– Even After Another Big Hike Real Funds Rate Will Be Negative
– Mixed Signals About How High Fed Willing to Go to Fight inflation
By Steven K. Beckner
(MaceNews) – The Federal Reserve will almost certainly take another fairly aggressive monetary tightening step at its Federal Open Market Committee meeting next week, but its interest rate hike announcement won’t likely answer key questions on the minds of Fed watchers: how much more tightening is needed to rein in inflation and how much more will actually get done.
Those are two different questions, because, despite their protestations, it is not clear Fed policymakers realize how much additional tightening may be necessary or whether they are prepared to do it. There is room for doubt.
FOMC participants won’t be updating their economic and interest rate projections until the December 13-14 meeting, so Fed watchers will have to divine the Committee’s policy proclivities from the November FOMC statement and from Chair Jerome Powell’s comments to reporters after the rate announcement.
Recent speculation has been that the FOMC will consider slowing the pace of rate hikes, and such a discussion wouldn’t be surprising at all. But if Powell signals that the Fed is about to wind down its monetary tightening he will be perceived in some quarters as giving up on the inflation fight prematurely, and that could have adverse longer run consequences.
The Fed has raised short-term interest rates fairly sharply since belatedly leaving the zero lower bound in March, and Fed officials have vowed to keep raising them aggressively and holding them at “restrictive” levels as long as it takes to reduce inflation. The problem is that rates remain relatively stimulative and prospectively seem likely to stay that way, judging from the kinds of comments officials have been making.
At its upcoming Nov. 1-2 meeting, the rate-setting FOMC seems likely to raise the federal funds rate by another “unusually large” amount, to use Powell’s phraseology. If, as expected, they raise it by 75 basis points for a fourth straight meeting, the target range would rise to 3.75% to 4.0%.
That would make 375 basis points of cumulative “tightening” since March 16. On its face, that looks like pretty tough central banking. But while Fed officials may claim that is “restrictive,” particularly when considered in conjunction with shrinkage of the Fed balance sheet, it is hard to make that case in reality.
True, when measured against its 2.5% estimate of the “longer run,” putatively “neutral” funds rate, that range might seem restrictive, but not when measured against inflation – even the Fed’s preferred inflation gauge, the price index for personal consumption expenditures (PCE), which some observers consider a low-ball measurement.
As we’ve already seen, “restrictive” is a moving target for the Fed. Back in June, after the FOMC had raised the funds rate to 1.5% to 1.75%, Powell was talking about needing to move the funds rate to a “moderately restrictive” range of “between 3 and 3 ½%.” After the FOMC moved the target range to 3-3.25% on Sept. 21, Powell told the press that he and his colleagues had “just moved I think probably into the very lowest level of what might be restrictive” and said the FOMC intended to take it up to a “moderately restrictive” range of 4% to 4.5%.
Even reputedly hawkish St. Louis Federal Reserve Bank President James Bullard said that, after the September rate hike, the FOMC “has arguably moved into restrictive territory … above the level consistent with a long-run neutral policy where inflation is at 2% and expected to remain at 2% and unemployment is at the natural rate.”
“The policy rate would be 2.4% in that idealized world,” he continued. “Now we’ve moved above that level—that long-run neutral level — with more to come at future meetings.”
Governor Christopher Waller, Bullard’s former director of research, called current monetary policy “slightly restrictive.”
But how restrictive would that redefined “moderately restrictive” 4-4.5% range really be? It all hinges on whether the Fed’s rosy inflation wish, er, forecast comes true.
In the September Summary of Economic Projections, FOMC participants forecast that PCE inflation will fall to 2.8% in 2023 and to 2.3% in 2024. Realizing that forecast would be quite an accomplishment, considering that the PCE was up 6.2% from a year ago in August – more than three times the Fed’s 2% target. The consumer price index, which ordinary Americans pay the most attention to, looks far worse. It was up 8.2% from a year earlier in September – down from the June peak of 9.1%, but still over four times the Fed’s 2% target.
