– Jefferson: Must Be Mindful of Downside Risks; Tighter Financial Conditions
– Dallas Fed’s Logan: Must Stay Restrictive to Cut Inflation ‘In Timely Way’
By Steven K. Beckner
(MaceNews) – Federal Reserve Vice Chair Phillip Jefferson declined Monday to conclude that the Fed has raised interest rates enough but said it should be careful to avoid making monetary policy too restrictive, especially in a climate of tightening financial conditions.
“Even though recent inflation data have been encouraging, inflation remains too high,” Jefferson told the annual meeting of the National Association for Business Economics, but he said the Fed should “proceed carefully as the risks of tightening monetary policy too much relative to those of not tightening enough move closer into balance.”
Jefferson also indicated he and his fellow policymakers will need to cautiously parse why long-term interest rates are rising sharply even as the Fed has dramatically showed increases in short-term rates.
He said rising bond yields “may reflect investors’ assessment that the underlying momentum of the economy is stronger than previously recognized and, as a result, a restrictive stance of monetary policy may be needed for longer than previously thought in order to return inflation to 2%.” But he said increases in real yields can also arise from “changes in investor’s attitudes toward risk and uncertainty.”
Jefferson said he and his fellow policymakers will need to assess financial conditions and their underlying causes in setting the federal funds rate target.
Earlier, Dallas Federal Reserve Bank President Lorie Logan said ,“we will need continued restrictive financial conditions to return inflation to 2% in a timely way,” while saying the extent of further short-term interest rate hikes will depend on overall financial conditions, in particular long-term rates.
Bond yields have spiked in recent months, amid conflicting suppositions as to the cause. Logan, a voting member of the Fed’s rate-setting Federal Open Market Committee, stressed that the reasons for that uptrend matter for monetary policymakers.
“If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate,” she told the NABE. “However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more.”
Jefferson and Logan spoke in wake of a stronger than expected September employment report that reinforced the spike in bond yields. The 10-year Treasury note yield has soared 90 basis points since July, undermining stock prices and threatening the housing recovery.
After raising the federal funds rate by 25 basis points in July, the FOMC left that key money market rate in a 5.25% to 5.5% target range on Sept. 20, but retained a tightening bias in its policy statement, which Chair Jerome Powell reinforced in a press conference.
“We are prepared to raise rates further if appropriate, and we intend to hold policy at a restrictive level until we are confident that inflation is moving down sustainably toward our objective,” he said, but added the FOMC is “in a position to proceed carefully.”
Powell said 525 basis points of cumulative tightening had left rates “meaningfully positive” in real terms, and said the Fed is “close” to where it needs to be. But he and he and his colleagues believe “one more hike” before year’s end is needed. Since the September meeting, New York Fed President John Williams and others have said the funds rate is “at or near the peak.”
In their revised, quarterly Summary of Economic Projections, the 19 FOMC participants projected that the funds rate will end 2023 at a median 5.6%. Next year, they projected the funds rate will end at 5.1% compared to 4.6% in June — a sharp reduction in expected rate cuts, especially when compared to the March projection of 4.3%.
The revised rate projections were accompanied by notable changes in FOMC participants’ economic forecasts. GDP was forecast to grow by 2.5% in 2023, up from 1.0% in June and by 1.5% in 2024, up from 1.1%. The unemployment rate was seen ending at 4.1% next year – down from 4.1% and 4.5% in June. They saw inflation, as measured by the price index for personal consumption expenditures (PCE), ending this year at 3.3% and next year at 2.5%, compared to 3.2% and 2.5% in the June SEP. They forecast the core PCE to end 2023 at 3.7% and 2024 at 2.6%., compared to June forecasts of 3.9% and 2.6%.
Jefferson, who became vice chair less than a month ago after joining the Board of Governors May 23, 2022, stepped lightly in his first major policy address as Powell’s top lieutenant, staking out a middle ground between hawkish and dovish positions.
