The Fed Should Focus on Inflation Rather Than Stock Market Performance

The U.S. Federal Reserve (Fed) faces a challenging task, and its communication with the markets often complicates this responsibility further.

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Financial markets are highly attuned to statements, testimonies, and speeches made by Fed officials. These comments are analyzed closely to gauge the evolving consensus within the central bank and to predict future interest rate decisions. However, this constant stream of public communication can often hinder effective policymaking by introducing confusion or shifting market expectations.

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The Federal Open Market Committee (FOMC), made up of the Fed governors and regional bank presidents, has the responsibility to achieve price stability and maximize employment. Alan Greenspan, former Fed Chair, defined price stability as a situation in which expected changes in the general price level do not significantly influence business or household decisions. Essentially, inflation should neither be so high that it prompts households to rush into major purchases, nor so low that businesses fear deflation, which could lead to burdensome debt.

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Central banks in major advanced economies have generally agreed on a 2% inflation target. In 2020, the Fed indicated its willingness to tolerate periods of inflation above 2% in order to make up for times when inflation falls below this target. However, it has proven difficult for the Fed to bring inflation back down to the 2% mark.

Price stability plays a crucial role in fostering sound investment decisions. Achieving and maintaining 2% inflation would promote healthy job growth and a stronger stock market, which are key goals for the central bank.

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Communication Challenges

To achieve price stability, the FOMC influences credit conditions by adjusting the federal funds rate. Through forward guidance, the Fed communicates its expectations regarding future policy actions, influencing household, business, and investor behavior.

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After each of its eight annual rate-setting meetings, the FOMC releases a statement outlining the rationale for its decisions. Every other meeting, it publishes the individual forecasts of its 19 members on key economic indicators, such as GDP growth, unemployment, inflation, and the fed funds rate. However, the Fed is faced with significant uncertainty between meetings, with unexpected changes in data concerning employment, inflation, and GDP.

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The Fed frequently emphasizes that its decisions will be based on incoming data, which creates a tension between the forward guidance it provides and the ultimate decisions made by the FOMC. For example, in its September and November meetings, the FOMC reduced the federal funds rate by half a percentage point and one-quarter percentage point, respectively. Both Fed Chair Jerome Powell and other committee members signaled that the economy was on track to reach 2% inflation, and they implied that further rate cuts could follow.

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However, at the December 17-18 meeting, the FOMC revised its median inflation forecast for 2025 from 2.1% to 2.5%. Despite this upward revision in inflation expectations, the committee decided to cut interest rates by another quarter percentage point, likely to avoid disappointing investors who still anticipated a rate reduction.

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This type of decision-making can significantly influence stock market movements. The Fed's actions should focus on achieving its stated goal of 2% inflation, rather than responding to market expectations. Catering to short-term market sentiment risks undermining the Fed's long-term objectives.

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The real issue lies in the lack of a unified voice from the Fed. Aside from the statement issued after meetings, there is no singular, cohesive narrative. FOMC members often hold differing views. Currently, inflation forecasts for 2025 range from 2.1% to 3.1%, and the appropriate federal funds rate to achieve 2% inflation is debated, with estimates ranging between 2.4% and 3.9%.

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Fed statements and Powell consistently remind the public that decisions will be driven by incoming data. However, this did not appear to be the case in December, when the Fed raised its inflation forecast yet moved its policy in the opposite direction, likely in response to market pressures.

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This undermined the Fed's credibility and raised doubts about its ability to achieve its inflation target. Despite a full percentage-point rate cut since September, yields on both the 2-year and 10-year U.S. Treasuries—key indicators of future Fed policy—have risen by about 0.7% and 1%, respectively. This suggests that investors are skeptical about the Fed's ability to reduce inflation to 2%.

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Recent U.S. inflation data reveals that prices for goods, many of which are imported, have been falling, especially as economies like China and much of Europe struggle. However, prices for services, excluding shelter, which are more influenced by domestic demand and labor market conditions, have been rising at an alarming rate of about 4.1%.

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Policies introduced by President Trump, such as curbing immigration, tax cuts, and tariffs, may further tighten labor markets, increase demand, and complicate the task of bringing inflation down to 2%.

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The Fed is currently conducting a quinquennial review of its monetary policy strategy, tools, and communication practices. To improve its effectiveness, the central bank should set a firm goal of maintaining inflation at or below 2%, regularly publish forecasts for inflation and other key economic indicators after each meeting, clearly explain any decisions to adjust interest rates, and reduce the frequency of public speeches. These steps would help provide clearer guidance and restore confidence in the Fed's ability to meet its inflation target.

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