So, in real terms the funds rate is deeply negative — nowhere near the positive levels officials acknowledge they need to attain to reduce inflation and ultimately get it down to the Fed’s 2% target, and it will remain so after the expected Nov. 2 rate hike.
Officials can only talk truthfully about achieving positive real rates prospectively. Some might think them delusional.
Powell and Co. are hoping and presuming that inflation will moderate to just 2.8% next year through a combination of their own efforts to weaken demand, supply chain improvements and “well anchored” (they think) inflation expectations.
We can all hope the supply side of things will get better, despite regulatory and other policies that seem designed to do the opposite, but it’s hard to see how a still stimulative, negative real interest rate stance will meaningfully cool wage-price pressures or even sufficiently weaken demand and loosen up tight labor markets.
New York Federal Reserve Bank President John Williams, among others, has spoken optimistically about the inflation outlook since the last FOMC meeting.
“First, prices of many commodities, such as lumber, are in retreat,” said the FOMC vice chair. “Absent further supply disruptions, I expect slowing global growth, in part reflecting tighter monetary policy here and abroad, will continue to reduce demand for these products. This should put downward pressure on commodity prices and help ease inflationary pressures, especially for goods and services that are heavily reliant on commodity inputs.”
““Second, we have seen significant improvement in global supply chains, and I expect this to continue ….,” Williams continued. “Although significant supply-chain problems are still affecting some industries, such as autos, improvements in supply should help ease supply-demand imbalances and result in lower prices for affected products.”
The FOMC cannot count on supply constraints easing, though, as Powell himself has said. As in the past, it has to be prepared to suppress demand and inflict economic pain. But Fed officials’ rhetoric, as well as their minimalist rate projections, makes one wonder whether they are up to it.
While talking about expeditiously moving to tighten monetary policy to fight inflation, various officials have also been warning against over tightening, raising doubts about how strong their anti-inflation commitment really is. The rhetoric coming out of the Fed since the Sept. 20-21 FOMC meeting has been inconsistent at best.
True, there has been one common theme: an oft spoken commitment to reducing inflation. Powell set the tone in his Aug. 26 keynote address to the Kansas City Federal Reserve Bank’s annual Jackson Hole symposium, where he warned of the danger of letting inflation become entrenched and vowed to keep tightening credit to lower inflation “until the job is done.”
“Restoring price stability will likely require maintaining a restrictive policy stance for some time,” Powell said. “The historical record cautions strongly against prematurely loosening policy,”
He echoed that theme in his Sept. 21 post-FOMC press conference and vowed, “we need to bring the federal funds rate to a restrictive level and keep it there for some time.”
Powell said that “at some point, as the stance of monetary policy tightens further, it will become appropriate to slow the pace of increases, while we assess how our cumulative policy adjustments are affecting the economy and inflation.” But he said the FOMC won’t think about lowering rates until it sees “compelling evidence” that inflation is on its way down to 2%.
And he warned that defeating inflation was “likely to require a sustained period of below trend growth (and) some softening of labor market conditions.”
Subsequently, other FOMC voters expressed similar sentiments.
“(T)he Fed’s commitment to achieve and sustain 2% inflation is a now bedrock principle,” said Williams. “his transparency about our objectives provides a ‘North Star’ for policy decisions and communications … It has also served us well in keeping longer-term inflation expectations well anchored.” He voiced confidence that monetary policy is on the right track.
Meanwhile, Fed Board Vice Chairman Lael Brainard said, “Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. For these reasons, we are committed to avoiding pulling back prematurely.”
While calling the current 3-3.25% funds rate range “slightly restrictive,” Governor Waller said, “more needs to be done to bring inflation down meaningfully and persistently.” He said he “anticipate(s) additional rate hikes into early next year, and I will be watching the data carefully to decide the appropriate pace of tightening as we continue to move into more restrictive territory.”
Because “inflation has been more persistent,” Waller said, “we have to be lot more aggressive than we thought 4 or 5 months ago …. So the probability of a soft landing is a lot less.”
