By Steven K. Beckner
(MaceNews) – Federal Reserve policymakers are unlikely to find a reason to slow their monetary tightening campaign at their Federal Open Market Committee meeting next week, and increasingly the expectation is that they will raise interest rates at least as aggressively as they did at their previous two meetings.
Although hopes for a slower pace of monetary tightening ran high after the FOMC raised short-term interest rates for a fourth straight meeting in late July and although signs of economic cooling have proliferated since then, there has not been enough moderation of 40-year high inflation or softening of labor markets to belay another aggressive rate hike on Sept. 21.
The question is how aggressive will the FOMC decide to be at this meeting and how much more monetary tightening it deems necessary in coming months.
While a third straight 75 basis point increase in the federal funds rate will no doubt be “on the table,” so now will a 100 basis point rate hike. Chair Jerome Powell and other policymakers have lately sounded more “hawkish.” Talk of a 50 basis point move, which certainly had its supporters on the FOMC, has disappeared, at least in the market’s estimation, since the disappointing August consumer price index report followed by a similar producer price report.
The startling deterioration of the core inflation picture makes it difficult to seriously contemplate slowing the pace of rate hikes just now.
Although Fed officials are united in wanting to reduce inflation, they have been divided on how to go about it. More cautious Fed officials can point to signs of softening in the August employment report and to some easing of headline inflation and wage pressures.
The perception among Fed leaders is that now is not the time for gradualism or for any appearance of a lessened determination to fight inflation., although it could be argued that the considerable tightening of financial conditions since the CPI report lends itself to a degree of caution.
The fact is that the late-to-the-party Fed faces a real dilemma — one largely of its own making, although certainly it’s getting no help from the fiscal side.
If the choice is now between 75 and 100 basis points, it’s worth keeping in mind that, ahead of the Sept. 20-21 meeting, the FOMC has already substantially increased the amount of balance sheet reduction, having voted on July 27 to sharply increase the runoff from its bond portfolio to $95 billion per month starting Sept. 1.
That action added an element of monetary tightening on the long end of the yield curve that must be taken into consideration in determining how much more short-term rate action is needed at this time.
More important than the size of the Sept. 21 rate hike is the longer run funds rate path, as New York Federal Reserve Bank President John Williams recently said. “In terms of the costs and benefits (of a 50 versus a 75 basis point rate hike), I think it’s really about getting monetary policy in the right place … making sure that we’re creating conditions so that demand is more in line with supply.”
Williams added, “We always have the opportunity at following meeting to adjust the policy actions as well. So, it’s not like you make one decision once and for all… but the path of policy.”
We’ll get some idea of the anticipated rate path from the fresh quarterly Summary of Economic Projections, which the FOMC will be publishing, including the eagerly awaited “dot plot” of funds rate projections by Fed governors and the 12 Federal Reserve Bank Presidents. At a time when Powell has eschewed explicit “forward guidance” on the pace of rate hikes, the September SEP will provide invaluable information on how FOMC participants envision the monetary process unfolding the rest of this year and next year.
We’ve already seen a considerable steepening of funds rate projections. In the June SEP, they were revised sharply higher from March. Officials’ median projection in June was 3.4% for the end of this year and 3.8% for the end of 2023, falling back to 3.4% in 2024 – up from 1.9% and 2.8% in the March SEP. Those rates projections compared to estimated “longer run” or “neutral” rate of 2.5%.
Based on the kinds of comments Fed officials have been making lately, further upward revisions seem likely, though not as dramatic as those that were made from March to June.
When the FOMC raised the federal funds rate by 75 basis points for a second straight meeting on July 27 to a target range of 2.25-2.50%, financial markets drew the wrong conclusion from some of Powell’s post-FOMC comments to reporters. At least that was the retrospective assessment of Fed officials after stocks rallied sharply on the presumption that the Fed chief was signaling a slower pace of rate hikes. Some market players even jumped to the conclusion that the FOMC would be cutting rates next year.
The following week, a host of Fed officials took every opportunity to try to dispel any dovish connotations market participants might have inferred and to reaffirm their determination to vanquish inflation.
The capper came on Aug. 26, when Powell delivered a bluntly anti-inflationary keynote address to the Kansas City Federal Reserve Bank’s annual symposium in Jackson Hole, Wyoming.
After months of equivocation and mixed messaging, Powell finally delivered a much more straightforward or less nuanced speech on the Fed’s commitment to reducing inflation.
Getting inflation back down to 2% is going to require “forceful” actions that will involve keeping interest rates high for a sustained period, and there will be “pain,” he told symposium participants. In other words, the central bank’s responsibility for ensuring “price stability” goal is more important than avoiding recession and rising unemployment, particularly at a time when labor markets seem “strong.”
