Fed Credibility At Risk

Stocks opened higher this morning, but quickly gave way after the Federal Reserve’s policy announcement (see below). Currently, the Dow is down 50 points and the S&P 500 is down .2%. Bonds are also under pressure due to rising interest rates expectations.

As expected, the Fed raised its short-term policy interest rate by .5% to 4.5%. This breaks a string of three consecutive .75% hikes and confirms the Fed’s intent to slow the process of monetary tightening. So far, so good. But the Fed’s updated 2023 projections are a bit unsettling—higher unemployment, lower economic growth and even higher interest rates. Fed Chair Powell said this is cost of ensuring we get inflation under control. So the Fed has “more work to do.”

Inflation is clearly slowing. The Consumer Price Index (CPI) decelerated to an annual rate of 7.1% in November from 7.7% in the prior month. Economists were expecting something closer to 7.3%. “Core” inflation—excluding food & energy—slowed to 6.0%. At the same time, it is true that the economy has accelerated somewhat over the last several months. And the labor market remains resilient. While investors view this as a sort of Goldilocks scenario, the Fed doesn’t see it that way.

Mr. Powell says the labor market is still “out of balance” and this is keeping inflation from returning to normal. He views stronger economic growth as counterproductive for the same reason. Therefore, he believes monetary policy is not yet restrictive enough to accomplish his goal. And that’s why he has “more work to do.” It seems to me that the Fed’s downgraded economic outlook is not necessary instructive as to what will happen in 2023, but is rather a window into what the Fed would like to see (and will try to engineer): the US economy at stall speed.

But capital markets—judging by what has happened to stock prices & bond prices over the last month—clearly don’t agree with the Fed’s “hawkish” thinking. I wonder if this announcement will strain the Fed’s credibility with investors.