– Case for Tightening ‘Clear-Cut’ But Speed ‘An Open Question’
– Hiking Rates Too Fast Could Create ‘Strains,’ Increase Recession Risks
– Warns of Inverting Yield Curve, Upsetting Markets While Shrinking Balance Sheet
– Urges More ‘Steady’ And ‘Predictable’ Rate Hikes
By Steven K. Beckner
(MaceNews) – Kansas City Federal Reserve Bank President Esther George issued strong words of caution about raising interest rates too fast Monday morning.
George, who dissented against the Fed’s 75 basis point hike in the federal funds rate in favor of a smaller move on June 15, warned of potential conflict with the Fed’s simultaneous balance sheet reduction, and said overly rapid funds rate hikes could invert the yield curve, cause market dysfunction and increase recession risks.
While the Fed does need to move “decisively” against inflation, she counseled more “steady” and “predictable” rate hikes in a speech to the Mid-America Labor/Management Conference in Lake Ozark, Missouri.
At its June 14-15 meeting, the Federal Open Market Committee raised the funds rate target 75 basis points to a range of 1.5% to 1.7%, and the minutes show participants envisioned a further 50 or 75 basis point hike at their late July meeting and continued rate increases thereafter. Officials thought “an even more restrictive” monetary stance than then anticipated might become necessary to bring demand and supply back into balance to curb inflation that was running far above the Fed’s 2% target.
However, George, who ordinarily is considered one of the more “hawkish” Fed presidents, took a different view, favoring only a 50 basis point rate hike. And she made clear Monday that she would continue to take an incremental approach to monetary tightening.
She did not deny the pressing need to combat inflation, saying, “the Fed must act decisively to bring inflation down and reestablish price stability ….. Strong demand for goods and services has been outpacing lagging supply for some time, resulting in a tight economy with prices rising as a consequence ….”
George said “the broad-based nature of inflation suggests that a tight economy is driving price pressures rather than individual supply disruptions and shocks.”
Elaborating on the causes of the highest inflation in more than 40 years, she observed, “the federal government has provided about $6 trillion of fiscal stimulus since the start of the pandemic. Monetary policy was also very accommodative, as the Federal Reserve cut interest rates to zero and added over $4 trillion to its balance sheet.”
At the same time, she cited “long-lasting damage to the supply side of the economy as a result of the pandemic.” She further noted that “the labor market is considerably stronger and tighter than it was before the pandemic. Both constrained labor supply and exceptionally strong labor demand are shaping this outcome.”
Echoing Chairman Jerome Powell and other Fed policymakers, George said monetary policy can’t reverse supply shocks but can “moderate the pace of demand growth to narrow imbalances in the economy and reduce price pressures.” And she added, “to promote sustainable growth, monetary policy must therefore take decisive steps to tighten financial conditions and bring inflation down.”
But while George’s diagnosis of the inflation task facing the Fed does not differ markedly from those of her colleagues, her preferred policy response does.
“With the policy rate still relatively low and a $9 trillion dollar balance sheet in the early stages of shrinking, the case for continuing to remove policy accommodation is clear-cut,” she said. “The speed at which interest rates should rise, however, is an open question.”
George described herself as “certainly sympathetic to the view that interest rates need to increase rapidly, recognizing that current rates are out of sync with today’s economic landscape.”
“However,” she added, “I am also mindful of how the rate of change in tightening policy can affect households, businesses, and financial markets particularly during a time of heightened uncertainty.”
“Policy changes transmit to the economy with a lag, and significant and abrupt changes can be unsettling to households and small businesses as they make necessary adjustments,” she continued. “It also has implications for the yield curve and traditional bank lending models, such as those prevalent among community banks. For these reasons, several considerations influence my own thinking about the appropriate path for policy.”
George went on to detail the three main problems she sees with overly rapid rate hikes.
First, “communicating the path for interest rates is likely far more consequential than the speed with which we get there,” she said. “Moving interest rates too fast raises the prospect of oversteering.”
Noting that financial conditions have already tightened over and above actual Fed rate hikes, she said, “this is already a historically swift pace of rate increases for households and businesses to adapt to, and more abrupt changes in interest rates could create strains, either in the economy or financial markets, that would undermine the Fed’s ability to deliver on the higher path of rates communicated.”
George expressed concern about “growing discussion of recession risk, and some forecasts are predicting interest rate cuts as soon as next year.:
“Such projections suggest to me that a rapid pace of rate increases brings about the risk of tightening policy more quickly than the economy and markets can adjust,” she said.
Her second reason for proceeding cautiously is that “the transmission of higher policy rates and the associated tightening in financial conditions to spending, employment, and inflation is subject to considerable uncertainty.”
“For example, the shift in spending away from services to housing and durable goods during the pandemic may make the economy more sensitive to higher interest rates,” she continued. “Another possibility is that the significant accumulation of liquid savings during the pandemic will dampen the effects of higher interest rates on spending and ultimately inflation.”
“Given this range of outcomes, it is unclear just how high rates will need to move in order to bring inflation down,” she went on. “These dynamics suggest it will be particularly important to observe how the economy is adapting to changes in monetary policy.”
The third area of concern which George cited was that “the pace of increases in the federal funds rate could have implications for balance sheet runoff.”
“The economy is in unfamiliar territory, with a combination of high inflation and tight labor markets not witnessed in decades,” she elaborated. “Therefore, markets are understandably volatile as they grapple with the many unknowns surrounding the outlook for the economy and the path of policy.”
George said “limiting the extent to which uncertainty about the pace of interest rate adjustments contributes to this volatility could be important especially as balance sheet runoff gets underway.”
“Certainly, relative to the last time balance sheet reduction was initiated in 2017, market conditions are considerably more unsettled,” she continued. “To the extent that the current strains in the Treasury market can be attributed in part to heightened uncertainty about the path of policy rates, a steady path of rate increases, and predictably adjusting this path to incoming data, could improve market functioning and facilitate balance sheet runoff, especially as the pace of runoff accelerates later this year.”
George further warned that “raising short-term rates much faster than longer-term rates could further invert the yield curve and challenge traditional bank lending models as a consequence. To the extent an inverted yield curve has historically preceded recessions in the United States, such a scenario could pose yet another challenge to achieving a significant reduction in the balance sheet.”