By Steven K. Beckner
(MaceNews) – It now seems all but guaranteed that the Federal Reserve will raise short-term interest rates for a second straight Federal Open Market Committee meeting in early May, but it is less certain what the Fed will do thereafter.
With a 50 basis point hike in the federal funds rate on May 4 considered a foregone conclusion, the real question is where the FOMC goes from there and how fast.
Various Fed officials have advocated a steep upward rate path, but for all the belatedly bold talk of rushing the federal funds rate to “neutral” and then into restrictive territory, one has to wonder whether Fed policy-makers will really be willing to keep ratcheting rates higher in the face of proliferating signs of economic slowing, mounting global downside risks and tightening financial conditions.
First things first.
At their May 3-4 FOMC meeting, Federal Reserve policy-makers will decide whether to quicken the pace of monetary firming to try to regain control of an alarming inflationary process which they helped unleash by overstaying their emergency-anti-pandemic monetary stance.
After finally leaving the zero lower bound on March 16 with a 25 basis point hike in the funds rate, the question on the FOMC table will be whether to accelerate the pace at which that key short-term interest rate is returned to some semblance of neutrality.
The outcome is not predetermined, but there appears to be overwhelming support among Fed governors and Federal Reserve Bank presidents to move the funds rate up by 50 basis points this time, which would take the target range to 50-100 basis points. Chairman Jerome Powell sent a strong signal to that effect in his last pre-FOMC comments on April 21.
Whether or not the FOMC decides to take a larger rate step, it seems very likely to launch a near-term reduction of its $9 trillion balance sheet, guidelines for which were previewed in minutes of the March 15-16 meeting.
But all we have are projections for the funds rate, which won’t be revised until the June 14-15 meeting.
Even more “dovish” or, if you like, complacent Fed officials now recognize the United States faces an inflationary threat that could subvert the central bank’s reputation for protecting price stability which the Fed won at considerable cost under Paul Volcker in the late 1970s and 80s.
More than the Fed’s cherished credibility is at stake. The purchasing power of the dollar, and its role in the world, is in jeopardy and with it global prosperity and stability.
After interminably hanging on to the “transitory” narrative and, in the case of some policy-makers, even talking up inflation and inflation expectations into last fall, the Fed now faces a scary prospect by almost any measure. The consumer price index rose 8.5% compared to a year ago in March. The producer price index for finished goods looks even more gruesome, having risen a record 11.2% year over year in March.
The Fed’s preferred gauge, the price index for personal consumption expenditures, looks better, rising 6.4% year-over-year in February, but that’s still more than triple the Fed’s target. Wages are also climbing, though not enough to keep up with price inflation. Average hourly earnings were up 5.6% last month.
So far, these wage-price pressures are occurring within a context of above-trend growth and tightening labor markets. The unemployment rate fell to 3.4% in March, even as the labor force participation rate ticked up to 62.4%.
So the case is strong for a 50 basis point hike, coupled with quick reversal of the Fed’s bond buying splurge.
And, indeed, Powell seemed to confirm that such a move is baked in the cake. Participating in a panel discussion at the International Monetary Fund’s spring meeting, he stopped short of explicitly predicting that outcome – something he has seldom been willing to do. But he said a 50 basis point move “will be on the table.”
What’s more, he compared the current inflation spike to the much slower pace of inflation during the 2006-08 tightening cycle, when the FOMC did a long sequence of 25 basis point rate hikes, and said “it is appropriate to be moving a little more quickly.”
Powell said he and his colleagues “had an expectation that inflation would peak around this time and come down over the course of the rest of the year and then further,” but acknowledged that “these expectations have been disappointed in the past …. We are not going to count on help from supply side healing. We are going to be raising rates.”
What’s more, Powell validated Wall Street expectations of the funds rate rising to between 2.75% and 3.00% by year’s end by saying markets were “reacting appropriately, generally.”
Another giveaway was when Powell said the Fed will be raising rates “expeditiously” toward neutral. He was repeating what has become a code word for aggressive rate action in the minds of Fed watchers.
That term of art originated at the March 15-16 FOMC meeting, minutes of which disclosed that “participants judged that it would be appropriate to move the stance of monetary policy toward a neutral posture expeditiously.”
Powell used the word “expeditiously” twice in a March 21 speech, viz, “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability.” And “the risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher, which underscores the need for the Committee to move expeditiously ….”
Since then, the word “expeditiously” has peppered remarks by other Fed officials.
