Real data is unlikely to be decisive for policy in coming months, leaving market expectations to determine financial conditions.
At their July meeting, the FOMC voted 9-3 to leave the fed funds rate unchanged. Productivity growth and capital investment were characterised as “strong” and overall economic momentum “solid” despite considerable uncertainty. Labour demand and supply were assessed to be in balance, the unemployment rate having “changed little”.
“Inflation [meanwhile] remains elevated… in part reflecting supply shocks that have driven price increases in certain sectors”. In both the statement and the press conference, the FOMC and Chair Warsh were resolute in their determination to bring inflation sustainably back to the 2.0%yr target. However, also apparent is that, at this juncture, it is unclear how far price shocks are permeating through the consumer basket. This applies to the current volatility in energy prices, due to the conflict in the Middle East, and the ongoing price surge for tech components. It will take many months to determine the full implications for underlying inflation; though, in the interim, expectations amongst households and businesses and the skew of risks will shape policy decisions.
In the press conference, Chair Warsh highlighted another area of debate for the Committee: the drivers and implications of long-term yields. Nominal and real yields have risen materially in recent months. The strength of economic activity, particularly investment, was cited as a factor, and potentially greater uncertainty over the FOMC’s reaction function. It seems the FOMC may be comfortable allowing the market to adjust financial conditions to balance inflation risks without an explicit contribution from the FOMC. The immediate response of the market to this idea was a material steepening of the yield curve, highlighting participants’ anxiety over inflation and policy uncertainty.
Overall, it appears the FOMC is not in a rush to determine whether the current stance of policy is appropriate to bring inflation back to target, or indeed if it is better to allow the market to balance expectations by itself. Several months of data and discussion are likely necessary to determine the next step based on economic data alone. However, it is entirely possible risks to inflation, or to the long end of the yield curve, will push the FOMC to a decision sooner. Policy will be live at coming meetings, particularly in September and October. On hold decisions are most likely, but by a very narrow margin.
