– At Issue: The Funds Rate May Be ‘Restrictive,’ But Is it ‘Sufficiently Restrictive‘?
By Steven K. Beckner
(MaceNews) – In the run up to the Federal Reserve’s mid-June monetary policy meeting we’ve been witnessing a kind of clinic on central bank communication or, some would say, miscommunication.
With key data yet to arrive and with uncertainty about the economic outlook rampant, there is doubt about what the Fed’s interest rate setting Federal Open Market Committee will decide to do at the conclusion of its June 13-14 meeting.
If the FOMC decides to desist from raising the federal funds rate again just now after 10 consecutive rate increases, don’t assume that Chair Jerome Powell and his fellow policy-makers have decided to “pause” rate hikes indefinitely.
They may just be biding their time until the data and financial conditions warrant a resumption of monetary tightening.
Since the FOMC raised the funds rate another 25 basis points on May 3 to a target range of 5.0% to 5.25% different perceptions on the committee have developed about just how “restrictive” the real funds rate is. And there is plenty of skepticism across the policy spectrum whether the funds rate setting is yet “sufficiently restrictive,” to use the phrase which the FOMC discontinued formally using in the May 3 policy statement but which officials continue to employ.
So, communication will be paramount — more so than usual — on June 14. If the FOMC decides not to raise rates again that soon, the Committee and Powell will probably want to be very careful to avoid being interpreted as “pausing” for the foreseeable future, because that would risk misleadingly easing financial conditions in counterproductive ways.
Rather, Powell & Co. would likely want to send the message that, although monetary policy is now “restrictive,” it may not be “sufficiently restrictive,” and that the FOMC is prepared to go higher if it doesn’t see compelling evidence that it is making enough progress toward the 2% inflation target.
Even if the FOMC does do a 25 basis point hike on June 14, as some expect, Powell and his colleagues would not likely want to signal that they’re finished. Instead, they will convey that they will continue to monitor economic and financial conditions and assess whether cumulative monetary tightening, including balance sheet reduction, cum bank credit tightening, is getting the job done as far as “re-balancing” the economy, particularly the labor market, enough to make significantly more progress on lowering core inflation.
An important part of the Fed’s communication will undoubtedly be the new funds rate projections which the FOMC will be releasing as part of its quarterly Summary of Economic Projections. After leaving them unchanged in March following a series of bank failures, those “dots” seem likely to be revised higher this time.
And, of course, Powell’s remarks to reporters after the FOMC rate announcement will be parsed for hints about how high the funds rate might be headed and for how long.
The Fed’s Communication Challenge
In this modern era of “forward guidance,” which is premised on the belief that the Fed should be simpatico with financial markets and never surprise them as it was once wont to do, Fed communications are regarded as crucial.
Powell and his team have been facing an increasingly tricky challenge in trying to communicate their intentions with regard to the path of the funds rate: Having gone from ultra accommodation to tentative liftoff from the zero lower bound; to aggressive tightening; to some semblance of “neutral”; back to more incremental tightening to reach what they regard as a somewhat “restrictive” stance, how could they let the world know they now want to take a more cautious, conditional approach without creating the misimpression that they are in the verge of completely halting the monetary normalization process and that the next step is to cut rates?
The latter was the message that many thought the Fed was giving them, especially after Powell and others loudly proclaimed the substitutionary effects of presumed bank credit tightening in wake of March’s mini-wave of bank failures.
The problem was that, at the same time, incoming data showed demand remaining relatively strong, labor markets tight, and core inflation persistently, stubbornly elevated.
Also complicating the Fed’s signaling ability, inevitably, was that, after implementing 500 basis points of tightening with near unanimity over 14 months, plus shrinking the Fed’s securities portfolio by $95 billion per month, the FOMC consensus began to fray. As one might expect, Fed officials were becoming increasingly divided over the appropriate way forward.
This was shown not just in divergent rhetoric but in the funds rate projections of FOMC participants. In the last “dot plot” contained in the March 22 Summary of Economic Projections, the median funds rate for the end of 2023 was kept at 5.1%, which happens to coincide with the current 5.0-5.25% target range, instead of rising as had seemed likely, following the bank panic. But projections ranged from as low as 4.9% to as high as 5.9% — three tenths more than in the December SEP.
Further perplexing Fed policy-makers were dramatic swings in market sentiment and market pricing, partially resulting from their own mixed signals. After initially pricing in a “pause” in rate hikes at the June 13-14 FOMC meeting and an eventual cut, markets swung at one stage back toward a high probability of an eleventh rate hike of 25 basis points, with perhaps more to come thereafter.
