Market Wire - Fear of "Entrenched" Inflation Expectations Drove Fed's Jumbo-Sized June Hike

According to minutes taken during the Federal Reserve’s meeting on June 15, policymakers underscored a commitment to bringing inflation down - even if at the risk of triggering a slowdown in the economy. The bank delivered a 75 basis point hike that day, after having prepared markets earlier in the week by leaking its intentions to the press.

The meeting record details how high headline inflation and the potential for a destabilization of price expectations have come to dominate the Fed’s reaction function. Officials "raised the concern that longer-run inflation expectations could be beginning to drift up to levels" that threatened price stability, and many thought there was a "significant risk... that elevated inflation could become entrenched if the public began to question the resolve" of the central bank.

Officials agreed “the economic outlook warranted moving to a restrictive stance," and, "recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist”. Several judged that higher rates "would be appropriate from a risk management perspective" because they would leave the Fed "in a better position to implement more restrictive policy if inflation came in higher than expected."

During the press conference that followed the decision, Chair Jerome Powell described the Fed’s “overarching focus” as “bringing inflation down to 2.0 percent and keeping longer-term inflation expectations well-anchored”. He also said “either a 50 basis point or 75 basis point increase seems most likely” on July 27.

In testimony to Congress in late June, Powell described the commitment to price stability as “unconditional”, He admitted a policy-driven recession — although “not our intended outcome” — is “certainly a possibility.”

Indeed, markets are now worrying about a possible slowdown, with manufacturing surveys pointing to a drop in new orders and employment - even if services surveys remain more optimistic. Commodity prices are falling, along with nominal yields and inflation breakevens.

It is too soon to project a dovish turn: policymakers have said they would “need to see compelling evidence that inflation is coming down” in “a series of declining monthly readings on inflation” before changing course. But a softening in the Fed’s message could come at the Jackson Hole conference in late August or at the September meeting, once the central bank can assess the impact of its tightening efforts on prices and growth.