Financial markets got the message loud and clear.
Since the FOMC began belatedly raising interest rates from near zero in March Powell’s rhetoric has evolved considerably. Initially he sounded very hopeful about achieving a “soft landing.” But he had adjusted his outlook by the time of the second rate hike. On June 15, he said the FOMC’s objective was still to get inflation down while sustaining a “strong labor market,” but conceded that the path to a “soft landing” had narrowed because of “many factors we don’t control,” notably the war in Ukraine.
“There is a path for us to get there, but it’s not getting easier; it’s getting more challenging,” he said.
After the July 27 rate hike, Powell was perceived as hinting at a less aggressive tightening course when he pointed to signs of slowing and said he was no longer going to give forward guidance on the size of future rate hikes now that the funds rate had reached a “neutral” range of 2.25 to 2.5%. Other officials had recently made cautionary comments about the risks of raising rates too fast.
The subsequent rally prompted a noticeable shift in Fed rhetoric, culminating in Powell’s curt and hard-hitting Jackson Hole speech. Indeed, it’s hard to escape the perception that Powell and his colleagues tailor their comments to financial market vicissitudes. Whenever market rallies loosen financial conditions in a way that runs counter to the Fed’s effort to curb demand, a chorus of hawkish comments predictably follows. If markets come to expect more aggressive monetary tightening, we hear more dovish comments.
As the Dow rallied from as low as 29,653 on June 17 to as high as 34,281 on Aug. 16, there was a noticeable shift in Fed rhetoric that seemed to reflect not any economic data (indeed inflation moderated somewhat while the economy slowed), but an untoward easing of financial conditions.
In any event, Powell pretty much laid it on the line in Jackson Hole. Although he continued to allow for slowing the pace of rate hikes at some point, he insisted the Fed will tighten monetary policy and keep it tight “until the job is done” of bring inflation back down to the 2% target.
In contrast to some of his previous pronouncements, Powell did not shy away from conceding that monetary tightening will involve economic “pain.” Gone were any hopeful thoughts of a “soft landing,” replaced by a dogged determination to reduce inflation whatever the cost.
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” Powell told fellow central bankers and economists.
“Reducing inflation is likely to require a sustained period of below-trend growth,” he continued. “Moreover, there will very likely be some softening of labor market conditions.”
Powell went on to warn, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
And he poured ice cold water on hopes for 2023 rate cuts: “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”
Williams, not always the most hawkish of policymakers, echoed that sentiment a few days later.
“We need to have a somewhat restrictive policy to slow demand, and we’re not there yet,” said the FOMC vice chairman and a key Powell lieutenant. “So if you think about next year if inflation is somewhere between 2 ½ and 3% — a forecast that I think is reasonable – you’re thinking about having interest rates that are well above that, because it’s the interest rates minus inflation rate that tells us where the real interest rate is.”
“So, we’re still quite a ways from that (cutting rates), and to me that’s one of the benchmarks,” Williams continued. “We need to get the interest rate relative to where inflation is expected to be over the next year into a positive space, probably higher than the longer run neutral level, which I think is about a half percent on real rates…”
Voting Cleveland Fed President Loretta Mester did not see any monetary easing on the horizon either. “My current view is that it will be necessary to move the fed funds rate up to somewhat above 4 percent by early next year and hold it there; I do not anticipate the Fed cutting the fed funds rate target next year,” she said at the end of August.
After Powell spoke, the Dow plummeted 1,008.38 points, and stocks continued to sell off the following week. Bond yields rose, with the two-year spiked the most to 3.391%, leaving it 0.357 points higher than the 10-year yield – an inversion that is never a good sign.
One has to wonder whether Powell’s hawkish turn on monetary policy was influenced by the latest developments in fiscal policy. In the days leading up to Jackson Hole, President Biden signed into law the so-called Inflation Reduction Act, which authorized another $433 billion of deficit spending. And he signed an executive order forgiving over $500 billion in student loan debt.
Powell gave no indication that fiscal profligacy influenced him to adopt a sterner tone in monetary tightening. Nor would he. But the measures were widely seen as adding to inflationary pressures – by, among others, former Treasury Secretary Lawrnece Summers and President Obama’s top economic advisor Jason Furman. “Pouring roughly half a trillion dollars of gasoline on the inflation fire that is already burning is reckless,” said the latter.
In any case, the FOMC will confront a prickly mix of wage-price pressures and slowing economic activity at the upcoming meeting.
There have been signs that inflation is moderating a bit. The year-over-year increase in the price index for personal consumption expenditures (PCE) fell from 6.8% in June to 6.3% in July. The core PCE rate fell from 4.8% to 4.6%. Obviously, that’s still well in excess of the Fed’s 2% target, but the trend is in the right direction. Williams called it “encouraging.” Mester called it “welcome.’
