– Key To Watch Is How Much Higher Fed Officials Move Their 2023 Rate Dots
By Steven K. Beckner
(MaceNews) – The Federal Reserve has well prepared financial markets for another “unusually large” interest rate increase in mid-December – just not quite as aggressive as we’ve seen since the spring.
The Fed, nevertheless, is struggling with ongoing communications problems, and the forthcoming deceleration of rate hikes will present a tough challenge for Chair Jerome Powell and his colleagues.
After four straight 75 basis point moves, the Fed’s rate-setting Federal Open Market Committee seems likely to raise the federal funds rate by just 50 basis points on Dec. 14 to close out the year with the policy rate in a target range of 4.25% to 4.50%.
Some Fed watchers are still calling for yet another 75 basis point move but that seems improbable based on what officials have been saying.
The FOMC will almost certainly retain the language adopted in its Nov. 2 policy statement, namely that it “anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time. In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
A slowing of the pace of rate hikes to 50 basis points was clearly signaled by Powell less than two weeks before the meeting. Because monetary policy affects the economy and inflation with “uncertain lags,” and because “the full effects of our rapid tightening so far are yet to be felt,” he said, “it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down.”
“The time for moderating the pace of rate increases may come as soon as the December meeting,” Powell added in Nov. 30 remarks at the Brookings Institution.
Vice Chair Lael Brainard and others had previously sent similar signals. Even Governor Christopher Waller and voting Cleveland Federal Reserve Bank President Loretta Mester, no doves, are on board, the former saying, “the data of the past few weeks have made me more comfortable considering stepping down to a 50-basis-point hike.”
Minutes of the Nov. 1-2 FOMC meeting disclosed, “a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability.”
Powell and other Fed officials have stressed since the November meeting that the level of the funds rate, not the pace of rate hikes, matters most. But they have also emphasized the great “uncertainty” about the “terminal” funds rate.
That “uncertainty” is reflected in the fact that the higher rates have gone, the more differences have emerged about the appropriate level. While some officials think money remains too cheap in real terms and argue for much higher rates, others caution against “over-tightening.”
It all makes for a potentially stormy policy debate at the Dec. 13-14 meeting, complicating the communication task.
It helps that FOMC participants will publish a new quarterly Summary of Economic Projections, including revised funds rate “dots.” That will go far toward imparting the central bank’s intent. And, of course, Powell’s post-FOMC comments will be closely parsed for hints on the future course of policy.
Though the final 2022 rate hike will be more modest, that should not be taken as a signal that the Fed is on the verge of winding down its war on in inflation. That, at least, is what the Fed leadership would have us believe.
To the contrary, many Fed policymakers are letting it be known they are ready to move rates higher next year than they had planned and keep them higher for longer to push inflation down to the Fed’s 2% target.
Powell himself said as much in his Brookings talk. Reiterating what he said in his Nov. 2 press conference, he said “it seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections. .… (W)e have more ground to cover.”
Governor Michelle Bowman said she plans to move her funds rate projection “slightly higher” in the December SEP. Chicago Fed President Charles Evans, a reputed dove soon to be replaced by former White House economic advisor Austan Goolsbee, said, “We probably are going to have to have a slightly higher peak rate of the funds rate, even as we likely will step down” the pace.
Similarly, New York Fed President John Williams said “stronger demand for labor, stronger demand in the economy than I previously thought and then somewhat higher underlying inflation suggest a modestly higher path for policy relative to September — not a massive change, but somewhat higher.”
Curiously, minutes of the November meeting cast doubt on how much higher officials think the funds rate needs to go. “Many participants commented that there was significant uncertainty about the ultimate level of the federal funds rate needed to achieve the Committee’s goals and that their assessment of that level would depend, in part, on incoming data,” they say.
“Even so, various participants noted that, with inflation showing little sign thus far of abating, and with supply and demand imbalances in the economy persisting, their assessment of the ultimate level of the federal funds rate that would be necessary to achieve the Committee’s goals was somewhat higher than they had previously expected,” the minutes add.