Surprisingly strong economic data and a fixation on more “hawkish” Fed commentary produced that swing in financial market expectations. In any case, it became clear, given uncertainty about the outlook and divergent viewpoints, that a new, more flexible communications strategy was needed.
And that’s just what we’ve been hearing in recent weeks.
The word “pause” is slowly but surely being extirpated from the Fed’s preferred lexicon. The more accepted term is to “skip” – as in, to skip a meeting.
To take a “pause” on rate hikes is now deemed to imply an indefinite cessation of interest rate hikes, whereas merely “skipping” a meeting is seen as staying open to a resumption of rate hikes – perhaps sooner rather than later.
Some Fed officials, such as Atlanta Federal Reserve Bank President Raphael Bostic and Philadelphia Fed President Patrick Harker, had openly called for a “pause,” while others had explicitly rejected “a pause.”
Meanwhile, there were overt rate hikers, such as St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester.
At the top, Powell was seen as setting up “a pause” in his May 3 press conference and later at a May 19 event, when he said, “We’ve come a long way in policy tightening, and the stance of policy is restrictive, and we face uncertainty about the lagged effects of our tightening so far and about the extent of credit tightening from recent banking stresses. Having come this far, we can afford to look at the data and the evolving outlook to make careful assessments.”
And there was another perceived Powell pauser: “Until very recently, it has been clear that further policy firming would be required. As policy has become more restrictive, the risks of doing too much versus doing too little are becoming more balanced.”
But subsequent to those Powell comments we began to hear less about “pausing,” as the Fed leadership began to perceive a need for a new, more open-ended kind of Fed rhetoric – a shift in the terms of debate.
The evolution of Fed thinking was taking shape at the May FOMC meetings, as minutes disclosed: “In light of the heightened uncertainty regarding the outlooks for both inflation and real economic activity, most participants emphasized the need to retain flexibility and optionality when moving policy to a more restrictive stance.”
Building on that, Fed Governor Christopher Waller set the tone in a May 24 speech, in which he laid out three policy options for the June meeting — “hike, skip, or pause.” And he went on to distinguish between “pause” and “skip.”
“One might lean toward hiking by focusing on the economic data and interpreting it to suggest that inflation and economic activity are not consistent with significant and ongoing progress toward the FOMC’s 2 percent inflation goal,” he said. “Based solely on the data we have in hand as of today, we are not making much progress on inflation. If one doesn’t believe the incoming data will be much better, one could advocate for another 25-basis-point hike as the appropriate action in June.”
Moving on to the second option, Waller said, “Alternatively, one might view the current and incoming data as supporting a hike in June but believe that caution is warranted because there is a high level of uncertainty about how credit conditions are evolving. Another hike combined with an abrupt and unexpected tightening of credit conditions may push the economy down in a rapid and undesirable manner. This possibility is the downside risk of an additional rate hike in the current environment. If one is sufficiently worried about this downside risk, then prudent risk management would suggest skipping a hike at the June meeting but leaning toward hiking in July based on the incoming inflation data ….”
Or, third, Waller said “one might want to pause hikes at the June meeting, meaning that the target range is at its terminal rate, if the current stance of policy is thought to be enough to bring inflation down over time. Between policy lags and possible tightening credit conditions, the current stance of monetary policy may be seen, at that point, as sufficiently restrictive to move us toward the dual mandate. From this viewpoint, the policy rate is high enough and we simply need to hold it there to bring inflation down toward our 2% target.”
If “pausing” means presuming that a “sufficiently restrictive” “terminal rate’ was reached on May 3, then Waller was having none of it: “I do not expect the data coming in over the next couple of months will make it clear that we have reached the terminal rate. And I do not support stopping rate hikes unless we get clear evidence that inflation is moving down towards our 2 percent objective.”
“But whether we should hike or skip at the June meeting will depend on how the data come in over the next three weeks,” he went on. “We will get additional labor market data, with some information about wages, and additional inflation numbers in the next few weeks that will continue to shape my view on where we stand relative to the FOMC’s dual mandate. During this time, I’ll also be reviewing data on credit conditions to evaluate how much potential tightening is coming from the banking sector.”
Waller is one of a number of officials who think the funds rate may well need to go higher, assuming the data support it, but who are ambivalent about the timing of the next rate hike. Hence, they are prepared to “skip” a meeting, but are not prepared to “pause,” if pausing means concluding that rates have gone high enough.
In a matter of days, other officials were also slinging the word “skip” around.
Most notably, on May 31, Fed Governor Phillip Jefferson cautioned that “a decision to hold our policy rate constant at a coming meeting should not be interpreted to mean that we have reached the peak rate for this cycle.”