“After increasing the target range for the federal funds rate by 525 basis points since early 2022, my view is that the FOMC is in a position to proceed carefully in assessing the extent of any additional policy firming that may be necessary,” he said.
“We are in a sensitive period of risk management, where we have to balance the risk of not having tightened enough, against the risk of policy being too restrictive,” he continued. “The balancing of these two risks was a good reason for holding the policy rate constant at our most recent FOMC meeting.”
Pointing to the sharp rise in long-term rates, Jefferson vowed to “remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy.”
“I will be taking financial market developments into account along with the totality of incoming data in assessing the economic outlook and the risks surrounding the outlook and in judging the appropriate future course of policy,” he added.
While calling inflation data “encouraging,” Jefferson said, “we will need to see further slowing in this area to meet our inflation objective. Nevertheless, I believe that core PCE prices will moderate further as the labor market comes into better balance.”
Referring to the Labor Department’s report that non-farm payrolls jumped 336,000 last month, Jefferson said, “Despite the strong September labor market data we received last week, there is evidence that the imbalance between labor demand and labor supply continues to narrow, as labor demand cools while labor supply improves. Even so, the labor market remains tight.”
Echoing Powell, he suggested there is hope for a “soft landing” of the economy. “The fact that the unemployment rate and layoffs have remained low over the past year amid disinflation suggests that there is a path to restoring price stability without the kind of substantial increase in unemployment that has often accompanied significant tightening cycles.”
Jefferson said his expectation is for “further gradual easing in labor market conditions, as restrictive monetary policy continues to slow labor demand without causing an abrupt increase in layoffs or the unemployment rate.”
But he wasn’t entirely optimistic, saying he attaches “a high degree of uncertainty to my outlook and see multiple risks.”
Though he is “particularly attentive to upside risks to inflation,” Jefferson said “there are also important downside risks to economic activity, such as the slowdown in foreign economic growth.”
He also cited risks posed by tighter financial conditions. Not only do higher market rates
increase borrowing costs for households and businesses face, dampening spending and investment,
he said they “raise the exchange value of the dollar, which then boosts imports and reduces exports.” Rising yields also “reduce the value of the stock market, which then reduces consumption through wealth effects and business investment through the cost of capital.”
“In addition, monetary policy affects risk premiums,” he said. “Tighter monetary policy tends to reduce the willingness of investors to bear risk, increasing yield spreads and reducing the prices for a range of asset classes…”
Jefferson seemed to suggest tighter financial conditions may make him hesitant about supporting further funds rate hikes.
“Given that this additional tightening is in train, it may be too soon to say confidently that we’ve tightened enough to return inflation to our 2% target,” he said. “At the same time, I will be mindful of the additional tightening in train because of our past rate hikes as I consider whether there is a need to tighten policy further in the future.”
Responding to questions, Jefferson said he intends to “be mindful of the restrictive stance of policy (already in place) — that the cumulative effect of past rate increases has not yet been fully felt…”
“I have to be mindful that there still is in train some restriction associated with what we’ve already done, which could influence what I think should happen next,” he added.
Jefferson said the FOMC must be “nimble.” He declined to say when he thinks the FOMC should discontinue or phase our “quantitative tightening” or whether it should halt balance sheet shrinkage before or after the FOMC starts cutting the funds rate.
Logan lived up to her reputation as one of the more hawkish FOMC members in her earlier speech to the NABE.
“(I)nflation remains too high, the labor market is still very strong, and output, spending and job growth are beating expectations,” she said in prepared remarks. “I anticipate that we will need continued restrictive financial conditions to return inflation to 2% in a timely way and sustainably achieve our goals of maximum employment and price stability.”
Logan found encouragement in recent data, but not enough to warrant the Fed calling off its war on inflation.
“Over the summer, we saw welcome progress on inflation,” she said. “However, the monthly inflation data have been somewhat uneven…..(W)aiting to declare victory until 12-month inflation rates get all the way back to target would be a recipe for undershooting our inflation target….”