It’s hard to say what FOMC Secretary James Clouse meant by “various participants,” but considering that the chair himself said rates would probably have to go higher, it seems odd that only “various” officials held that view. Maybe more just didn’t express themselves on the point. But in a different context, the minutes describe support for slowing as coming from “a substantial majority.”
Of course, the minutes reflect thinking of more than a month ago.
It will be interesting to see how much higher FOMC participants take their funds rate projection above the 4.6% median rate for 2023 projected in September. It’s not clear what Bowman and Evans meant by “slightly.” The proof of the pudding will be in the December SEP.
If the intended message is that the Fed is not in retreat, Powell & Co. are having trouble convincing markets. His heavy hint at the end of November that the FOMC will slow the pace at its Dec. 13-14 meeting was taken on Wall Street as delimiting the cumulative amount of rate hikes through this tightening cycle, witness the huge rally that followed Powell’s latest remarks.
Powell didn’t vary his message very much from his Nov. 2 post-FOMC press conference — namely, that it’s time to slow the pace, but that doesn’t mean the Fed is discontinuing monetary tightening; that the Fed still has “more work” to do; it’s “premature” to think of easing, or even pausing, and ultimately rates need to go higher than once thought.
The problem is markets don’t seem to be getting the message. Much as Powell & Co. try to emphasize their commitment to reducing inflation, sticking with it “until the job is done,” aiming at “higher for longer” rates, etc., markets don’t really believe them. In the minds of many, downshifting to smaller dosages of tightening is tantamount to stopping it. The result has been an easing of financial conditions which runs counter to the Fed’s stated objective of slowing demand to bring it back into balance with supply to reduce inflation.
Perhaps Powell and others’ ever more frequent admonitions about “over-tightening” are being heard as a contradictory signal – that a nervous Fed is getting to the point of calling a halt, despite what they say.
Mixed messages are being perceived. Better looking inflation numbers, together with signs of labor market softening and slower growth, contribute to that perception – or misperception if you like.
Pity poor Powell, who is dealing with evident widening divergences among fellow policymakers, not to mention stirrings of political pressure. One wonders if he is trying to reconcile the “hawks” and “doves” in his midst – reaffirming a commitment to fighting inflation whatever it takes on the one hand, while simultaneously inveighing against “over-tightening.”
In good part, the Fed is basing the coming shift to a more tentative, incremental strategy on its own rosy inflation forecasts. In the September SEP, FOMC participants forecast that inflation, as measured by the Fed’s preferred gauge the Price Index for Personal Consumptions Expenditures (PCE) will fall to 2.8% next year and to 2.6% in 2024. They forecast that core PCE inflation will recede to 3.1% then to 2.3%.
But Fed forecasts are notoriously unreliable. True, inflation has moderated, but in October, the overall PCE index still rose 0.3% and 6.0% from a year ago, same as in September. The core PCE looked a little better, rising 0.2% for October and 5% from a year earlier (down from 5.2% in September).
The consumer price index looks worse. The year-over-year CPI rise has fallen from a June peak of 9.1%, but still rose 7.7% in October. Core services inflation has accelerated while goods prices have calmed down, leaving a persistent underlying rate to bedevil the Fed.
The National Association for Business Economics’ new outlook survey shows members continue to raise their inflation expectations. They expect the overall CPI to be up 8.1%, year-over-year, in 2022—compared to the 8.0% forecast in the NABE’s October 2022 survey. It is expected to remain elevated in 2023 at 4.2%. They see the unemployment rate rising to 4.5% next year, and most see a better than 50-50 chance of recession. Stagflation anyone?
The Fed also worries about wage pressures in an “extremely tight” labor market. Although officials deny there is a “wage-price spiral,” they fear one could develop if inflation remains elevated. Two days after Powell lamented that “wage growth remains well above levels that would be consistent with 2% inflation,” the Labor Department announced average hourly earnings rose a more than expected 5.1% last month, while non-farm payrolls grew a surprisingly large 263,000, and unemployment stayed at 3.7%.