The differently constructed consumer price index has been rising much faster than the PCE index, but it too has shown some moderation. In July it rose 8.5% from a year earlier – down from 9.1% in June. In August, total CPI slowed to 8.3% compared with expectations for 8.1%.
The nasty surprise in August was core inflation, excluding food and energy, with a monthly rate of 0.6%, twice as much as the previous month, and a 12-month rate of 6.3%, up from 5.9% in July. Expectations were 0.3% and 6.1% in an Econoday survey, with the highest forecasts at 0.5% and 6.2%, respectively.
Meanwhile, wages, though falling short of inflation, have been rising too fast for the Fed’s taste.
“Wage pressures have been building up for a while and show little sign of abating …,” said Mester, noting that the Employment Cost Index for private industry workers accelerated over the six months ending in June to a 6.0% annual pace. “(C)urrent wage increases are not consistent with inflation returning to our 2% goal.”
Nevertheless, there are signs of moderation in wages as well. In August, average hourly earnings slowed from a 5.4% to a 5.2% year-over-year pace.
That seemed to reflect the Fed’s conscious effort to “balance” labor demand and labor supply. The August employment report almost seems made to order for the Fed. As hiring slowed, non-farm payrolls grew by 315,000 – more than 200,000 less than in July but still more than expected. June and July payrolls were revised down significantly.
The unemployment rate rose two tenths to 3.7 percent, but that was due to a much desired three tenths increase in labor force participation to 62.4% as more Americans sought jobs.
This mix of reduced labor demand and increased labor supply is just what the Fed has been hoping for as it seeks to restrain wage-price pressures.
Naturally, Powell & Co. would like to see more of this “re-balancing” in the labor market, as long as it doesn’t get too much of it. In the June SEP, FOMC participants forecast the unemployment rate will rise to 3.9% by the end of next year and to 4.1% by the end of 2024. It wouldn’t be surprising if those forecasts are revised higher in light of Powell’s warning that the fight against inflation will have to involve “some softening of labor market conditions.”
Of course, the Fed doesn’t just look at non-farm payrolls and the unemployment rate. Increasingly, it examines job openings and job quitting from the Job Openings and Labor Turnover Survey (JOLTS). the results of which have been validating the Fed’s impression that the labor market is not just strong, but tight.
In July, job openings rose by 200,000 to a larger than expected 11.24 million – nearly double the amount of available workers. The number of people quitting their jobs declined to a 14-month low, but the 2.7% quit rate remained historically high.
Richmond Fed President Thomas Barkin commented that such data prove “the job market is still very tight.” Mester drew the same conclusion: “Although the number of job openings has eased in recent months, they remain at historically high levels: there are close to 2 openings per unemployed worker; in 2019, another time of tight labor markets, there were about 1.2 openings per unemployed worker.”
But the employment picture is a complicated one, and the labor market may not be as solid as it seems.
That’s not all, of course. The economy may not be in recession, as Powell and others have said, but there are proliferating signs of weakness. The once hot housing market is looking colder and colder. In another important interest sensitive sector, motor vehicle sales dropped a full percent in August.
Consumer spending more generally has also been weakening – rising just a tenth of a percent in July after rising a full percent in June. In part, this reflected a drop in gasoline prices. After allowing for the vagaries of gasoline prices, overall consumption has clearly slowed.
Manufacturing output rose 0.7% in July, but that followed two months of declines. In August, the ISM’s manufacturing output index dropped more than three points to 50.4 – just barely positive.
To be sure, the Fed is seeking slower growth as well as softer labor market conditions. Only by cooling demand for goods and services as well as for labor, policymakers believe, can they bring down inflation. They’re also hoping for some help from the supply side, but that’s not something they can control, and so their main focus is necessarily on reducing demand.
The question is: when does this slowing of demand become too much of a good thing?
Increasingly policymakers are asking that question.
Although Powell openly warned of economic “pain,” officials’ pain tolerance varies, as reflected in minutes of the July 26-27 meeting.
FOMC members were unanimous in approving a second straight 75 basis point rate hike to fight inflation on July 27, but the minutes revealed concern about overdoing the tightening among some officials. There was division in how FOMC participants assessed risks and in turn policy choices.
On one hand, they “judged that a significant risk facing the Committee was that elevated inflation could become entrenched if the public began to question the Committee’s
resolve to adjust the stance of policy sufficiently…,.” the minutes tell us.
On the other hand, “many participants remarked that, in view of the constantly changing nature of the economic environment and the existence of long and variable lags in monetary policy’s effect on the economy, there was also a risk that the Committee could tighten the stance of policy by more than necessary to restore price stability.”
