Why the Fed's Next Move Could Be a Hike, Not a Cut

Since the beginning of the year, continuous inflationary pressures have put monetary policy at odds with conventional wisdom. Since the end of last year, the so-called Taylor rule has been diverging from the federal funds rate of the 3.50%–3.75% range, closing in on the 6% mark. The Taylor rule provides an estimate for the optimal Fed funds rate based on the gaps between the target and actual inflation rate and between potential and actual output.

Underlying issue

Since the beginning of the pandemic, the spike in inflation was driven by separate shocks in the form of energy price spikes and fiscal stimulus that fed into higher goods costs during the 2021–2023 period. Since March, the impact of the recent military escalation in the Middle East and closure of the Strait of Hormuz are also being felt.

The pandemic period also saw an increase in housing inflation and so-called "supercore" inflation, which considers service costs, excluding housing. It has been causing headaches for Fed officials for the last five years. While energy and housing inflation effects have largely subsided from the pandemic highs, supercore inflation, which contributes more than half to the core PCE index, hasn't returned to pre-pandemic levels.

Core service inflation includes sectors such as health care, education, personal care and hospitality. These are largely labour-intensive sectors where wages account for the majority of costs. According to Stephen Miran, former FOMC member, labour compensation accounts for 60% of value added in the leisure and hospitality sectors and 83% in education and health services.

As such, inflation in these sectors is largely driven by labour market developments. Since reaching a low of 3.4% in April 2023, unemployment has increased to 4.2% but remains at historically low levels.

This has been reflected in the deceleration in wage growth. From the pandemic peak of 8%, wage growth has retracted to around 3.5% – close to the level seen after the Global Financial Crisis that would match the Fed's target.

Despite wage growth slowing, there are signs that the Fed is losing patience with inflation. Fed Governor Christopher Waller underlined the issue, saying that "at this point, I am concerned about the elevated pace of core inflation this year" while adding that "sternly staring at inflation until it melts before our withering gaze is not an option." Dallas Fed President Lorie Logan, in her speech, noted that "modestly higher interest rates would better balance the outlook and risks for the FOMC's maximum employment and price stability goals."

Warsh's preferred measure heads in the wrong direction

Kevin Warsh argued in his confirmation hearing that "trimmed averages" serve as a better measure to understand underlying inflation, according to research. The trimmed mean inflation measure, a form of core inflation, removes the most extreme observations from both ends of the headline figure. The Federal Reserve Bank of Dallas' trimmed mean PCE measure removes 24% of the weight from the lower tail and 31% of the weight from the upper tail.

Since the first quarter of this year, the trimmed mean (see chart below) has also picked up, along with headline and core inflation measures.

Wary of the mistakes made during the pandemic, when they waited too long before raising rates, Fed officials will be careful not to fall behind the curve. However, the hiking cycle, barring any additional shocks, should remain limited to one or two hikes given where rates and the economy are now, along with a potential further slowdown in wage growth. AI-related spending has so far had limited impact on prices.

Significance for crypto

In response to inflationary pressures, yields on two-year and 10-year Treasuries have increased. As short-term yields have risen on expectations of higher interest rates, the spread between two-year and 10-year Treasury yields has narrowed. The flattening of the yield curve has been accompanied by the declining price of Bitcoin as the market prices in future rate increases.

Meanwhile, Sandmark's analysis suggests that Bitcoin's 90-day return correlation with the Nasdaq stands at 0.529, with a one-year correlation of 0.495. Although both assets react similarly to risk-on and risk-off shifts, Bitcoin produces different cumulative returns, as its selloffs are larger and its rallies weaker, even as the Nasdaq trades up around 10% year to date.