Those numbers are probably not enough to get the FOMC to revert to a 75 basis point base hike, but they do lend themselves to projecting a higher destination rate.
The Fed has a long way to go to lower inflation to 2%. It will be interesting to see whether FOMC participants mark up their inflation projections in the December SEP, as would seem mandatory if funds rate dots rise.
Powell & Co. can hope for continued declines in inflation. They are counting on relief from supply chain problems and lower commodity and durable goods prices and hope their efforts to reduce demand for goods and services bear fruit. But it’s still just a hope.
Whether or not markets believe inflation will decline to 3% or less next year, they do think the Fed believes it, and that’s what matters when it comes to all-important financial conditions.
At the upcoming meeting, Fed officials must decide how serious they are about restoring “price stability” and how firmly they want to convey their determination — whether they need to be more blunt and stop pulling their punches.
We’ll see on Dec. 14 whether Powell & Co. are prepared to reinforce their commitment to reducing inflation. The new dot plot will be one vehicle, but Powell may need to strengthen his rhetoric as well.
Though smaller than the rate hikes approved at the June, July, September and November meetings, a 50 basis point move would still be relatively aggressive. As pointed out by St. Louis Fed President James Bullard, it “would still be a very significant tightening action.” When the FOMC moved by 50 in May, after leaving the zero lower bound with a 25 basis points hike in March, it was the largest increase since 2000.
Even so, there has been concern at the Fed that the anticipated slowing will be interpreted on Wall Street as heralding an imminent halt in the tightening of monetary policy — and with justification.
After the consumer price index came in lower than expected in October, stocks surged in hope the Fed would soon pause. The Dow jumped 1200 points in one day. Other equity gauges rose even more percentage-wise. More recently, Powell’s slowing signal sent the Dow up 737 points (more than 2%); the Nasdaq gained 4 ½%.
At this writing, stocks remain 14% to 19% above their recent lows, in hopes the Fed will be able to defeat inflation without inflicting much economic pain. A simultaneous bond rally sank yields. The 10-year Treasury yield fell from 4.33% on Oct. 20 to a 3.50% as this was written.
The two-year note is roughly 75 basis points higher – an inversion that can be interpreted as confidence that the Fed will bring down inflation or that the Fed will cause a recession.
Nice as the market rally may seem, it can’t be altogether pleasing to monetary mavens, who have been counting on tighter financial conditions to help reduce inflation by softening demand.
Fed leaders are very well aware of the risk that slowing the pace could be misread in financial markets as a signal that the Fed is easing up on its anti-inflation campaign and loosen financial conditions in a way that would work against what it’s trying to do.
So, the plan is to communicate as clearly as possible that the FOMC remains firmly committed to the 2% inflation goal and that, despite the slower pace, it is determined to get rates to a “sufficiently restrictive’ level to bring demand and supply into balance.
Powell and other policymakers will be stressing that point after the Dec. 14 rate announcement. Part of the message will be that not only will rates need to go higher than previously projected, but will need to stay there longer.
September’s 4.6% median funds rate projection for 2023 seems likely to rise to 5% or more. There is a recognition that the real funds rate remains too negative and insufficiently restrictive. A prominently held belief is that the real funds rate needs to be at least 1 ½% above whatever the prevailing PCE inflation rate is – or is expected to be.
If PCE inflation is 3 ½%, that would imply a 5% nominal funds rate, for example. But of course, the terminal rate is going to depend on what PCE inflation actually does next year.
Some think the funds rate will need to go well above 5%, possibly 6% or higher.
Fed strategists are operating on the assumption that commodity and goods price inflation will continue to moderate and that this will spill over into progress on reducing core services inflation, lowering the floor for a “sufficiently restrictive” rate. Whether their optimism is justified remains to be seen.
Markets will be told the Fed wants to avoid raising rates too much or leaving rates too high, but that for now and the foreseeable future monetary policy will need to become significantly more restrictive to accomplish its purpose.
