The Fed may not be able to take its foot off the gas

The Fed exists to fulfil its dual mandate; achieving maximum employment and attaining price stability, defined as 2% inflation over a longer term. The press release of July 27 states, "The Committee is strongly committed to returning inflation to its 2 per cent objective."

Inflation concerns have driven the market since the Fed chair announced the retirement of the term "transitory" in his address to lawmakers on November 30 last year. However, we assess that the markets had been discounting higher inflation even before this announcement, since September 2021.

Consider the annual rates of change of core CPI and core PCE:


Firstly it's important to note that core PCE is likely the better inflation gauge. This is because it has a dynamic aspect that accounts for cheaper substitutes. It is also broader, looking at the goods businesses sell (the CPI doesn't account for more affordable replacements and looks only at the goods households buy).

Despite this, they have a strong correlation, and both series kicked up from May 30 (blue dashed horizontal). Moreover, this momentum push comes when core PCE is still 2.79 per cent from the Fed's target (down red arrow). Recent market movements are astounding due to the assurance in Wednesday's statement that the Fed is committed to achieving its 2% target. Real rates have declined markedly since the Fed chair's press conference:


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The 10-yr real rate is just 7bps from 0 (black line chart), and the 5-yr is 7bps below 0 (red line chart). Given that interest rates are included in the denominator of the time value of money, this deterioration is supportive of present values. I.e. it is acting against the whims and desires of the Fed's stated intention of controlling inflation.

Assuming that inflation remains the primary focus of the Fed, the drop in real rates is a directional anomaly. Therefore caution is appropriate - either the market realises its error or a central bank official will communicate this to the market.

Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.

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