– But FOMC Will Withdraw Monetary Stimulus ‘Carefully’ To Avoid ‘Adding Uncertainty’
– Ultimate Aim is ‘Neutral’ Rate of 2-2.5%; Perhaps Higher; Must Act ‘With Care’
By Steven K. Beckner
(MaceNews) – Russia’s invasion of Ukraine will not prevent the Federal Reserve from beginning to raise interest rates in two weeks, but it will make the Fed more cautious about withdrawing monetary stimulus to bring inflation under control, acting Fed Chair Jerome Powell made clear Wednesday
Powell said he and his fellow policymakers will raise the federal funds rate from near zero and halt new bond buying on March 16, but repeatedly stressed the central bank will need to proceed “carefully” to avoid “adding to the uncertainty” generated by the Ukraine crisis and its knock-on effects.
Powell said he will propose a 25 basis point hike in the federal funds rate on March 16. Beyond that, he anticipated “a series” of rate hikes, but said the extent of those hikes is hard to determine at this point.
He said the Fed’s plan, before the Ukraine war, was to move rates to “a more normal level of rates — and perhaps tighter,” but he suggested that plan has now become more subject to doubt.
Powell’s testimony comes two weeks ahead of an anxiously awaited March 15-16 meeting of the Fed’s rate-setting Federal Open Market Committee. On Jan. 26, the FOMC left monetary policy unchanged, but strongly signaled that, at its upcoming meeting, it would start withdrawing the emergency monetary stimulus initiated two years ago to support the economy in face of Covid-19.
As the March meeting approached, Fed watchers were anticipating a fairly aggressive FOMC policy decision, along with an increase in FOMC rate projections. But then a week ago, Russia invaded Ukraine, unleashing incalculable economic and financial repercussions for the United States and the world.
The Monetary Policy Report, released last Friday, acknowledged the potential impact of the fighting in Ukraine, saying, “Recent geopolitical tensions related to the Russia–Ukraine situation are a source of uncertainty in global financial and commodity markets.”
Before the invasion, financial markets were pricing in five or more 25 basis point rate hikes this year, above the three projected by FOMC participants in December, along with balance sheet reduction. Some Fed officials were calling for an initial 50 basis point hike on March 16.
Now, many Fed watchers expect the FOMC to be less aggressive – an impression reinforced by some Fed officials before the Powell testimony. Governor Christopher Waller, among the more “hawkish” FOMC members, said the Russian invasion could change the economic outlook and “may mean a more modest tightening is appropriate.” Cleveland Federal Reserve Bank President Loretta Mester said the war risks higher inflation but also hurts prospects for growth.
Powell told the House Financial Services Committee “the near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain. Making appropriate monetary policy in this environment requires a recognition that the economy evolves in unexpected ways. We will need to be nimble in responding to incoming data and the evolving outlook.”
Nevertheless, Powell said the FOMC remains on track to lift off the zero lower bound for short-term interest rates in mid-March, then start reducing the Fed’s near $9 trillion balance sheet.
“With inflation well above 2% and a strong labor market, we expect it will be appropriate to raise the target range for the federal funds rate at our meeting later this month,” he said in prepared testimony, adding, “Reducing our balance sheet will commence after the process of raising interest rates has begun, and will proceed in a predictable manner primarily through adjustments to reinvestments.”
Not only has the Fed surpassed its inflation target, it has met its “maximum employment” objective, said the Fed chief, who was testifying as chair pro tempore pending Senate confirmation of President Biden’s nomination for another four-year term.
Pointing to the economy’s 5.5% growth rate last year, Powell said “the labor market is extremely tight.” And he added, “wages are rising at their fastest pace in many years.”
While reiterating his expectation will moderate, Powell said the FOMC must guard against upside risks.
“We continue to expect inflation to decline over the course of the year as supply constraints ease and demand moderates because of the waning effects of fiscal support and the removal of monetary policy accommodation,” he said. “But we are attentive to the risks of potential further upward pressure on inflation expectations and inflation itself from a number of factors.”
“We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and a strong labor market,” he added.
However, Powell conveyed a cautious approach as he responded to questions from members of Congress.
“Coming into this meeting, let’s say before the Ukraine invasion, the Committee was set to raise our policy rate – the first of what was to be a series of rate increases expected for this year,” he said. “Every meeting was live; decisions would based on incoming data and the evolving outlook. We also expected to make great progress on our plan to shrink the balance sheet.”
Now, Powell went on, “the question now really is how is how the invasion of Ukraine, the ongoing war, the response from nations around the world, including sanctions, may have changed that expectation.”
“It’s too soon to say for sure, but for now I would say that we will proceed carefully along the lines of that plan,” he continued. “The thing is the economic effects of these events are highly uncertain. So far we’ve seen energy prices move up further, and those increases will move through the economy and push up headline inflation and also (impact) spending We’re seeing effects on other commodities and perhaps undermining risk sentiment and weaker growth abroad.”
“The thing is we can’t know how large or persistent those effects will be …,” he added.
Elaborating on “where that leaves me,” Powell said, “I do think it will be appropriate to raise our target range for the federal funds rate at the March meeting in a couple of weeks.” And he said he is “inclined to propose and support a 25 basis point rate hike ….”
Powell also said he expects the FOMC “will make good progress on a plan to shrink balance sheet,” but said, “We will not finalize that plan at this meeting. We’ll do that when we think the time is right ….”
Powell said, “the bottom line is that we will proceed,” but “we will proceed carefully as we learn more about the implications of Ukraine war for the economy. We will use our tools to support financial stability and macroeconomic stability.”
“We are going to avoid adding uncertainty to what is already an extraordinarily challenging (situation),” he added.
Powell said the Fed’s task is to “move away from these highly accommodative settings to more appropriate settings ….” A funds rate near zero “is not an appropriate level going forward .… It’s appropriate we engage in a series of rate increases over the course of the year” and reduce the balance sheet.
Powell said the FOMC’s ultimate aim is to “return the balance sheet to the size relative to the economy that it was before” the Fed began massive bond buying in March 2020. He said that will take about three years.
Powell said the economy is strong enough that it “can take” a series of rate hikes, and he expressed confidence that the Fed can achieve a “soft landing” – reducing inflation while sustaining expansion and maximum employment.
But he again emphasized the FOMC will raise rates and shrink its balance sheet “with care, particularly now” and reiterated “we’re going to move carefully.”
Echoing New York Federal Reserve Bank President John Williams, Powell said the Fed eventually wants to get the funds rate to a “more normal” or “neutral” level of rates.
The FOMC estimates the nominal “longer run” funds rate at 2.5%, but that estimate of the “neutral” rate could change depending on how Fed officials reassess the “real” component and whether or not inflation is, in fact, returning to the FOMC’s 2% average target.
Powell suggested the funds rate may eventually need to go above neutral, though not any time soon. “We’ve talked about getting to a neutral rate, which would be somewhere between 2 and 2 ½. It may well be we need to go higher than that. We just don’t know.”