Kansas City Federal Reserve Bank President Esther George, a voting member of the FOMC, said on March 30 that “moving expeditiously to a neutral stance of policy is appropriate ….”
Fed Vice Chair Lael Brainard used the term on April 5 and again on April 12. On the first occasion, she said, “Our communications have resulted in broad market expectations for an expeditious increase in the policy rate toward a neutral level and a more rapid reduction in the balance sheet compared with 2017–19.”
More recently, voting St. Louis Fed President James Bullard said, “What we need to do right now is get expeditiously to neutral and then go from there.” On April 20, San Francisco Fed chief Mary Daly joined the chorus: “I see an expeditious march to neutral by the end of the year as a prudent path. We will continue to evaluate the data and the risks, but today I see little indication that the economy needs policy accommodation.”
Richmond Fed President Thomas Barkin has also advocated an aggressive posture: “Without perfect foresight, the best short-term path for us is to move rapidly to the neutral range and then test whether pandemic-era inflation pressures are easing, and how persistent inflation has become. If necessary, we can move further.”
If it was only the hawkish Bullard saying it, it wouldn’t mean as much, but when erstwhile “doves” start talking about raising rates “expeditiously,” it takes on added meaning.
Even Chicago Fed President Charles Evans, who a year ago was pining for more inflation and worrying about a return of disinflation, said on April 19 that 50 basis point rate hikes “could make sense” and said the FOMC will “probably” have to push the funds rate beyond neutral.
Such rhetoric has to be taken seriously.
Bullard has called for a 3.5% funds rate by year’s end. Daly, Evans and others are talking about 2.5%. Both are far above the 1.9% median projection made by FOMC participants in the March Summary of Economic Projections. So, one would have to assume that if the “dot plot” were being revised now, the median would be much higher.
However, signaling a 50 basis point move on May 4 does not mean a series of large moves are inevitable at subsequent FOMC meetings. That may be the predominant mood now, but things can change. Indeed, it could be argued that things are changing.
Although Fed officials have generally been sounding more hawkish lately, one doesn’t have to go back very far to find a different tone. Interspersed with vows to combat inflation aggressively, there has been more gradualistic rhetoric. Since the March meeting, various Fed officials have used such words as “steady,” “deliberate,” “cautious,” “measured” and “methodical” to describe the proper pace of rate hikes.
Perhaps the most recent inflation data prompted a shift toward more hawkish rhetoric, but policy-makers have by no means abandoned their concern about downside risks.
Neither the cautionary words nor the more aggressive tightening ones should be taken at full face value in isolation. Looking beyond the May meeting, it might be better to balance them and take them in context.
The horrendous March inflation data make it hard for the FOMC not to approve a big increase on May 4, but subsequently the policy outlook remains in doubt.
Perhaps the most reliable policy statements are more conditional ones – to the effect that the Fed will raise rates more aggressively if inflation does not moderate. Policy-makers’ original thought was that they would give it until mid-year before making that determination. Going by that timetable they’ve still got a ways to go before committing to continued aggressive rate hikes.
Meanwhile, the Fed can get going emphatically with balance sheet reduction. They can also point to the tacit tightening they’ve already accomplished in financial conditions.
Powell and his fellow policy-makers are trying to walk a fine line and manage market expectations in the quest for a “soft landing.” They don’t want to trigger a major, lasting “tantrum” that could do enough economic damage to force them retreat from their anti-inflationary campaign. And they’re still hoping inflation will moderate.
While there is clearly a case for aggressive monetary tightening, there is also a four-fold case for a less aggressive approach.
First, there is the residual hope that inflation will moderate as the Fed has long hoped. Powell & Co. are no longer calling inflation “transitory,” but they have not given up on that thesis.
As Powell outlined in his March 16 press conference, “part of inflation coming down at the very beginning is clearly to do with factors other than our policy. And those would include potentially supply chains getting a little bit better. Certainly base effects you’re lapping when you look at a 12-month trailing window you’re lapping very high inflation in March, April, May June of last year so there should be effects from that in the 12 months picture. What we’re looking for is month by month inflation coming down.
Powell added that the Fed has been expecting a “shift away from goods and back to services, including supply chains getting better, including labor force participation.”
And “monetary policy starts to bite on inflation and on growth with a lag …,” Powell went on. “And so you would see more (inflation reduction) in ’23 and ’24. We started talking about rate increases last year …. (M)oves are priced into the market for a few months now. Some of that will be seen in the second half of the year as well.”