To reduce inflation and prevent it from becoming embedded in inflation expectations, he said, “we want to get real rates out of the negative range into a positive range.” How “positive” he didn’t say, although he expressed satisfaction with where market rates have gone.
Waller dismissed the notion of a “pause” in rate hikes any time soon. “Right now, until we see any signs of inflation beginning to moderate I don’t see how we can pause…. If it takes off… then you[re playing catch-up again.”
Governor Michelle Bowman declared, “If we do not see signs that inflation is moving down, my view continues to be that sizable increases in the target range for the federal funds rate should remain on the table … To bring inflation down in a consistent and lasting way, the federal funds rate will need to move up to a restrictive level and remain there for some time.”
“However, it is not yet clear how high we will need to raise the federal funds rate and how much time will pass before we begin to see inflation moving back down in a consistent and lasting way,” she added.
Newly minted Fed Governor Lisa Cook also made a strong commitment to fighting inflation. “In our current economy, with a very strong labor market and inflation far above our goal, I believe a risk-management approach requires a strong focus on taming inflation…. (T)he longer it persists and the more people come to expect it, the greater the risks of elevated inflation becoming entrenched.”
“Reports over the past few months have shown high inflation to be stubbornly persistent, while the labor market has remained strong,” Cook went on. “Being data dependent, I have revised up my assessment of the persistence of high inflation. And given my risk-management approach, with upside risks to inflation being the most salient, I fully supported the step-up in the front-loading of policy over the past three FOMC meetings.”
Phillip Jefferson, who came onto the board on May 23, joined the chorus, saying, “Restoring price stability may take some time and will likely entail a period of below-trend growth. However, I want to assure you that my colleagues and I are resolute that we will bring inflation back down to 2%.”
“The full effects of monetary policy take time, but in my brief time on the Federal Open Market Committee, we have acted boldly to address rising inflation, and we are committed to taking the further steps necessary,” he added.
Susan Collins, who stepped into a voting role when she took over as Boston Fed President on July 1, said, “Returning inflation to target will require further tightening of monetary policy, as signaled in the recent FOMC projections. It will be important to see clear and convincing signs that inflation is falling, and I will continue to assess the range of incoming data, both quantitative and qualitative, as inputs to my future policy determinations.”
“I do anticipate that accomplishing price stability will require slower employment growth and a somewhat higher unemployment rate,” Collins also said.
Bullard called inflation “a serious problem” and warned, “the credibility of our inflation targeting regime is at risk…. We need to make sure we respond to it appropriately (so as to) not replay the volatile era of the 1970s.”
Bullard said the fact that “the labor market is doing very well” gives the FOMC “room to try to take care of the inflation problem as soon as we can while the labor market is still strong.” With inflation having “broadened and … spread into the rest of the economy,” he urged “an abrupt and forceful response by the Fed to get inflation under control …..”
As noted earlier, Bullard contends that the funds rate already “has arguably moved into restrictive territory.” He said “we will have to stay at that higher rate for some time to make sure we’ve got inflation under control.”
Fellow hawk Cleveland Fed President Loretta Mester sounded more hawkish, as one would expect. “In order to put inflation on a sustained downward trajectory to 2 percent, monetary policy will need to be in a restrictive stance, with real interest rates moving into positive territory and remaining there for some time…..”
“(H)igh inflation is proving to be more persistent, and more restrictive policy will be needed and for longer to ensure that inflation expectations do not move up and that inflation moves back down,” Mester added.
Taking a harder line than many of her fellow voters, Mester said “We’re still not even in restricted territory on the funds rate.” She said “real interest rates — judged by the expectations over the next year of inflation — have to be in positive territory and held there for a time.”
Granted that these kinds of comments are suggestive of determination to battle inflation, other remarks and other facts leave doubt about the FOMC’s constancy and perseverance – its willingness to persevere in the face of economic suffering and what is sure to be mounting political pressure to stay its hand.
