In sum, Powell did all he reasonably could to sound hawkish. Financial markets were unimpressed. After the FOMC meeting, the 10-year U.S. Treasury yield ended lower, the U.S. dollar weakened, and the equities rallied.
I have noted in previous comments that the Fed has a credibility problem, given that over the past decade and a half it has conditioned markets to expect monetary policy to always support asset prices. Investors have been conditioned into a fear of missing out on a rally at any encouraging data point or soundbite. The December FOMC press conference confirmed just how serious the Fed’s credibility problem is.
It’s hard to fault the Fed’s current stance. The only way to overcome this credibility problem would probably be to go overboard on tightening—but that would imply risking a deep(er) recession, something that the Fed is understandably reluctant to do.
The obvious complication is that as financial markets express their total disbelief in the Fed’s rhetoric, they drive financial conditions looser. This will make it harder for the Fed to bring inflation back to target—which in turn makes it even more necessary for the Fed to do what it says it will do, that is, bring rates above 5% and keep them there for longer than the market expects.
To me, the Fed’s read of the economy and inflation outlook seems broadly right (though I am still optimistic about inflation): the economy remains resilient, there are only tentative signs of a weakening labour market and wage growth, and core and sticky inflation measures are running persistently around 6%. Interest rates across the maturity spectrum are still below current inflation. Bringing inflation down to target will be a hard slog, and the risk of inflation getting entrenched at about 4-5% is still real. Raising the policy rate above 5% and keeping it there for a while seems quite a realistic view of the kind of policy trajectory that can help achieve the inflation target. But investors no longer believe in a hawkish Fed.
Financial markets seem to have gone from “don’t fight the Fed” to “don’t believe the Fed.” This might turn out to be a self-defeating prophecy. It is most likely a recipe for a lot more volatility.