By Steven K. Beckner
(MaceNews) – As the Federal Reserve gets set to kick off its first monetary policy deliberations of 2023, it’s almost a foregone conclusion that Chair Jerome Powell and his colleagues will keep raising short-term interest rates, but speculation has been mounting for weeks that the Fed will further decelerate monetary tightening.
Financial markets have priced in a further step down in the pace of rate hikes to 25 basis points by the Fed’s rate-setting Federal Open Market Committee. And there is plenty of justification for that thinking.
It would be a huge shock on Wall Street if the Fed does anything more than 25, particularly in wake of a report that its preferred inflation gauge, the core price index for personal consumption expenditures, moderated further in December, as well as more dovish rhetoric from Fed officials, including some usually thought of as “hawks.”
But while some Fed officials have overtly advocated a smaller move, others have been much more ambiguous, and still others have explicitly advocated taking a relatively aggressive tack for at least one more meeting.
So, while the FOMC seems increasingly likely to approve a 25 basis point move, it cannot be said to be a done deal. The Committee will likely have a vigorous debate on the appropriate action, taking into consideration not just recent trends on inflation, labor markets and other aspects of economic activity, but also financial conditions and how they are likely to shift if the FOMC opts for a modest rate hike.
A lot rides on the decision, most notably including the central bank’s credibility as a guardian of the dollar’s purchasing power less than a year after it belatedly conceded that inflation was not merely “transitory.”
At its last meeting of December 13-14, the FOMC followed four straight 75 basis point increases in the federal funds rate with a 50 basis point rate hike that left the policy rate in a 4.25% to 4.50% target range – a 4.3% median. The FOMC said “ongoing” increases would be needed to get the funds rate to a level that is “sufficiently restrictive” to reduce inflation to the Fed’s 2% target.
FOMC participants in December revised up their projections for 2023 from 4.6% in the September Summary of Economic Projections to 5.1% in the December SEP. Individual projections ranged from as low as 4.9% to as high as 5.6%, and 17 of the 19 officials projected the funds rate will need to go above 5% to become “sufficiently restrictive.”
At the upcoming meeting, FOMC participants will not be publicly revising their rate projections and the economic forecasts upon which they are based again. The next SEP won’t come until the March 21-22 meeting. But Powell & Co. will certainly be discussing internally how their assumptions about inflation, GDP growth and employment have changed over the past six weeks and how that colors their expectations about the “appropriate” funds rate level going forward.
Going from a 75 basis point rate hike on Nov. 2 to a 50 basis point increase on Dec. 14 to a 25 basis point increase on Feb. 1 might seem like a whiplash-inducing deceleration of monetary tightening, but that’s not how some officials see it.
Some have explicitly called for another step down.
Philadelplhia Federal Reserve Bank President Patrick Harker, one of this year’s FOMC voters, was quite explicit in saying 25 basis point rate hikes “will be appropriate going forward.”
More recently, Fed Governor Christopher Waller, who is not usually thought of as a “hawk,” took a similar view. After speaking with “cautious optimism” about the outlook, he said, “in keeping with this logic and based on the data in hand at this moment, there appears to be little turbulence ahead, so I currently favor a 25-basis point increase at the FOMC’s next meeting at the end of this month.”
“Beyond that, we still have a considerable way to go toward our 2% inflation goal, and I expect to support continued tightening of monetary policy,” he added.
Boston Fed President Susan Collins has also indicated she is leaning toward a 25 basis point move, although she stopped short of that in her most recent comments. “Now that rates are in restrictive territory and we may (based on current indicators) be nearing the peak, I believe it is appropriate to have shifted from the initial expeditious pace of tightening to a slower pace – though appropriate policy will, of course, depend on a holistic review of available data.”
Other Fed officials have also spoken of the merits of raising rates more gradually and incrementally without directly coming out for a 25 basis point rate hike.
“Doing it in more gradual steps does give you the ability to respond to incoming information,” San Francisco Fed President Mary Daly said.
Richmond Fed President Thomas Barkin defended the December slowdown without supporting a further slowdown on Feb. 1.