Begin, again, with policymakers’ relatively low rate projections. The highest funds rate projection for 2023 made in the September SEP was 4.9% — a view held by just six of the 19 FOMC participants. The highest rate level projected for 2024 was 4.4%. These numbers suggest a high level of confidence in the effectiveness of fairly limited Fed actions that may or may not be borne out. Some question whether it will.
Then consider some of the comments Fed officials have made. At times, they’ve seemed to pull their punches in talking about what might be needed to arrest inflation, which they freely admit has been both “broad-based” and “persistent.
For example, Brainard sounded very vague – and cautious — about how much more might need to be done. While saying monetary policy would need to be “restrictive for some time,” she added, “we also recognize that risks may become more two sided at some point.”
“Uncertainty is currently high, and there are a range of estimates around the appropriate destination of the target range for the cycle,” she continued. “Proceeding deliberately and in a data-dependent manner will enable us to learn how economic activity and inflation are adjusting to the cumulative tightening and to update our assessments of the level of the policy rate that will need to be maintained for some time to bring inflation back to 2%.”
Williams sounded fairly optimistic about reducing inflation without a lot of damage, He anticipated inflation going down to 3% next year, with unemployment rising only to 4 ½%.
“I expect the combination of cooling global demand and steady improvements in supply to result in falling rates of inflation for goods that rely heavily on commodities, as well as for those that have been most affected by supply-chain bottlenecks,” he said. “These factors should contribute to inflation declining to about 3% next year….I see inflation moving close to our 2% goal in the next few years.”
Such rosy scenarios may prove right, but some fear that kind of thinking could risk underestimating the size of the Fed’s task.
Although Williams said “tighter monetary policy has begun to cool demand and reduce inflationary pressures,” he conceded, “our job is not yet done. It will take time, but I am fully confident we will return to a sustained period of price stability.”
He gave no sense of how much more might need to be done, but his inflation and
unemployment forecasts imply a limited amount of further tightening in his mind.
Cook said a “preemptive approach” has been “appropriate” so far, but added, “at some point, as we continue to tighten monetary policy, it will become appropriate to slow the pace of increases while we assess the effects of our cumulative tightening on the economy and inflation.”
Like Williams and others, Jefferson suggested the Fed has already made progress toward its inflation goal. Though inflation is still “elevated,” he said, “We have already seen some indications from survey data, information from transportation hubs, and producer prices that supply bottlenecks have, at long last, begun to resolve.”
Referring to mounting recession warnings, Collins said she “believe(s) the goal of a more modest slowdown, while challenging, is achievable. There are reasons to be somewhat more optimistic about the ability to achieve the necessary slowing of demand without leading to a significant downturn, this time around….”
Despite “favorable conditions,’ such as “considerably stronger” balance sheets and the dearth of willing workers, she said “there are of course also downside risks to the outlook. A significant economic or geopolitical event could push our economy into a recession as policy tightens further.”
Collins added that “calibrating policy in these circumstances will be complicated by the fact that some effects of monetary policy work with a lag…..”
Even more hawkish voices have sometimes sounded a bit tentative.
For example, Bullard expressed the view that the Fed has already “raised the funds rate a lot” and “has arguably moved into restrictive territory … above the level consistent with a long-run neutral policy where inflation is at 2% and expected to remain at 2% and unemployment is at the natural rate.”
Bullard also said he was “encouraged” that inflation expectations have not risen more and that financial markets have priced in future rate hikes.
“That means we have a better chance of success … (because) we got a tighter policy in place sooner through market pricing ….,” he explained. “We have a better chance of success with less disruption to the economy than we would have had.”
Officials generally have taken comfort from the tightening of financial conditions, citing this as proof that the mere anticipation of rate hikes is working to slow demand and in turn inflation.
It’s certainly true that market interest rates have risen (the 10-year note yield now residing above 4%), pinching housing, and that attendant declines in stock prices have taken a large bite out of household wealth. But tighter financial conditions can’t take the place of actual policy. At the very least, the Fed has to follow through and fulfill market expectations, if not get out in front of them.
Among non-voters, some of the comments sounded even less committed to “staying the course” against inflation.
