Powell punctures the "window paper" of potential stagflation risks in the United States
The Federal Reserve lowered the federal funds rate by 25 basis points to 4.25-4.50% at the December meeting. Although it raised the GDP growth and inflation expectations for next year, the dot plot indicates two rate cuts next year, which has confused the market, believing that rate cuts should not occur. Powell pointed out that the labor market is robust and inflationary pressures are not significant
Main Situation of the Interest Rate Meeting
In the early hours of today, the United States announced the decision from the December interest rate meeting, with the federal funds rate lowered by 25bp to 4.25-4.50%. Trump will be inaugurated on January 20 next year, marking the last interest rate meeting before the change of the U.S. government.
This was a major interest rate meeting, which also included economic outlook and dot plot.
Regarding the economic outlook, the Federal Reserve raised its GDP growth forecast for next year from 2.0% to 2.1%, and significantly increased its inflation forecast from 2.1% to 2.5%.
This indicates that the Federal Reserve has significantly raised its estimate of the neutral interest rate level, leading to a substantial increase of 10bp in the ten-year U.S. Treasury yield.
Surprisingly, there are some conflicts between this dot plot and the economic outlook; the dot plot does not express the same concerns about inflation as the economic outlook, indicating two rate cuts next year.
The dot plot suggests that: 1. There will be two 25bp rate cuts next year; 2. There will be another two 25bp cuts the year after.
Based on this path, the two-year U.S. Treasury yield should be at 3.96%.
Market Confusion Over Future Rate Cut Path
However, the market expressed confusion over the rate cut path depicted by the dot plot.
The two-year U.S. Treasury yield surged to 4.35%, which is far from 3.96%. It is evident that the market does not fully agree with the implied rate cut path of the dot plot, and there has been a significant adjustment in the market regarding the dot plot.
The market believes that, if other conditions remain unchanged, according to the economic outlook depicted, the Federal Reserve should not cut interest rates next year.
As shown in the above chart, if we use the ten-year U.S. Treasury yield to proxy the approximate position of the neutral rate, currently, the U.S. policy interest rate spread (note: neutral rate minus policy rate) is just around the zero axis, which maintains a certain degree of restrictiveness.
If actions are taken according to the rate cut path depicted in the dot plot, then the policy rate is likely to deviate from the restrictive range, creating pressure for secondary inflation.
Uncertainty in Fiscal Spending
On one hand, the U.S. has potential inflationary pressures, while on the other hand, the Federal Reserve seems quite eager to cut rates. At the press conference, Powell made the following statement:
Regarding the employment outlook, the labor market remains robust and is not a significant source of inflationary pressure, and it has not cooled to a concerning degree, and we will continue to monitor it.
In simpler terms, the private sector is not the source of "inflationary pressure"; rather, the government sector is the source of "inflationary pressure."
In fact, we discussed this issue in the article "On the Relationship Between Government Revenue and Expenditure Status and Inflation."
As shown in the above chart, after a long period of anti-inflation, the inflation problem in the U.S. is mainly concentrated in non-productive organizations, which falls under the realm of fiscal policy.
Understanding this broader context makes it easier to comprehend the Federal Reserve's "little calculations":
- Inflation in productive organizations is well-contained, and the labor market is no longer overheating;
- Monetary policy can only adjust productive organizations, but cannot adjust government departments;
- If inflation rises again, it must be due to poor performance in fiscal matters;
- There is hope for faster fiscal reforms, which would create space for monetary policy;
There is an economic common sense that monetary policy is powerless against "stagflation."
So, how does stagflation arise? There is a very obvious logical loop: government departments are bloated, squeezing the survival space of the productive sector. Monetary policy is ineffective against such structural issues.
Thus, we have Musk's Department of Government Efficiency.
After understanding these convolutions, one can see why U.S. stocks have plummeted.
Powell has pierced a layer of window paper—the potential stagflation risk in the United States. If everyone really starts discussing "stagflation," then the problem will become extremely troublesome.
Conclusion
Currently, the biggest problem for the United States is its debt, which amounts to a staggering USD 36 trillion.
The incremental debt is not aimed at expanding production or shifting the supply curve, but rather to pay off old debts and to pay salaries to various civil servants.
However, the productive sector has already undergone "downsizing" with the help of the Federal Reserve. Thus, the main contradiction in the economy has shifted from the conflict between total supply and total demand to the conflict between the productive and non-productive sectors—the productive sector hopes that the non-productive sector will yield macro policy space.
If both sides can reach a compromise, we will observe a scenario where, on one hand, the U.S. government reduces inefficient spending, and on the other hand, the Federal Reserve further cuts interest rates, ultimately leading to a core CPI growth rate of 2%.
Currently, we have only observed signs of conflict breaking out. Whether it can be handled smoothly to avoid falling into a stagflation situation remains an unknown.
Author of this article: Cang Hai Yi Tu Gou, Source: Cang Hai Yi Tu Gou, Original title: "Regarding the December Monetary Policy Meeting and Stagflation Risk Warning"
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