“We moved quickly last year, but what we were doing was taking our foot off the gas,” he said. “Now, with forward-looking real rates positive across the curve and therefore our foot unequivocally on the brake, it makes sense to steer more deliberately as we work to bring inflation down in the context of the lags .…”
However, others aren’t ready to scale back monetary tightening. Take, for example, St. Louis Fed President James Bullard, whose top advisor was once none other than Waller,
Just before the Fed went into its pre-FOMC “blackout period,” he urged a second straight 50 basis point rate hike, arguing the Fed should “err on the tighter side to make sure we get the disinflationary process to take hold in the economy and ush inflaon back to the 2% targe.”
To that end, Bullard said the FOMC “should move as rapidly as we can” to get the funds rate above 5%. He sees the funds rate needing to get to a 5.25% to 5.50% range by year’s end. “Once you get there, say, ‘OK, we’re going to react to data.’”
Fed Governor Michelle Bowman has also continued to sound hawkish about the Fed doing whatever it needs to do to fight inflation, even if it means economic pain, although she’s hopeful there won’t be a lot of pain.
“Inflation is much too high, and I am focused on bringing it down toward our 2% goal …,” she said earlier in January. “Over the past year, I have supported the FOMC’s policy actions to address high inflation, and I am committed to taking further actions to bring inflation back down to our goal.…”
Bowman acknowledged that there has been “a decline in some measures of inflation,” but said, “we have a lot more work to do, so I expect the FOMC will continue raising interest rates to tighten monetary policy ….”
“My views on the appropriate size of future rate increases and on the ultimate level of the federal funds rate will continue to be guided by the incoming data and its implications for the outlook for inflation and economic activity,” she went on.
Bowman seemed to set the bar high for further deceleration of rate hikes, saying she “will be looking for compelling signs that inflation has peaked and for more consistent indications that inflation is on a downward path, in determining both the appropriate size of future rate increases and the level at which the federal funds rate is sufficiently restrictive.”
A more nuanced (and savvy) view came from Lorie Logan, the former head of the New York Fed’s open market trading desk who now runs the Dallas Fed ahead of the blackout period. She indicated she would favor a further slowing of rate hikes on Feb. 1, but said the FOMC will need to stay nimble and be prepared to raise rates higher than currently projected. A 25 basis point rate hike doesn’t necessarily mean the funds rate will stop rising once it reaches the 5.0 to 5.25% range, she suggested.
Logan, a 2023 FOMC voter, strongly suggested the Fed might need to go higher and cautioned against doing too little. And if financial markets react to a slower pace of rate hikes by easing financial conditions too much, she said projections for how high the funds rate should go might have to be adjusted upward.
“I supported the FOMC’s decision last month to reduce the pace of rate increases, and the same considerations suggest slowing the pace further at the upcoming meeting,” she said, adding that she doesn’t “see the argument for a slower pace as depending very much on the latest data. Nor should a slower pace signal any less commitment to achieving our inflation goal.”
Logan said “a slower pace is just a way to ensure we make the best possible decisions. We can and, if necessary, should adjust our overall policy strategy to keep financial conditions restrictive even as the pace slows. For example, a slower pace could reduce near-term interest rate uncertainty, which would mechanically ease financial conditions. But if that happens, we can offset the effect by gradually raising rates to a higher level than previously expected.”
“My own view is that we will likely need to continue gradually raising the fed funds rate until we see convincing evidence that inflation is on track to return to our 2 percent target in a sustainable and timely way.” she said.
Another surprise has been Minneapolis Fed President Neel Kashkari, a reputed “dove.” Writing in an essay published by his Bank, he admitted to being wrong about “transitory” inflation,
He said, “While I believe it is too soon to definitively declare that inflation has peaked, we are seeing increasing evidence that it may have. In my view, however, it will be appropriate to continue to raise rates at least at the next few meetings until we are confident inflation has peaked.”
Kashkari, a 2023 voter, said that once the peak of inflation is reached the next step “will be pausing to let the tightening we have already done work its way through the economy.” But he said he sees no pause until the funds rate reaches 5.4%.
And he added, “wherever that end point is, we won’t immediately know if it is high enough to bring inflation back down to 2% in a reasonable period of time. Once we see the full effects of the tightened policy, we can then assess whether we need to go higher or simply remain at that peak level for longer. To be clear, in this phase any sign of slow progress that keeps inflation elevated for longer will warrant, in my view, taking the policy rate potentially much higher.”