Chicago Fed President Charles Evans said “downside risks” predominate and looked ahead to an eventual halt to monetary tightening.
“Given that the funds rate was essentially at zero just seven months ago, this has been quite a pivot in monetary policy,” he said. “In light of this expeditious repositioning—and because the full effect of tighter financial conditions takes time to show through to output and inflation—at some point it will be appropriate to slow the pace of rate increases and eventually let policy rates sit at a plateau for a while in order to assess how our policy adjustments are affecting the economy ….”
“We must be watchful and ready to adjust our policy stance if changes in economic
circumstances dictate,” Evans added.
Minneapolis Fed President Neel Kashkari said, “we are committed to restoring price stability,” but was quick to add “we also recognize, given these lags, there is the risk of overdoing it on the front end.”
San Francisco Fed President Mary Daly said the Fed must “communicate to the public” that getting inflation down is “extremely important,” but so is “doing it as gently as possible so that the economy can be in a balanced state as easily as possible – whatever that looks like, we are going to take the easiest path we can find.”
She added, “If Europe goes into recession, that’s a headwind; if China falters, that’s a headwind on our growth, and we have to take that into account so that we don’t end up over tightening policy.”
Mester pretty much kept her hawk feathers unruffled. She too said the Fed should be “cautious” “risk management” approach, but she hastened to add “being cautious does not mean doing less. Instead, it means being very careful to not allow wishful thinking to substitute for compelling evidence, leading one to prematurely declare victory over inflation and pause or reverse rate increases too soon. It means not being complacent that inflation expectations will remain well anchored in this high inflation environment but taking appropriate actions to keep them anchored.”
Mester said she wouldn’t support any less aggressive policy stance until she starts seeing inflation actually coming down. She called inflation “unacceptably high” and said it is “broad-based,” “persistent” and a threat to inflation expectations.
“In order to put inflation on a sustained downward trajectory to 2%, policy will need to move into a restrictive stance,” she said. “That means that short-term interest rates adjusted for expected inflation, that is, real interest rates, will need to move into positive territory and remain there for some time….”
Despite 300 basis points of tightening, Mester said, “policy is not yet restrictive.”
Referring to the FOMC’s 2.5% estimate of the longer-run nominal fed funds rate, Mester said that “means that if inflation were 2% and inflation expectations were well anchored at levels consistent with that goal, a real fed funds rate of half of a percent would be neutral in the sense of neither stimulating nor restraining economic activity.”
But “that is an important if,’” she went on. “Currently, inflation and shorter-term inflation expectations are well above 2%. If we adjust the current nominal fed funds rate by the SEP median projection for inflation next year, which is 2.8%t, policy is still a tad accommodative.”
So “further funds rate increases are needed to get policy into a restrictive stance,” Mester said.
The Fed was perilously late in conceding that way-above-target inflation was not “transitory,” and that interest rates had been kept way too low for far too long, although they remained reluctant to publicly admit that monetary and fiscal excess had been primary drivers of inflation (as opposed to supply shocks and such).
Now officials freely observe that inflation is something more than a passing phenomenon. In fact, it’s been stubbornly “persistent, “broad-based” and “unacceptable,” just to quote some of the adjectives officials have been using regularly.
Yet, officials seem to be holding on to the hope that inflation can be overcome by relatively modest measures, good luck on the supply side and “anchored” inflation expectations.
“Credibility” is a central bank’s most precious asset, and in this modern era of fiat currency, confidence in the central bank is key to maintain the purchasing power of the currency. The Fed is in danger of losing that confidence and credibility.
It waited far too long to start raising short term interest rates and to start shrinking its balance sheet to get long term rates off the floor. It’s been raising rates for the past seven months, but it’s playing catch-up and is far from where it needs to be, as a number of officials have admitted.
The longer it waits to get to real rate levels that really bite the more inflation could become entrenched and the more it’s credibility will slip — until the economy reaches a crisis stage. That’s the lesson of history, learned painfully in the 1970s and now, potentially, having to be learned again.