Once the FOMC feels it has reached a “sufficiently restrictive” rate level it will look around, reassess, decide the appropriate strategy going forward and make adjustments as necessary. They will be “data driven,” particularly with regard to inflation and inflation expectations. At some point, if the Fed is successful in its mission and inflation moderates, the real funds rate could become overly positive and might have to be lowered, but that’s well down the road.
Explaining the Fed’s strategy in his Brookings webcast, Powell did his best to make the case that slowing the pace of rate hikes is totally consistent with getting policy to a “sufficiently restrictive” stance and leaving it there.
“My colleagues and I do not want to over-tighten because…cutting rates is not something we want to do soon,” he said. “That’s why we’re slowing down and going to try to find our way to what that right level is.”
Powell said, “it is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
To determine what is “sufficiently restrictive,” Powell said the Fed will monitor financial conditions and their economic impact and assess whether financial conditions are tight enough to restore supply-demand balance. He said the Fed wants to see “significantly positive real rates” across the yield curve.
Under a “risk management” approach, Powell said the Fed will “go slower and feel our way,” then “hold at a higher rate longer.”
A side issue is that the higher the funds rate goes the more it could bump up against “r double star” – the newly popular, hypothetical threshold at which a rising funds rate jeopardizes financial market stability. But so far, officials profess not to be greatly concerned about financial vulnerabilities.
So expect Powell and the FOMC to accompany a 50 basis point rate hike announcement with strong signals that more is coming and that the funds rate will ultimately need to go higher if the Fed is to fulfill its 2% goal. How much higher will be left necessarily vague.
Again, part of that communication task will be met, presumably, through upwardly revised funds rate “dots” in the SEP to be released Dec. 14 with the FOMC policy statement. Expect the 2023 median funds rate projection to rise to at least 5%. In September FOMC participants projected the funds would fall to 3.9% in 2024. Less subsidence seems likely in the December dot plot.
As we’ve seen, “restrictive” is a moving target. What will ultimately prove to be “sufficiently restrictive” will depend heavily on the behavior of inflation and inflation expectations, among other things. But clearly ideas about what constitutes “restrictive” have changed. Not long ago, a target range of 4.25-4.50% would have been considered at least “moderately restrictive” and grounds for seriously discussing a “pause.” But officials’ notions of “restrictive” have moved steadily higher.
Bullard says that, even using the “most generous” assumption, the funds rate “is not yet sufficiently restrictive” and needs to go higher. “To attain a sufficiently restrictive level, the policy rate will need to be increased further.”
Using Taylor Rule calculations, he estimated a “sufficiently restrictive zone” from 5% to more than 7%. Due to “policy inertia,” Bullard said, “the policy rate has been adjusted only partially toward the recommended policy rate during 2022.”
Waller, Bullard’s former director of research, supported a downshift from 75 to 50 basis points, but stressed that slower tightening should not be interpreted as monetary hesitancy – just a natural shift from a steep climb to a more gradual ascent to a probable higher rate level. He used an aeronautical analogy.
“When an airplane is taking off, the pilot fires the engines as much as possible to get off the ground,” he said. “The goal is to get to cruising altitude quickly, so the initial ascent is steep. But as the plane gets closer to cruising altitude, the pilot slows the rate of ascent, while continuing to climb. The final cruising altitude will depend on many factors, most notably details about the weather. Turbulence may force you to a higher or lower altitude, but you adjust as you go to have a smooth ride.”
“When the Fed was faced with rapidly escalating inflation and a strong labor market, it lifted rates aggressively off the effective lower bound including several 75-basis-point steps,” Waller continued. “But as the policy rate gets higher, the stronger is the case for slowing the rate of ascent while continuing to climb. This would correspond to slowing to 50-basis-point hikes.”
“At a certain point, policy will reach an optimal cruising altitude, but we don’t know exactly what that level will be because it depends on the data,” he went on. “Maybe new data will point to a shallower climb and a lower cruising altitude, which would suggest stepping down to 25-basis point hikes. Or maybe it could be necessary to continue climbing a little longer to a higher final attitude by implementing a sequence of 50 basis point hikes.”