A second reason for moving more cautiously or incrementally is that past Fed actions and rhetoric have caused a significant tightening of financial conditions, as the Fed itself acknowledges. There has been a steady drumbeat of financial repercussions. Consider:
* bond yields have soared, with the 10-year Treasury note yield going as high as 2.9540%, compared to 1.5120% at the end of last year;
* the yield curve has flattened and at times inverted – a traditional advance warning of recession.
* mortgage rates have risen for seven straight weeks, pushing the 30-year fixed rate to 5.11%, highest in at least four years.
* Car and other borrowing costs are rising concurrently; the average new car loan with a 5-year term rose to 4.21% in early April vs. 3.86% at start of 2022.
* Investors have become “more skittish” about buying bonds backed by consumer debt.
* As the muni boom “sputters” in the face of rising interest rates, states and cities have been forced to cut bond prices to sell bonds
* Banks are facing the first fall in deposits since at least World War II.
* Equity prices have plunged in recent weeks on worries about higher rates and slowing growth.
A third possible reason for staying on a more gradual or incremental rate path is that this tightening of financial conditions has started to have an impact on economy, though not thus far on inflation. There are increasing signs of a cooling recovery. Among the straws in the wind:
* Real GDP unexpectedly shrank by 1.4% in the first quarter.
* Retail sales slowed in March, rising 0.5% after a revised 0.8% jump from January to February. Excluding an 8.9% increase from surging oil prices, overall retail sales were down 0.3%.
* The housing market isn’t looking quite as hot these days with mortgage rates surging.
For instance, existing home sales declined 7.2% in February from a month earlier.
* Manufacturing output rose 0.9% in March after growing 1.2% in February. The purchasing managers’ manufacturing index dropped 1.5 percentage points last month.
* The global economy is slowing even more, with the IMF further marking down its forecast for 2022 growth to 3.6% from last year’s 6.1% in its latest World Economic Outlook report.
* Even on the inflation front, there are signs of cooling. The core CPI, excluding food and energy, rose 0.3% in March, down from a 0.5% increase in February. Brainard called that “very welcome.”
The final argument for caution is the increase in downside risks from, among other things, Russia’s invasion of Ukraine and, most recently, China’s new draconian Covid lockdown.
So far, Powell and his colleagues have been tightening policy despite these downside risks, but that doesn’t mean those risks are insignificant.
At the mid-March FOMC meeting, the minutes say, “various participants noted downside risks to the outlook, including risks associated with the Russian invasion, a broad tightening in global financial conditions, and a prolonged rise in energy prices.”
Since then, while keeping their main focus on inflation, Fed officials have made clear they haven’t forgotten about potential threats to the other side of their dual mandate – “maximum employment.”
“Needless to say, in the current environment all forecasts are subject to a great deal of
uncertainty and risks,” Evans said. “Of course, two major sources of uncertainty today are the crisis in Ukraine and waves of the virus that currently are hitting abroad. Both of these present upside risks to inflation and downside risks to growth, and we will be monitoring their impact on the economy very closely.”
Evans added, “With all of the uncertainty we face today, policy-makers need to be cautious, humble, and nimble as we navigate the course ahead. Monetary policy is not on a preset course: Each meeting’s decision will be based on an assessment of economic and financial conditions at the time, as well as the risks to the outlook.”
Earlier this month, Brainard called Russia’s invasion of Ukraine “a seismic geopolitical event” that would “exacerbate high prices for gasoline and food as well as supply chain bottlenecks in goods sectors.” And she said, “the recent COVID lockdowns in China are also likely to extend bottlenecks.”
While exerting upward pressure on inflation, Brainard said “these geopolitical events also pose downside risks to growth.”
Thankfully, she added, “the U.S. economy entered this period of uncertainty with considerable momentum in demand and a strong labor market.” So, the Fed can afford to give “paramount importance to get inflation down. Accordingly, the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.”
But Brainard made clear that, as far as she’s concerned, the FOMC will also need to keep one eye on downside risks even as it tries to moderate inflation.
In Powell’s remarks at the IMF, he said the upward pressure on inflation from the war in Ukraine has been accompanied by “downward pressure” on growth.
Clearly, the current Fed consensus is that “upside risks to inflation outweigh downside risks to growth,” as Cleveland Fed President Loretta Mester has said, but it’s not hard to imagine that calculus changing as monetary restraint and other forces generate more evidence of economic slowing.