“Indeed, skipping a rate hike at a coming meeting would allow the Committee to see more data before making decisions about the extent of additional policy firming,” added Jefferson, who significantly has been nominated to succeed Lael Brainard as vice chair.
Former “pauser” Harker adjusted his attitude as well that day, saying, “I am in the camp increasingly coming into this meeting thinking that we really should skip.” Elaborating on his new choice of words, the FOMC voter said, “A pause says that you are going to hold there for a while.”
Harker said he does “believe that we are close to the point where we can hold rates in place and let monetary policy do its work to bring inflation back to the target in a timely manner.” But that’s different from calling for a June pause, which would imply that point has already been reached.
Dallas Fed President Lorie Logan, another FOMC voter, also evidently got the memo: “The data in coming weeks could yet show that it is appropriate to skip a meeting,” but she added, “As of today, though, we aren’t there yet.”
To say you’re prepared to merely “skip” a meeting implies that you’re also prepared to resume raising rates if need be.
The spreading use of this new kind of Fedspeak is no accident, nor does it only reflect views on the fringes.
“Sufficiently restrictive”?
In the highest policy councils, there is a realization that the Fed may have to raise interest rates further, but that doesn’t mean there is any sense of urgency to go higher now that monetary policy has been moved into what they regard as a “restrictive” mode.
The predominant view now seems to be that the FOMC may well have to raise rates further, but there is uncertainty about how much more is needed and hence a willingness to wait and see the lagged effects of both the five percentage points of rate hikes and “quantitative tightening” already implemented plus the lagged effects of the bank lending restraint that is presumed to be in the pipeline because of the March bank failures.
In short, there is a willingness to push rates higher, but no presumption that this has to be done as soon as June 14.
If a “pause” means an indefinite suspension of monetary tightening, that now seems to be a minority view. Potentially “skipping” as Waller, Jefferson and others have been saying, better describes where the leaders’ heads are going into the June meeting.
Much more so than vocal hawks like Bullard, the prevailing, mainstream view is that the Fed has already done a lot in leaving the zero lower bound and moving the funds rate from very accommodative to neutral to, now, “restrictive.” But that’s not the same thing as coming to a hard-and-fast conclusion that policy is “sufficiently restrictive.” The jury is still out on that.
One could argue that the current 5.1% (5.0% to 5.25%) funds rate really isn’t very “restrictive” at all, given that core inflation is still near 5%. But the controlling view at the Fed holds that monetary policy is now, in fact, ‘restrictive” in real terms. That belief is based not on a straightforward comparison of the nominal funds rate with the current inflation rate, but prospectively, on the assumption that inflation is going to fall to around 3% or a little higher by the end of this year.
In the March SEP, FOMC participants forecast that the inflation rate, as measured by the Fed’s favorite price index for personal consumption expenditures (PCE) will fall to 3.3%, while the core PCE inflation rate was forecast to be 3.6%. Both of those forecasts were up from the December SEP, reflecting the fact that inflation has not fallen nearly as fast as the Fed had hoped.
It seems questionable whether the June SEP will show as much optimism about core inflation. A relative lack of progress on core PCE inflation has continued in recent months. In the last reading, for April, core PCE was still up 4.7% year-over-year. The Dallas Fed’s respected trimmed mean price index rose a tenth faster than that.
Officials are particularly concerned about price pressures in core services excluding housing, which have been running between 4% and 5% for two years with very little sign of diminution. New York Fed President John Williams concedes that measure of inflation is “driven by a continued imbalance in overall supply and demand, and it will take the longest to bring down,”
The Fed simply has not made as much progress in reducing core inflation as hoped.
That hasn’t prevented key policymakers from using forecasts of lower PCE inflation to call policy “restrictive.” But there is not a great deal of confidence in that prospective approach, which is why uncertainty remains whether policy is “sufficiently restrictive.”
The idea that the funds rate is already “restrictive” is also premised on belief in a very low r* (the real equilibrium short-term interest rate). In the March SEP, FOMC participants estimated the “longer run” funds rate at 2.5%, which they arrived at by adding the 2% inflation target to a 0.5% r*. On that basis alone, 5.1% is thought to be “restrictive.”
All this theorizing is very interesting, but if core inflation doesn’t start to come down quicker, such assumptions could increasingly come into question.
For now, top policymakers remain open-minded on whether the funds rate is now “sufficiently restrictive.” Though “restrictive,” the 5.1% setting may prove not to be “sufficiently restrictive.” But there is a reluctance to come to that conclusion just yet.