“These participants highlighted this risk as underscoring the importance of the Committee’s data-dependent approach to judging the pace and magnitude of policy firming over coming quarters,” the minutes add.
These mixed feelings about the appropriate pace of tightening in turn reflected a dichotomy on the balance of economic risks.
Although Powell denied the economy was in recession, FOMC participants acknowledged that “recent indicators of spending and production had softened….” They noted that “consumer expenditures, housing activity, business investment, and manufacturing production had all decelerated from the robust rates of growth seen in 2021.”
Aside from weaker domestic demand, “a deterioration in the foreign economic outlook and a strong dollar were contributing to a weakening of external demand,” the minutes say. So “participants anticipated that U.S. real GDP would expand in the second half of the year, but many expected that growth in economic activity would be at a below-trend pace, as the period ahead would likely see the response of aggregate demand to tighter financial conditions become stronger and more broad based.”
Even with regard to the “strong” employment situation, the minutes say, “many participants … noted …. that there were some tentative signs of a softening outlook for the labor market: These signs included increases in weekly initial unemployment insurance claims, reductions in quit rates and vacancies, slower growth in payrolls than earlier in the year, and reports of cutbacks in hiring in some sectors.”
“In addition, although nominal wage growth remained strong according to a wide range of measures, there were some signs of a leveling off or edging down,” they add.
Policy divergences and ambivalence have continued since July and were on display just two days before Jackson Hole, Host, Kansas City Fed President Esther George, who went along with a 75 bp hike in July after dissenting in favor of a 50 bp move in June, said the Fed has “more work to do,” but gave no clear indication she will vote for another 75 bp hike on Sept. 21. If anything, she seemed to suggest the need for caution.
In June George said the FOMC needed to avoid what she called “oversteering” monetary policy. She didn’t repeat that, but suggested the Fed needs to be careful to let the economy and the markets absorb the tightening moves already done before proceeeding too aggressively.
“I don’t think we have seen the effects [of rate hikes] yet,” George said. “But remember, we are operating in an uncertain time… It will be important for us to communicate clearly the path ahead, so that those financial conditions can tighten alongside those rate moves…..”
“(T)he effects of those rate increases have not come through yet and it is likely that we will need to do more before we see that demand begin to cool….,” George went on. “As I watch the combination of these rate hikes and the balance sheet coming down, it’s going to be important to see how the economy adjusts to what the Federal Reserve is doing.”
Atlanta Fed President Raphael Bostic seemed even more uncertain about how “expeditiously” the FOMC should proceed, saying he was inclined to just “toss a coin” as to whether to raise rates 50 or 75 basis points on Sept. 21. He wanted to see a lot more data before making up his mind.
Others, such as Mester and St. Louis Fed President James Bullard have been more emphatic about tightening credit.
Cautionary comments should not necessarily be interpreted as implying that the FOMC majority is ready to “pivot” or slow the pace of tightening at the upcoming meeting. That may be premature. The funds rate may have reached a “neutral range,” as Powell said, but it’s still deeply negative in real terms when compared to still quite elevated inflation. And if the Fed is to reclaim any measure of credibility it must live up to its pledge to “expeditiously” move to aan at least “moderately restrictive” policy posture to convince the public and the markets that it means business about restoring “price stability” (as defined by 2% annual inflation).
Powell has defined “moderately restrictive” as reaching a 3% to 3.5% funds rate range by year’s end, but he was basing that on the June dot plot, which could change considerably in the revised version to be released the day of the rate announcement.
But the misgivings which officials have expressed about moving too far, too fast, together with some slowing of core inflation and clear evidence of slower growth should allow the FOMC to give strong consideration to a somewhat less aggressive tightening step – to tapping instead of slamming the brakes.
Also, don’t minimize the importance of the substantial tightening of financial conditions that has occurred since Jackson Hole.
Powell and other policymakers have repeatedly told us that policy will be guided by how incoming data inform their view of the economic outlook, but in reality it seems that, at times, they’ve been guided more by the behavior of financial markets than by the data.
That’s somewhat understandable. After all, as Powell has also reminded us, monetary policy works through financial conditions to impact the economy. Over the years, Fed officials have denied that monetary policy is affected by swings in financial markets, but the central bank has earned a reputation for exercising a “put” – easing policy when markets decline.
It’s hard to escape the conclusion that financial conditions have affected monetary policy at least as much as policy has affected financial conditions in the past few months. Certainly, policy rhetoric has been heavily influenced by market behavior. After Wall Street interpreted (or perhaps misinterpreted) Powell’s July 27 post-FOMC remarks as having a dovish tilt and rallied strongly, assorted Fed officials came out zealously talking about their determination to conquer inflation. That culminated in Powell’s rally-reversing Jackson Hole speech.