Inflation is on a crab walk and Fed officials fear its pinch

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New York CNN —

The possibility of a market rally in 2023 stalled last week amid an onslaught of unfortunate inflation and economic data that scared investors and increased the likelihood that the Federal Reserve will continue its economically painful hike-rate campaign longer than Wall Street had hoped.

All major indexes posted their biggest weekly losses of 2023 on Friday. The S&P 500 fell 2.7%. The Dow Jones Industrial Average fell 3% and the tech-heavy Nasdaq fell 3.3%.

What’s happening: It appears that the pace of inflation is moving sideways after months of steady decline. The January personal consumption expenditure index — the Fed’s preferred indicator of inflation — came in hotter-than-expected on Friday.

Prices rose a whopping 5.4% year over year in January, the Commerce Department’s Bureau of Economic Analysis reported. In December, prices increased by 5.3% annually.

In January alone, prices rose 0.6% mom, a higher monthly gain from December’s 0.2% rise.

This inflationary crab walk will almost certainly prompt Fed officials to reconsider policy.

A paper presented Friday at the Booth School of Business’ Monetary Policy Forum in New York argued that disinflation will likely be slower and more painful than markets expect.

“Substantial disinflation caused by monetary tightening is associated with recessions,” the paper said. “‘Flawless disinflation’ would be unprecedented.” (Flawless in this case refers to the possibility of inflation falling quickly to the Fed’s 2% target without serious economic damage).

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Several Fed presidents, governors and top economists attended Friday’s Booth School forum to discuss paper and monetary policy. The majority of speakers expressed their deep concern at the persistence of inflation and the overall market reaction.

Inflation Won’t Stop: Cleveland Fed Chair Loretta Mester said that while price growth has moderated from its recent high, the overall pace of inflation remains too high and could be more sustained than her peers currently expect.

“My expectation is that further rate hikes will reach sufficiently restrictive levels and then stay there for some, maybe longer, time,” Boston Fed Chair Susan Collins reiterated at the conference.

Collins referred to the inflation as “unruly,” a charged million-dollar word meaning uncooperative or defiant of authority.

Fed Governor Philip Jefferson took a more confused stance on Friday, noting that inflation continues to confuse economists. “The inflationary forces currently affecting the US economy represent a complex mix of temporary and longer-lasting elements that defy simple, parsimonious explanation,” he said. Frugal is another million dollar word for frugal.

Economists stressed that more pain is to come. “It’s important for markets to understand that ‘no landing’ is not an option,” said Peter Hooper, associate research director at Deutsche Bank and author of the report.

While the latest data signals that the US economy remains strong, “we expect some bad news into the middle of this year, and the sooner markets get this news, the more helpful it will be for the Fed,” he said.

The final word: Former Bank of England Governor Lord Mervyn King summed up what many were thinking on Friday: Given the complexity of the current monetary situation, he said: “I don’t want to give any central bank advice on what we should do.”

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Researchers at the Federal Reserve Bank of New York have issued a dire warning: If President Joe Biden’s student loan forgiveness plan does not materialize, the US could face another credit crunch.

Some background: The Covid-19 crisis triggered a sudden change in student loan policies and a new openness to forgiveness. In March 2020, Congress passed the CARES Act, which automatically paused required payments on all federally held student loans.

This forbearance has since been extended eight times and is not due to end until August, 40 months after it began.

The Biden administration had announced an unprecedented debt relief proposal that would relieve more than 40 million borrowers. An analysis by the New York Fed found that about $441 billion in federal student loans could be forgiven under the proposal, canceling about 30% of all outstanding federal student-loan debt.

That forgiveness proposal is now on hold following an injunction from the 8th US Circuit Court of Appeals. On Tuesday, the United States Supreme Court will hear the case, which is expected to rule by June 2023.

What’s at stake: If the Biden administration’s forgiveness plan survives court challenge, the New York Fed says it will mean the largest mass writedown of consumer debt in modern history. About 40% of those with federal student loan debt would have a zero balance; even more would have a much lower monthly payment.

But: “If payments resume without debt relief, we expect both defaults and student loan arrears to increase and potentially exceed pre-pandemic levels,” Fed researchers warned.

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“We are seeing a sharp increase in new credit card and auto loan arrears for borrowers with eligible student loans in recent quarters, which have been growing faster than those without student loans and those with ineligible loans,” they wrote.

These missed payments indicate that some federal student loan borrowers are struggling to meet their monthly debt obligations. “We expect that if federal student loan payments resume without relief, these delinquency patterns will worsen,” the report said.

The data “may portend problems to come, a sign of economic hardship that may arise, particularly in relation to the resumption of the burden of student loan payments.”

Future worries: If student loan borrowers anticipate future debt relief, they could borrow even more, the researchers said, which would increase debt balances even more. “Without direct action to deal with this growing burden, taxpayers could be asked to provide further relief in the future,” they concluded.