Since the Federal Reserve’s last monetary report in June 2022, inflation has eased, but still remains higher than the central bank’s 2% target, it said Friday in its latest monetary policy report. As usual, it reaffirmed its commitment to achieving that objective.
The report was issued ahead of Fed Chair Jerome Powell’s testimony in Congress, scheduled for Tuesday and Wednesday. Specifically, the report pointed out that inflation for goods has eased, and housing-related inflation is expected to subside later this year. The prices for other services, though, remain a concern.
“For other services, however, price inflation remains elevated, and prospects for slowing inflation may depend in part on an easing of tight labor market conditions,” according to the report.
Wage growth is contributing to the higher-than-hoped for inflation. “Nominal wage gains slowed over the second half of 2022, but they remain above the pace consistent with 2% inflation over the longer term, given prevailing trends in productivity growth.”
Financial conditions are significantly tighter than a year ago, the report said. That’s intended to put downward pressure on inflation. But the Fed’s higher interest rates will take time to filter through the economy.
“Financial vulnerabilities remain moderate overall” against a backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty since June, the Fed said.
Market liquidity remained low in several key asset markets, including the Treasury market, when compared with levels before the COVID-19 pandemic, the report said.
Business and household debt levels
Nonfinancial business and household debt rose in line with GDP, leaving vulnerabilities associated with borrowing by businesses and households unchanged at moderate levels.
Overall, household balance sheets remain strong, but that’s mostly from households with higher credit scores. “In contrast, some signs of increased stress have become apparent for households at the lower end of the income distribution as delinquency rates for near-prime and subprime borrowers have risen,” the report said.
Low funding risks
Funding risks at domestic banks and broker-dealers remain low, and the large banks at the core of the financial system continue to have ample liquidity.
“Prime and tax-exempt money market funds, as well as many bond and bank-loan mutual funds, continue to be susceptible to runs,” it said. For example, bond and bank-loan mutual funds continue to be vulnerable to large redemptions, as they hold assets that can become illiquid in times of stress.
While it’s not a bond or bank loan mutual fund, the Blackstone (BX) Real Estate Income Trust has seen large redemption requests as high interest rates impact the valuation of real estate assets.
Note that the market is pricing in a 69.4% probability of a 25 basis point increase at the Fed’s March 21-22 meeting and a 30.6% probability of a 50-bp hike, down from a 31.4% probability on Thursday, according to the CME FedWatch tool.
Near-term risks to financial stability were little changed in the last months, but they’re still notable. “If a recession were to coincide with higher-than-expected inflation and interest rates, the strains on households, businesses, and the financial sector would be exacerbated,” according to the report’s section on Developments Related to Financial Stability. “Moreover, low liquidity in some financial markets may amplify the volatility of asset prices, impair market functioning, and cause funding pressures at financial intermediaries.”
In Powell’s June 2022 testimony to Congress, he stressed the Fed’s “unconditional” commitment to fight inflation.