Federal Reserve Chairman Jerome Powell’s three big challenges

Consumer optimism is thriving despite the powerful headwinds of strong inflation and higher interest rates.

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Consumer optimism is thriving despite the powerful headwinds of strong inflation and higher interest rates.

In a recent Twitter post, Lawrence H. Summers, Charles W. Eliot University Professor and President Emeritus at Harvard writes, “Friday’s PCE figures, with both core and headline inflation running at 7 per cent last month and big upward revisions for the 4th quarter, are very troubling.” In another post of the same thread, Summers adds, “They suggest that the Federal Reserve may have made much less progress in containing underlying inflation than has been generally supposed and make a soft landing look less likely.”

Federal Reserve Chairman Jerome Powell has an unfinished task at hand. And, that is to bring inflation under 2%. The inflation that crossed multi-decade high levels of 9% in 2022 is still high despite Fed raising rates by 450 bps since then. Unexpectedly, the US CPI data in January came in at 6.4%, dropping marginally from the 6.5% witnessed in December.

Taming inflation remains one of the biggest challenges for the Fed. The sudden increase in the personal consumption expenditures index highlights the dangers of long-term high inflation. To lower the level of inflation, Fed Chair Jerome Powell is raising interest rates while trying to ensure that it does not negatively impact the economy.

However, the Fed’s journey so far is only half the battle won. Since last year, the Fed has raised rates by 4.50% from near zero, but inflation remains well below the central bank’s target of 2%.

The other big challenge is to keep the unemployment rate high in the economy. The Fed expected the job sector to show high unemployment as a result of increasing interest rates. However, the labour market remains strong, with weekly jobless claims down 1,000 to 194,000 from the previous week’s 195,000, while the consensus forecast expected an increase to 200,000. Monthly job data shows that the United States added 517,000 jobs in January, and unemployment fell to 3.4%, the lowest rate in 53 years.

The Fed aims to maximize employment while maintaining low inflation but higher wages but more jobs in the economy are likely to fuel inflation which remains a challenge for the Fed.

The third big challenge for the Fed is from the consumer spending data that revealed growing optimism among spenders. “Investor sentiment turned south this morning following the release of surprisingly strong retail sales data for January. Sales climbed 3% as consumers proved resilient to higher prices due to a strong labour market. Consumer optimism is thriving despite the powerful headwinds of strong inflation and higher interest rates,” says José Torres, Senior Economist at Interactive Brokers.

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While higher consumption and a hot labour market are good news for consumers and businesses, it also gives the Fed more room to continue tightening monetary policy.

The Fed is expected to keep raising rates at a slower pace in 2023. The markets are not expecting any pause or a rate cut this year and also expect the terminal rate to hover around 5.5% by the time the Fed pivot begins. As always, any positive or negative surprises may spook the market bringing in higher volatility during trading hours and giving opportunities to long-term investors.

Fed’s monetary policy action plays a role in the fortunes of stock market investors. In a rising rate environment, stock valuations dip and so do the earnings. Stocks thrive on the growth of corporate earnings which looks to be weakening amidst a rising rate scenario. “The Q4 earnings season continues to show that while growth is moderating and decelerating, it isn’t falling off the cliff that many feared could be in store for us. The growth challenge is widespread across most sectors, but it is most pronounced in the tech sector where a combination of cyclical forces and post-Covid normalization is dragging growth down,” says Sheraz Mian Director, Zacks Research.