- The Fed has plenty on its agenda in 2020, including fixing the short-term funding market, but some market pros expect it to also face inflation in the near future.
- Rising commodity prices and higher services inflation could combine to elevate inflation for the near term, and that could impact market expectations about Fed policy.
- The central bank has said inflation would not impact its view unless it moves significantly and persistently.
The Federal Reserve's annual reshuffle of its rate-setting committee means two dissenters will no longer cast votes, and a seemingly more unified group could be left to face a new challenge early in the year — the possible emergence of inflation.
Chairman Jerome Powell, after the central bank's December meeting, made clear that the Fed would keep its policy on hold and remain on the sidelines, unless the outlook for the economy changes or there is a significant and persistent change in inflation. Minutes from that meeting are expected to be released Friday afternoon.
"I think there are a couple of things that are going to happen that are going to be material changes to the economy," said Marc Chandler, chief market strategist at Bannockburn Global Forex. "One is there's going to be an inflation scare. Headline inflation is going to move up. Early in 2019, we had some low inflation." The comparison to those low levels will make a rise in inflation look relatively larger, and prices for agricultural commodities could continue to increase on new demand from China, he said.
The makeup of the voting members of the Federal Open Market Committee will change next month, with Boston Fed President Eric Rosengren and Kansas City Fed President Esther George, who voted against the Fed's three rate cuts, joining the ranks of nonvoters. St. Louis Fed President James Bullard and Chicago Fed President Charles Evans will also no longer be voters. Bullard voted against two rate reductions because he wanted the Fed to cut even more aggressively.
The four will be replaced in a rotation by Minneapolis Fed President Neel Kashkari; Dallas Fed President Robert Kaplan; Philadelphia Fed President Patrick Harker; and Cleveland Fed President Loretta Mester. Of the four, Kashkari is viewed as dovish, and Mester and Harker were both skeptical of the 2019 rate cuts.
"I don't think the configuration of the Federal Reserve matters all that much," Chandler said, adding the central bank may face challenges to its neutral position. "The inflation scare is the first part of it, then the weaker economy."
Chandler said CPI inflation could go to 2.5% or 2.6%, though the Fed favors the core personal consumption expenditures deflator, which is well below 2%.
Chandler said while the Fed says inflation needs to be persistent for it to move, markets may not care. "The market will overreact to it," he said. But Chandler does not think the Fed will respond because he also expects the economy to slow. Core CPI, the consumer price index, rose 0.2% or 2.3% annually in November.
"The same kind of thing is going to happen in Europe," he said. "When the inflation scare passes, we're going to see the U.S. economy is going to remain soft. That will change the prospect of a rate cut into the second quarter."
The market currently expects the Fed to remain on hold, but its next move is seen as more likely a cut, not a hike as might be needed to fight a real move in inflation.
Chandler said one signal that inflation could be on the rise is the Thomson Reuters CRB index, a measure of commodity prices, is now at its highest level since April. Oil prices have also been on the move, gaining more than 10% for December so far.
On top of that, wages have been rising. "Wages should push things up further, and optimism towards some sort of further positive developments on China trade would be impactful for commodities," said Tom Simons, money market economist at Jefferies. Average hourly wages are growing at above 3% annually, and even more so for nonsupervisory workers — up 3.7% in November.
Peter Boockvar, chief investment officer at Bleakley Advisory Group, said even if inflation data rises temporarily, the Fed is unlikely to change its view about its expectations for inflation unless it continues climbing. He did note services inflation is already at a higher level.
"I think we'll have to see if commodity prices continue to rise," Boockvar said. "The industrial metals are bouncing, as well, and rising energy prices can filter into other things. ... Because services inflation has remained so sticky, around 3%, anything that has the possibility of influencing the goods side of prices could move the needle."
Boockvar said the Fed would not do anything immediately if inflation did start to rise. "The bond market will start tightening for them. You'll see a rise in the 10-year yield, probably above 2%," said Boockvar. "That's what would happen. The bond market will do the job of the Fed."
Boockvar said the changes in voting members at the Fed could make it sound more dovish.
"George and Rosengren were obviously hawks. Evans is coming off, and he was viewed as a dove. Bullard was very dovish," he said. "You're taking off two hawks and a dove, and you're getting an uber dove and three middle of the road people."
Boockvar notes that Rosengren held a minority view that the Fed's rate cuts were stirring another type of inflation. "If you look at the rally in stocks in the last two months. Eric Rosengren will call that asset price inflation. They'll be looking at plain vanilla inflation," he said.
Boockvar said the much bigger challenge for the Fed will be what to do about its repo operations and its program to enlarge its balance sheet through Treasury bill purchases. Some market pros say that has helped prompt a rise in stock prices, based on better financial market liquidity.
The Fed beefed up its overnight and term repo operations to make sure the short-term lending market was not stressed at year-end. In September, there was a spike in rates in that market, considered the plumbing of the financial system. Market pros say the apparent cash crunch was in part caused by bank regulations that were tightened after the financial crisis.
The Fed jumped in to make sure the market was liquid enough and has provided up toward $500 billion to help the markets go through year-end, when banks are reluctant to keep risky bets on their balance sheets due to regulations.
Simons said the Fed programs have not been fully subscribed and rates have been falling. On Friday, the general collateral Treasury repo rate was as low as 3%, down from over 4% earlier in the month.
The Fed is expected to address a more permanent solution for the repo market. New York Fed President John Williams recently told CNBC he favors retaining the repo operations just as long as they are needed.
Williams remains a voting president on the Federal Open Market Committee, since the New York Fed has a permanent voting role. The committee is made up of all seven members of the Fed's board of governors, which currently has two vacancies, as well as five of the 12 regional bank presidents. Four voting seats are rotated each year among the presidents.