“In the end, the higher we raise the policy rate, the more pressing it is to think about the terminal rate and how policy should be adjusted to get there, but that will depend on the incoming data,” he added.
Waller cautioned, “If the FOMC were to step down to a 50-basis-point increase, it is important to remember that this would still be a very significant tightening action—in other words, just pulling back on the rate of ascent a little bit. At this angle of ascent, with policy already in restrictive territory, the federal funds rate can still be increased quite rapidly with several 50-basis-point increases, a pretty aggressive path for policy.”
“(A)lthough I believe we are seeing some progress in the economy to dampen demand that will help moderate inflation, we have not yet made enough progress….,” Waller said. “I expect that getting inflation to fall meaningfully and persistently toward our 2% target will require increases in the federal funds rate into next year. We still have a ways to go. Until then, I support continued rate increases and ongoing reductions in the Fed’s balance sheet to restrain aggregate demand. When we reach our terminal rate, how long we stay at that level will largely be driven by our progress in bringing down inflation.”
Bullard and Waller of course, are known “hawks.” But they’re not alone.
Fellow hawk Mester has indicated she’ll vote for a 50 basis point hike in December, but unlike some of her colleagues she’s not hinting at a pause any time soon. “I don’t think we’re anywhere near to stopping. We’re still going to have more work to do because we need to see inflation really on a sustainable downward path back to 2%.”
Brainard said recently “it probably will be appropriate soon to move to a slower pace of increases,” but “we have additional work to do. By moving forward at a pace that’s more deliberate, we’ll be able to assess more data and be better able to adjust the path of rates to bring inflation down.”
“It’s really going to be an exercise on watching the data carefully and trying to assess how much restraint there is and how much additional restraint is going to be necessary, and sustained for how long, and those are the kinds of judgments that lie ahead for us,” she said.
Esther George, soon-to-retire Kansas City Fed president, has also warned adamantly against taking the Fed’s foot off the monetary brakes and said it must be prepared to accept some economic pain to defeat inflation.
“I have not in my 40 years with the Fed seen a time of this kind of tightening that you didn’t get some painful outcomes,’ she said in mid-November. “I’m looking at a labor market that is so tight, I don’t know how you continue to bring this level of inflation down without having some real slowing, and maybe we even have contraction in the economy to get there.”
“Seeing that we’re not going to get help in the supply side, we have a lot of work to do,” George went on, adding that “the more important question for this committee, looking out over next year, is being careful not to stop too soon. This was the lesson of the 1970s and ’80s, is thinking, ‘Oh, we’ve got it now, we can stop,’ and then you find that inflation really reemerges in some way.”
But Powell must also contend with more dovish voices. In late November, San Francisco Fed President Mary Daly conceded the Fed has “more work to do,” but said policy is already “modestly restrictive.” Echoing research her Bank had done, she contended “the level of financial tightening in the economy is much higher than what the funds rate tells us.” So, she said the Fed has to guard against “too much” tightening that could cause “an unnecessarily painful downturn.”
Atlanta Fed chief Raphael Bostic said, “I do not think we should continue raising rates until the inflation level has gotten down to 2%. Because of the lag dynamics … this would guarantee an overshoot and a deep recession.
New Boston Fed President Susan Collins, who will vote at the upcoming meeting, has been on both sides. She said, “restoring price stability remains the current imperative and it is clear that there is more work to do. I expect this will require additional increases in the federal funds rate, followed by a period of holding rates at a sufficiently restrictive level for some time.”
However, Collins also warned against “over-tightening” and said she “remain(s) optimistic that there is a pathway to reestablishing price stability with a labor market slowdown that entails only a modest rise in the unemployment rate.”
So, Powell will have a delicate balancing act to perform when he talks to the press on Dec. 14. He will have to hope that the new dot plot speaks for him to a large extent.
Whatever the new projections turn out to be, the FOMC will be feeling it’s way along an uncertain path in coming years — ever upwards for a while, one suspects, before it’s able to bring rates back down.