Taking a more cautious or hesitant approach, top policymakers want to watch and wait a bit longer to see whether past monetary tightening, together with bank credit tightening, has the desired effect of cooling demand, softening the labor market, re-balancing supply and demand and bringing down inflation. The hope is that wage pressures will lessen and reduce price pressures in the core services ex-housing sector.
In this view, if that progress does not appear, policy will need to be adjusted, i.e. the funds rate will have to go higher than 5.1%. But there’s no precise timetable for making that assessment. It’s going to be a judgment call based on a wide array of economic and financial data.
Fed officials have been putting a lot of weight on the May employment and consumer price index reports, thinking that another strong set of labor market numbers and another high CPI reading could justify further tightening sooner rather than later.
They already have in hand an employment report, which was something of a mixed bag but on the whole conducive to the notion that the Fed hasn’t done enough to curtail demand and soften the labor market.
True, the household survey showed some weakness, with the unemployment rate rising from 3.4% to 3.7%, but that is still an historically very low rate of joblessness. And the establishment survey again showed bigger than expected non-farm payroll gains, coupled with upward revisions to prior months.
Perhaps most importantly, from the point of view of the Fed’s inflation phobia, average hourly earnings continued to grow at a pace thought to be “inconsistent” with the Fed’s 2% inflation target. They did slow a tad but were still up 4.3% from a year earlier, which the Fed deems excessive.
All in all, despite widely reported layoff announcements, the Labor Department report showed continued labor market tightness, which to the Fed implies continued upward pressure on labor costs and in turn core service prices.
The Fed can’t have been pleased either by the Bureau of Labor Statistics latest Job Openings and Labor Turnover Survey (JOLTS), which the Fed pays a lot of attention to. It showed a surprising jump in job openings in April after three monthly declines. The Fed is apt to see that as evidence that demand in the labor market is not cooling as much as they’d like to tamp down pressures on wages and in turn service prices.
Of course, not all of the data point in one direction. The Institute for Supply Management’s May manufacturing survey showed a sixth straight month of contraction, with the new orders component sinking deeper into negative territory. The price index (prices paid) also fell to 44.2%, down from 53.2% in April. On the other hand, the employment index rose 1.2 points to 51.4.
The ISM’s non-manufacturing (or services) survey showed continued expansion last month, but the composite index fell to 50.3 and included slippage in employment, new orders and other components.
Anecdotally, the Fed’s survey of economic conditions around the nation conducted for the upcoming meeting found that “employment increased in most Districts, though at a slower pace than in previous reports.”
“Overall, the labor market continued to be strong, with contacts reporting difficulty finding workers across a wide range of skill levels and industries,” the beige book continued. “That said, contacts across Districts also noted that the labor market had cooled some….Staffing firms reported slower growth in demand. As in the last report, wages grew modestly.
Taken together these various surveys seem to point to continued slowing of GDP. However, the employment report, the JOLTS survey and the ISM manufacturing employment component would seem to keep alive Fed concerns that its efforts to cooling wage-price pressures by slowing demand relative to supply aren’t quite getting the job done.
The longer those pressures persist, the fear in many Fed quarters is that higher inflation expectations will become embedded.
As Logan said a few weeks ago, “(I)f the FOMC doesn’t stay committed to restoring price stability, the public could come to expect persistently high inflation. A self-fulfilling spiral of unanchored inflation expectations would require much larger rate increases to stop….So, even as we consider how best to manage the risks, they must not stop us from doing what’s necessary to achieve 2% inflation.”
Concern about continued labor market tightness and resulting wage-price pressures doesn’t make a June 14 rate hike a foregone conclusion. By no means. We have yet to hear from the Labor Department on what the consumer price index did in May. Another upside surprise on CPI, particularly core prices, on the eve of the meeting could make it hard for the FOMC to stand still next Wednesday.
But if the divided FOMC decides not to raise rates on the 14th, it is highly likely to send some strong signals that they’re not necessarily done tightening. That could well include an increase in funds rate projections.
One issue that has been taken off the FOMC table is the federal debt limit, now that the ceiling has been raised until early 2025, The debt ceiling deal relieves immediate Fed concerns about playing its role as Treasury funding agent, but despite all the talk about spending “cuts” it does not meaningfully restrain fiscal stimulus, which has been a major impetus to demand pressures on inflation.
A bigger issue in some minds is that, now that the ceiling has been lifted, the Treasury will be issuing an estimated $1 trillion of T-bills to replenish cash balances, potentially draining liquidity from financial markets and pushing up money market rates at the same time that the Fed is shrinking its bond portfolio.