Fed's Inflation Timeline Extended
Advertisements
In a notable address on February 23, 2025, Mary Daly, the President of the San Francisco Federal Reserve, issued a striking declaration, instigating ripples across global financial markets. Highlighting the ongoing necessity of a "restrictive policy stance," she extended the time frame for combating inflation, aligning her views with recent hawkish sentiments expressed by various Federal Reserve officials. This situation underscores the precarious balancing act facing U.S. monetary policymakers amidst a myriad of economic indicators.
Since inflation peaked above 9% in 2022, the Federal Reserve has raised the federal funds rate by 525 basis points, bringing it to a 23-year high of 5.25%-5.50%. Despite a decrease in the core Personal Consumption Expenditures (PCE) price index to 3.5% in 2024, Daly pointed out that housing service inflation remains stubbornly high at a year-on-year growth rate of 6.5%, severely impacting core inflation. Behind these figures lies a structural crisis in the U.S. housing market: a decade of insufficient new housing supply has tightened the rental market, which, combined with mortgage rates hovering above 7%, creates a self-reinforcing mechanism for rising rents.
The phenomenon of "sticky inflation" is progressively reshaping the Federal Reserve’s monetary policy framework. Traditionally, the Phillips Curve theory posits an inverse relationship between unemployment rates and inflation. However, the current U.S. labor market is exhibiting an unusual coexistence of "high employment and high inflation." While the labor force participation rate has rebounded to 62.8%, job vacancies remain at 5.2%, resulting in sustained wage growth that outpaces productivity gains. Daly highlighted the price pressures in the service sectors, such as healthcare and education, where the inflationary stickiness intertwines with an overheated job market, presenting a substantial concern for policymakers.
The Fed's toolbox is undergoing an unprecedented test. In addition to maintaining elevated interest rates, the plan to reduce its balance sheet continues at a staggering pace of $95 billion per month, leading to persistent liquidity contraction in the banking system. This "dual-track tightening" strategy is almost uncharted territory, with its complex transmission mechanisms exceeding expectations. The financial market's reactions reflect this uncertainty: the S&P 500 Index has undergone three significant corrections over the past year, while the 10-year U.S. Treasury yield has breached the 5% mark, and corporate bond market credit spreads have widened to over 150 basis points, resulting in a default rate in the commercial real estate sector that has reached 3.2%, a peak not seen since 2008.
On the ground of the real economy, the lagging effects of tightening policies are starting to surface. A survey from the National Federation of Independent Business indicates that the index of small business loan availability has dropped to its lowest level since 2013, with 35% of business owners reporting that financing difficulties are affecting their normal operations. On the consumer side, the data is equally disheartening: auto loan delinquency rates have surpassed 5%, while revolving credit card debt has exceeded $1.2 trillion. Additionally, the housing market is experiencing a "lock-in effect," as fixed mortgage rates for 30 years remain high, leading to a year-on-year decrease of 28% in listings for existing homes. These figures weigh heavily on the Federal Reserve’s policy scales.
Nevertheless, the robustness of the job market provides a buffer for policy maneuvering. Non-farm payrolls have consistently added over 200,000 jobs per month for 18 consecutive months, with the service sector's employment share rising to historic highs. This "economic resilience" bolsters the Federal Reserve’s resolve to maintain a tightening stance, yet it conceals risks: the service sector accounts for 80% of GDP, and its price stickiness might lead to volatile inflation trajectories. Daly emphasized the "data dependency" principle in her address, suggesting that future policy adjustments will keenly focus on high-frequency indicators like core PCE month-on-month growth rates and rental price changes.
The global economic landscape is undergoing a restructuring influenced by the Federal Reserve’s policy shift. Emerging markets have faced capital outflows amounting to $850 billion, with currencies in countries such as Argentina and Turkey experiencing significant devaluation. The European Central Bank has been compelled to follow suit with interest rate hikes due to inflation pressures, pushing the Eurozone economy into a technical recession. Following the Bank of Japan's cessation of its yield curve control policies, the yield on 10-year Japanese government bonds has crossed 1%, causing turbulence in the global bond markets. This form of "beggar-thy-neighbor" policy transmission effect exerted greater international pressure on the Federal Reserve's decision-making.
Historical experiences provide a lens to perceive the current predicament. Under Paul Volcker’s leadership in the 1980s, the Federal Reserve raised interest rates to 20%, successfully curtailing inflation but bringing about a severe economic recession. Conversely, during the 2010s, Ben Bernanke's quantitative easing policy stimulated the economy while simultaneously sowing the seeds for asset price bubbles. Today, the Federal Reserve must navigate a third path between these two extremes.
Looking ahead to the latter half of 2025, three possible policy scenarios emerge: under the baseline scenario, core PCE month-on-month growth remains below 0.2%, prompting the Federal Reserve to initiate rate cuts in the third quarter; in a hawkish scenario, persistent service sector inflation keeps policy rates steady into 2026; while in a recession scenario, economic contraction forces the Federal Reserve to significantly cut rates ahead of schedule. Regardless of the trajectory, investors need to recalibrate their asset allocation strategies: within fixed income, there should be an increase in short-duration treasuries and inflation-protected securities; in the equity market, a focus on high-dividend, undervalued segments; in commodities, allocations should favor gold and energy; in the foreign exchange market, caution is advised against potential dollar liquidity reversal risks.
The profound implications of this inflation combat are becoming evident. With policy rates maintained at high levels for an extended period, the structural adjustments within the U.S. economy will deepen: corporate capital expenditures will pivot toward automation as a response to a high-rate environment, consumer saving rates will rise, thereby curbing excessive borrowing, and the housing market will seek a new equilibrium amidst increased supply and declining demand. Notably, the Federal Reserve's policy choices will not only influence the U.S. economy's potential to achieve a "soft landing" but will also dictate the fate of the global financial system during a deleveraging cycle. Mary Daly’s remarks undoubtedly set a new tone for this multi-trillion-dollar asset pricing game.
Leave Your Comment