overplay how much confidence we can have in the outlook for the future. I think central banks will try to prevent the return to high inflation and they're going to try to do their very best, but what that means exactly in terms of interest rates, it's just hard to guess.

Daniel Murray:

Thank you, Stefan. So if I could summarise perhaps, I think obviously current events create a wide range of possible outcomes than was the case before the bombing started, both on the upside and the downside. These factors are common to most central banks around the world, and in the short term at least, probably incentivizes to do very little until we get more information and understand exactly how the war and the changes in the oil price will impact the outlook for inflation and activity. So watch this space and see, but I think central banks are incentivized to tread carefully, both with regard to the fear of loosening monetary policy too early, as well as the fear of overtightening in the short term. Thank you very much for joining me, Stefan. Very interesting conversation. This has been Beyond the Benchmark. Thank you for listening, and hopefully you'll join for future episodes.

 

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