Between The Lines

Longer-term inflation expectations are rising, and the Fed can’t afford to be complacent about it.

That’s according to Loretta Mester who told CNBC that policymakers’ “job one” is fighting inflation. “That’s coloring how consumers are feeling about the economy and where it’s going,” she added.

Consumers, you’re reminded, have adopted a decidedly grim outlook. A gauge of expectations in the Conference Board’s survey dropped to a decade low this month, and University of Michigan sentiment has never been worse (figure below).

Mester said unemployment could rise as high as 4.25% over the next two years. That would still constitute “very good labor market conditions,” she remarked.

For some economists, including and especially Larry Summers, assessments like Mester’s are detached from reality. Headline CPI inflation is near 9% in the US. The jobless rate, many argue, needs to move materially higher for the Fed to have any hope of getting inflation back near target expediently. Not everyone agrees. Stephanie Kelton called that contention “some fallacious voodoo,” for example.

On Tuesday, Mary Daly said lifting the jobless rate “a bit” won’t push the US into recession. The Fed is “working quickly” to quell “too-high” demand, she told a virtual Q&A moderated by LinkedIn. “I wouldn’t be surprised [if] growth will slip below 2%,” Daly said, during the same event. She doesn’t she a recession. Neither does Mester. Or at least not officially.

I hope this is obvious to readers, but sometimes I feel like it’s totally lost on many market participants. What Fed officials say in public (and what they scribble down and submit as forecasts) isn’t necessarily what they actually believe. There are surely Fed officials who have a US recession as their base case, it’s just that those base cases are confined to the four walls around their homes. Market participants have a childlike penchant for petulant derision when it comes to public comments from central bankers — as though all of us always say exactly what we mean in public.

Almost no one tells the unvarnished truth in public about anything. If you’re speaking on the record in any kind of professional capacity and someone asks you about a sensitive subject, you’ll be inclined to euphemisms and obfuscation in the service of politeness. Otherwise, your employer will be inclined to find someone else to do your job. That’s not an ideal state of affairs. It ensures that an uninformed public remains uninformed, and it suffocates the honest exchange of ideas. But that’s a separate discussion. Let’s not pretend central bankers are somehow unique when it comes to sugarcoating public remarks.

Given that, you have to be able to read between the lines. Instead of wasting your time giggling at the latest cheap shot from the cheap seats, you’d be better served to assess subtle shifts in the official rhetoric. In this case, that means noting that Fed officials now universally acknowledge a downside asymmetry for growth and are gently nodding to the necessity (or purported necessity) of a higher unemployment rate. They’re saying precisely what their critics claim they don’t understand, they’re just understating the risks in an effort to preserve a veneer of calm.

Make no mistake: None of the “big name” Fed critics you hear from on a weekly basis would be making the same kind of bombastic remarks if they were actually tasked with making policy. We know that, because in some cases, they were previously employed by the Fed or by the government, and they made no such statements in public.

Mester on Wednesday conceded only that “there are risks of recession.” “We’re tightening monetary policy. My baseline forecast is for growth to be slower this year,” she said, describing the Fed’s rate hiking cycle as “just at the beginning” and noting that for her part, she’d like to see rates “a little bit” over 4%.

That’s problematic for risk assets. Stocks can’t sustain gains until the Fed downshifts from 50-to-75bps hike increments to 25bps increases, Well Fargo’s Chris Harvey said, adding that the bank expects stocks to fall more over the summer, setting up a rally later. In the near-term, a cooler-than-expected June CPI print or progress on a ceasefire in Ukraine, would count as upside catalysts, while softer corporate earnings or another sharp selloff at the US front-end would likely weigh further on beleaguered equities. Plainly, the latter are more likely than the former.

“It goes without saying that the Fed’s relentless hiking agenda will only serve to complicate the outlook and comments from Mester encapsulate the risk well,” BMO’s Ian Lyngen and Ben Jeffery said Wednesday. “In short, the Fed’s now effectively operating on a single-mandate platform, having reiterated that a recession is a potential outcome of fighting inflation but the benefits outweigh the costs at this moment of unprecedented uncertainty.”