In fact, the March minutes provide an illustration of how downside risks can influence monetary policy. “Many participants noted that—with inflation well above the Committee’s objective, inflationary risks to the upside, and the federal funds rate well below participants’ estimates of its longer-run level—they would have preferred a 50 basis point increase in the target range for the federal funds rate at this meeting,” the minutes say.
But “a number of these participants indicated, however, that, in light of greater near-term uncertainty associated with Russia’s invasion of Ukraine, they judged that a 25 basis point increase would be appropriate at this meeting.”
Going forward, we should expect that downside risks to growth and employment – not just inflation risks – will continue to impact policy. They may not cause the FOMC to pause, but they could certainly slow the pace of tightening.
Brainard suggested as much in her April 5 remarks: “Looking forward, at every meeting, we will have the opportunity to calibrate the appropriate pace of firming through the policy rate to reflect what the incoming data tell us about the outlook and the balance of risks.”
“For today, every indicator of longer-term inflation expectations lies within the range of historical values consistent with our 2 percent target,” she continued. “On the other side, I am attentive to signals from the yield curve at different horizons and from other data that might suggest increased downside risks to activity.”
Powell, like predecessor Janet Yellen and other administraion figures, have put much of the blame for inflation on supply constraints and shortages – both in the goods and labor markets. But of course, prices are set by the interaction of supply and demand.
The Fed can’t do a lot about supply, but it has a lot to do with demand, and there’s not much question that the Fed squeezed available supplies by stimulating demand well past the point that it was needed – not just by holding short-term interest rates near zero but by facilitating massive fiscal stimulus as it accommodated unprecedented federal deficit spending through its massive purchases of securities to hold down long-term borrowing costs.
Now the Fed must try to compensate for its inflationary policies while still seeking to fulfill its full employment mandate. Whether it can accomplish both will be one of the greatest challenges in the U.S. central bank’s 109-year history.
In nearly every public comment, Powell and his colleagues have stressed their intention to bring inflation back down toward the 2% target without harming the recovery or causing a recession. They have expressed confidence that, going into this tightening cycle, the economy was strong enough to withstand higher interest rates.
They haven’t promised a “soft landing,” but that is the underlying assumption of the March SEP, which projected continued above-trend GDP growth and 3.5% unemployment this year and next even as the funds rate was projected to go to 2.8% by the end of next year – four-tenths above the “longer run” neutral rate.
At this point, the FOMC has barely begun to tighten. Even if funds rate is raised 50 basis points on May 4, it will remain well below neutral and even more deeply negative in real terms.
There will come a point, especially if the FOMC accelerates the tightening pace, when it will face the moment of truth which every central bank does – is it willing to keep raising rates fast enough to curb inflation even at the risk of recession?
Much as Fed policy-makers try to convince themselves (and us) that a “soft landing” is possible, history suggests that may be very hard to accomplish. The Fed’s task becomes even more difficult when it gets little effective support from fiscal and regulatory policy.
When Volcker led his storied anti-inflationary battle, he had the benefit of support from President Reagan, who vocally backed Volcker’s monetary policy, and reappointed him even after the U.S. economy sank into recession and threatened his own reelection.
That’s not all. While the Fed was dampening demand, the Reagan administration worked with a then-divided Congress to promote supply side growth. It pursued a sounder fiscal policy, curbing federal deficit spending even while cutting marginal tax rates. In addition to cutting taxes, the Reagan administration built on deregulatory efforts begun under President Carter.
The cumulative result was to “restore balance between supply and demand,” just as Powell now says is needed. The difference these days is that the Biden administration wants to increase taxes and is steadily increasing all kinds of business regulations, especially in the energy sector.
Essentially, the Fed will be going it alone this time.
Fed policymakers’ will and their willingness to risk a harder landing could be severely tested. When faced with this kind of dilemma in the past, the Fed has usually blinked, particularly when recessionary risks were accompanied by financial turmoil. And that was without a policy framework putting even more emphasis on achieving “maximum inclusive employment” while allowing some overshooting of inflation.
Despite their repeated vow to “use their tools” to conquer inflation, Powell and most of his colleagues are not entirely comfortable with going full bore against inflation regardless of the economic consequences. Their premise is that the economy is strong enough to “take” higher rates, but it is highly doubtful whether they’re prepared to ignore downside risks if they become more pronounced. If the “soft landing” assumption comes into question, they may not be as gung ho.
So, while a 50 basis point hike at the upcoming meeting seems certain, don’t assume that the FOMC will keep raising rates at such a fast clip.