James Bullard, President and CEO of the St. Louis Federal Reserve, delivered a speech today to the CFA Society St. Louis. Bullard titled the speech “The Prospects for Disinflation in 2023.” Given Bullard defined disinflation as “a decrease in the rate of inflation toward the Fed’s 2% inflation target”, he could have more directly titled the speech “We Are Beating Inflation….But Don’t Celebrate Yet.” The essence of the speech suggested that the Federal Reserve can so far take some credit for a partial victory over inflation: “front-loaded Fed policy has helped keep market-based measures of inflation expectations relatively low.” However, that victory must be secured by staying the course to nudge the policy rate a little higher into the “sufficiently restrictive” zone. Critics who think the Fed uses too much discretion should appreciate the use of the Taylor rule to calculate the ultimate destination for monetary policy. Fed critics who think the Fed has gone too far should be relieved to see that the Fed is targeting the lowest possible Taylor-based rate and not the highest. (All charts copied from Bullard’s presentation).

As rates have risen, inflation expectations have declined sharply. Bullard offered the following chart to demonstrate the effectiveness of the Fed’s rush to front-load rate hikes.

Some people look at these expectations and conclude the Fed can stop before getting into the “sufficiently restrictive” zone. Some people might even conclude that Fed should start cutting rates. Most of those folks are probably focused on the stock market’s performance. Bullard instead is looking at the actual performance in the economy. GDP growth was unexpectedly strong in the second half of 2022. Even more importantly, the labor market remains very strong in aggregate as it glides through unprecedented territory. At least since 1980, the U.S. economy has never experienced such a wide gap between available jobs to the high side and available workers to the low side.

As long as this gap persists at such a magnitude, the Fed can feel comfortable about lifting rates into restrictive territory.

The Fed can declare partial victory since inflation expectations are back to previous norms. However, as Bullard noted consistently with the Fed’s messaging for months, “inflation remains too high.” If the Fed prematurely declares victory, the tightness of the labor market could become a source for reigniting inflation pressures, both real and expected.

Bullard’s words can generate out-sized market impacts. On this day, the market took Bullard’s caution pretty well. Bullard is still hawkish, but at least he is conceding some form of victory. The S&P 500’s (SPY) 1.2% loss is well within the volatility the index has experienced since it broke down below its 50-day moving average (DMA) in mid-December.

(Click on image to enlarge)

Be careful out there!

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