Citing “some further improvement” in the PCE inflation gauge, Logan said, “These developments are encouraging, but it is still too soon to say with confidence that inflation is headed to 2% in a sustainable and timely way.”
In wake of the Labor Department’s report that non-farm payrolls jumped 336,000 last month, Logan said, “While the job market isn’t as hot as it was a year ago, it remains very strong overall…..”
She expressed doubt that labor supply and demand are “in balance,” a condition Powell and his colleagues have repeatedly stipulated. And she said, “wages are rising faster than would be consistent with 2 percent inflation in the long run…”
Logan also pointed to “broad-based” strength in the economy before saying, “Putting all this information together, I expect that continued restrictive financial conditions will be necessary to restore price stability in a sustainable and timely way.”
She said she is “attentive to risks on both sides of our mandate,” but said “high inflation remains the most important risk. We cannot allow it to become entrenched or reignite.”
Logan devoted much of her remarks to trying to explain what’s driving bond yields. She said a number of different factors are involved in the yield spike, and said the Fed needs to figure out the main cause to make sensible policy decisions.
She said longer-term rates “influence economic activity more directly than does the fed funds rate. Yet the relationship between the fed funds rate and longer-term rates is not fixed. So, in setting the stance of monetary policy, the FOMC needs to account for how that stance will translate to the broader financial conditions, including long-term rates as well as credit spreads and other factors, that influence economic activity….”
In Logan’s view, “the rise in rates has come almost entirely in real interest rates. Inflation compensation has hardly moved. Market participants remain confident, as they should, that the FOMC will achieve the inflation target…..”
She gave “several reasons why longer-term rates may have risen. First, market participants may anticipate that the economic data will call for a higher fed funds rate target in the next few months or years. Second, market participants may judge that overnight rates will be higher, on average, over the long term, as a result of lasting changes in the structure of the economy or financial system. And, third, term premiums may have increased…..”
Logan said, “market participants understand that, to the extent stronger economic growth poses risks to inflation, the FOMC may need to offset that strength with higher interest rates….”
“(T)he economy has shown surprising resilience over the past year in the face of sustained real interest rates north of 1.5%,” she elaborated.
Logan added she is “starting to take some signal from that resilience, not only about the rates needed to restore price stability in the next few years, but also about the rates that will need to prevail to sustain price stability and maximum employment over a much longer horizon.”
“And higher term premiums have a different implication altogether,’ she went on. “Higher term premiums result in higher term interest rates for the same setting of the fed funds rate, all else equal. Thus, if term premiums rise, they could do some of the work of cooling the economy for us, leaving less need for additional monetary policy tightening to achieve the FOMC’s objectives….”
Logan, who ran the New York Fed’s open market trading desk before becoming Dallas Fed President in August 2022, estimated “more than half of the total increase in long-dated yields since the July FOMC reflects rising term premiums….”
“I see a mixed story,” she continued. “There is a clear role for increased term premiums in recent yield curve moves. But the size and persistence of the contribution are subject to uncertainty.”
Regarding the Fed balance sheet, Logan referenced the July FOMC minutes statement that runoff of the Fed’s bond portfolio “need not end when the Committee eventually begins to reduce the target range for the federal funds rate.”
Then she added, “In my view, while it is far too soon to think about rate cuts in our monetary policy strategy, there will presumably come a time when we are returning the fed funds rate to a neutral level from above.”
“Normalizing the fed funds rate in that way would be entirely consistent with continuing to normalize our asset holdings,” she continued. “Additionally, the more than $1 trillion of balances in the overnight reverse repurchase agreement facility leave plenty of room to reduce our balance sheet without making bank reserves scarce.”
“As market participants have taken on board these perspectives on the balance sheet, market expectations for the end of runoff have shifted out,” she went on. “In turn, the expectation of lower Federal Reserve asset holdings over time implies that other investors will need to hold more long-duration securities, which appears to be one factor among the many contributing to higher term premiums.”