Fed may be about to make a mistake

The natural state of a capitalist economy is expansion. Recessions occur when “something breaks” rather than an expansion simply dying of old age. Unfortunately, central banks have a history of pumping the brakes for too long and too hard when attempting to contain growth and inflation and are often the cause of a recession.
Given that the Federal Reserve has now shifted away from its so-called third mandate of financial stability, which dominated much of the post-crisis period, and back to worrying about faster inflation, concern about too much tightening is warranted. While inflation is indeed accelerating, investors remain skeptical that higher prices are returning with the vengeance needed to justify the several more interest-rate hikes the Fed is talking about. We fear another Fed mistake is in the offing.
Inflation concerns and hawkish rhetoric make up well more than half the talk, and are crowding out dovish comments and global and financial-stability concerns.
Zeroing in on inflation, Fed Chairman Jerome Powell and his fellow policy makers at the central bank have talked more about inflation in 2018 than any other post-crisis year. A good example is Chicago Fed President Charles Evans, a longtime monetary dove, who has shocked Fed watchers by putting on his seldom-used hawk talons. Evans suggested the Federal Open Market Committee may need to raise rates to “somewhat restrictive” levels to combat anticipated inflation.
Evans justified his position by pointing to economic surveys which see more inflation on the horizon. In a Bloomberg Opinion column in May we argued that such surveys no longer work. Nevertheless, investors are acknowledging the Fed’s commitment to battling higher prices by fully pricing in a rate hike at the September 26 FOMC meeting. Even the December meeting shows a very high 70 percent probability of a hike. The data is clearly softening, yet expectations for rate hikes remain elevated. Inflation concerns are superseding actual economic data.
Is the Fed right to worry so much about inflation? Six years ago, the Fed adopted a 2 percent inflation target. Other than the first few months after it was implemented, this target hasn’t been reached. Yet Fed officials are preparing for a battle by assuming inflation will exceed a target it has not hit it in seven years.
Periods of the Fed being more hawkish than markets have coincided with declining yields. Conversely, when the Fed is less hawkish than the market yields have risen. However, this circumstance has been infrequent in the post-crisis period, which we believe has contributed to the inability of 10-year yields to break out to the upside. Fed rhetoric is giving bond vigilantes a reason to drive yields higher.
The case for more Fed tightening hinges on inflation. The Fed assumes it will return, and it is talking about hiking well ahead of the economic data and market expectations. If policy makers are correct, and the economic surveys are right this time and inflation returns, they have the correct policy. But if the surveys are wrong — like they have been for two decades — and the Fed is worrying too much about something that doesn’t materialise, then it risks “breaking” the nine-year old expansion and becoming the catalyst for a recession. Evans needs a better argument.

— Bloomberg