The Fed finally caught on and started a tightening cycle that was unprecedented in both speed and degree (relative to long-term rates).
It is extraordinary to me that they made the same mistake in misreading the inflation data in 2023. On January 4, 2023,1 I strongly advocated that the Fed stand down on rate hikes. I argued that inflation was under control if real time data were used.
Consider the most recent CPI print of 3.4% YOY. This appears to be well above the Fed’s target rate. However, the 3.4% is misleading because the shelter inflation is reported at 6.2%. The rate of shelter inflation reported in the CPI is totally disconnected from reality. Surveys report YOY rents at -2%. Suppose you make the conservative assumption that shelter inflation is running at +2%. A recalculation of the CPI delivers a 1.9% YOY inflation well below the Fed’s target. Indeed, through most of 2023 we were in the Fed’s comfort zone.
To me, policy should be based on real time data - not the relics of the past. The Fed raised rates 1% in 2023 and each time justified their actions with a false narrative that inflation remained high. The “high” inflation was an artifact of the way the Bureau of Labor Statistics calculates inflation. Shelter inflation was high because this reflected what happened 12 months ago. In short, the data were stale.
In my opinion, the Fed's actions, particularly in 2023, increased the risk that we go into a deeper recession. It is imperative that they attempt to undo the damage of their overshooting.
To me, the most effective mitigant for the recession scenario is for the Fed to quickly reverse course. Ideally, the Fed Funds rate is 3.5% by year end (from 5.25% today) and the cuts should start immediately. The Fed failed to act in the January meeting citing inflation risk an extraordinary eight times in their official statement. In the March meeting, they will likely include some wording that they had a discussion about reducing rates and we likely need to wait until the May or June meetings for some action - and the action will be 25 basis points.
The wait, wait, wait, then drip, drip, drip strategy greatly increases the chance of a recession. In contrast, the Fed should take decisive action. Wouldn’t it be nice to hear a statement like: We admit we were late to begin hiking rates in 2022 and our new analysis of inflation data suggests that we pushed too far in 2023. As a result, we are cutting rates immediately by 50 bps and we are actively considering additional cuts in the near term.
While such a statement would be refreshing from policymakers, I know it is unrealistic. Nevertheless, the Fed holds the key to the soft landing. The sooner they open the easing door, the higher the probability of a soft landing.