Meanwhile, the Fed leadership has been much more nebulous or ambivalent in their comments. Collectively, they have said nothing to suggest the FOMC will continue at a 50 basis point pace, but neither have they said anything to disabuse the markets of their belief that a 25 basis point move will be forthcoming.
Powell has not spoken lately, but when he did on Jan. 10, he struck a distinctly hawkish tone. “(R)restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy.”
More recently, Vice Chair Lael Brainard defended slower tightening on Feb. 19, but was vague about whether she favors 25 or 50 on Feb. 1. Nor did she say how high she thinks the funds rate needs to go or for how long.
“The FOMC moved policy into restrictive territory at a rapid pace and subsequently downshifted the pace of increases in the target range at its most recent meeting,” she said. “This will enable us to assess more data as we move the policy rate closer to a sufficiently restrictive level, taking into account the risks around our dual-mandate goals…..”
Observing that “it takes a while for monetary tightening to flow through,“ Brainard said the Fed has “moved very quickly” into “restrictive territory.” So now, the FOMC is “probing” for a “sufficiently restrictive level of rates .…”
She said she and her fellow policymakers are “confident that inflation will come down over time” and said, “the more data we have the better we’ll be able to assess that.”
Asked about varying views on the appropriate pace of rate hikes, Brainard replied that “we will have an opportunity to talk about that at the end of this month and the beginning of February.” She anticipated the FOMC will “have very extensive discussions of the data and what does it mean.”
Brainard reiterated that last year the FOMC “raised rates rapidly to keep inflation expectations well-anchored,” but said that now a slower pace “gives us the ability to absorb more data … in a very uncertain environment … to better land at a sufficiently restrictive level.”
But she said the FOMC remains in “risk management” mode. “When moving very rapidly to restrictive territory to where monetary policy restrains economic activity and inflation, it’s important to demonstrate that resolve … so that people understand” that the Fed is determined to reduce inflation to 2%, she said, but now that policy has become restrictive, “the risks are more two-sided; there are risks on both sides.”
Later the same day, New York Fed President John Williams, the FOMC vice chair, said, “With inflation still high and indications of continued supply-demand imbalances, it is clear that monetary policy still has more work to do to bring inflation down to our 2% goal on a sustained basis.”
Whatever the different views may be on the size of the Feb. 1 rate hike, there does seem to be a strong consensus on keeping rates “higher for longer.” Relatedly, the FOMC seems united in the belief that it would be nearly catastrophic to ease monetary policy “prematurely.”
At the FOMC’s mid-December meeting, the minutes tell us that “all participants had raised their assessment of the appropriate path of the federal funds rate relative to their assessment at the time of the September meeting” and that “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.”
The minutes go on to say that “participants generally observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2%, which was likely to take some time.”
“In view of the persistent and unacceptably high level of inflation, several participants commented that historical experience cautioned against prematurely loosening monetary policy,” the minutes add.
Since then, Fed officials have continued to stress the need to keep rates high for an indefinite period to keep inflation expectations anchored, and they have continued to warn against premature easing.
For example, Bowman said that “once we achieve a sufficiently restrictive federal funds rate, it will need to remain at that level for some time in order to restore price stability, which will in turn help to create conditions that support a sustainably strong labor market. Maintaining a steadfast commitment to restoring price stability is essential to support a sustainably strong labor market.”
When Atlanta Fed President Raphael Bostic was asked recently how long the funds rate should stay above 5%, he responded, “Three words: a long time.”
“I am not a pivot guy,” he continued. “I think we should pause and hold there, and let the policy work.”
Taking all these comments collectively, it’s hard to be sure which way the FOMC will go, other than upwards.
But one factor that could inhibit a smaller rate hike is another area of consensus – the need to keep financial markets on the same page as the Fed when it comes to inflation fighting.
Ahead of the December meeting, financial conditions had eased considerably, in part because of comments from some officials about the need to avoid “over-tightening.” So, the FOMC was anxious to avoid a perpetuation of looser financial conditions, as the minutes reveal.
“A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price stability goal or a judgment that inflation was already on a persistent downward path,” the minutes say.
“Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability,” the minutes add.
That concern has not evaporated, as once again financial conditions have loosened on market speculation that the end is near for monetary tightening, the logical assumption being that the Fed’s next step is to ease.
Thus, Logan said she will “be attentive to how financial conditions respond to the economic data and monetary policy.”
“Ultimately, financial conditions need to be sufficiently restrictive to restore price stability,” she continued. “Even after we have enough evidence to pause rate increases, we’ll need to remain flexible and raise rates further if changes in the economic outlook or financial conditions call for it.”
So, the FOMC will need to be mindful of the risk that going the 25 basis route could send the wrong signal to Wall Street with counterproductive repercussions for its effort to soften demand and reduce inflation.
Abstracting from all the Fed speak, as the data continued to flow in ahead of the FOMC meeting, the case for continued slowing of rate hikes unquestionably seemed to mount.
In the latest reports for December, industrial production and manufacturing fell, as did retail sales. They were weaker than expected. That came on the heels of a negative January Empire State index.
Meanwhile, there were further signs of encouragement on inflation, as the producer price index fell 0.5%, after rising 0.2% in November. It was the first monthly decline since 2020. The PPI was still up 6.2% from a year earlier, but that was down from 7.3% the month before. That mirrors the disinflationary trend of other price indices.
The overall picture is one of slowing economic activity and disinflation – a seeming recipe for pressing on the brake a little less firmly.
Fed officials have been pretty confident (too confident in the view of some) in projecting a steady reduction of inflation without much economic pain — GDP growth slowing to 0.5% and unemployment rising to 4.6% this year, as PCE inflation moderates to 3.1% (3.5% core).
On that basis, the FOMC outlook is for winding up the monetary tightening cycle fairly soon.
Predicated on those relatively rosy December forecasts, FOMC participants projected the funds rate rising to a median 5.1% (from the current 4.3%) by the end of the year. If those projections hold, that leaves just 75 basis points of further tightening. The FOMC could do three 25 bp moves at coming meetings – on Feb. 1, March 22 and May 3. Or it could do 50 bp on Feb. 1 and 25 on March 22.
Then, presumably, we’d be looking at an extended plateau at that level, although some have mused about cutting rates.
On the other hand, labor markets are still tight, inflation remains far above the 2% target, and wages are rising more rapidly than is “consistent” with that goal, as we keep being told.
Looking beyond the size of the Feb. 1 rate hike, the FOMC has other important things to consider.
One of the topics on the FOMC’s agenda will be renewal of the Committee’s Statement on Longer-Run Goals and Monetary Policy Strategy. Some observers, including former Philadelphia Federal Reserve Bank President Charles Plosser, have urged an overhaul.
As revised in August 2020, that “framework” requires the Fed to put much more emphasis on “maximum” and “inclusive” employment, even at the cost of higher inflation. The Fed was to be less preemptive of inflation and more tolerant of overshooting to make up for past below-target inflation in pursuit of full employment. Achieving “maximum inclusive employment” in an age of reduced willingness to work has become more difficult, but that remains the goal.
Some contend the FOMC is somewhat trapped by its Statement on Longer-Run Goals and Monetary Policy Strategy, warning policymakers may find it difficult to raise rates more than projected or to maintain rates at a higher level if the economy goes sour, even if inflation is running well above target.
But Powell has given no indication that he’s ready to revisit that strategy.
Looking beyond the upcoming meeting, 2023 could be a time of testing for the Fed and financial markets, which revolve unsteadily around each other.
The testing may not come immediately, but as the year unfolds the Fed will face tough choices, and its credibility could come under question.
After 425 basis points of hikes last year, monetary policy is still only borderline restrictive, at best. The federal funds rate is well above the Fed’s 2.5% “longer run” estimate, but still far below the 6.1% PCE inflation rate, never mind CPI. Arguably, it remains accommodative. Money is still cheap in real terms. As Powell and other officials have acknowledged, it has a ways to go to reach a “sufficiently restrictive” stance.
Based on the December projections, the FOMC has just 75 basis points left to go to reach its imagined rate peak. How it divides up that 75 basis points is a matter of conjecture. It could go another 50 on Feb. 1, then go to 25 on March 22. Or it could do three 25s through the early May meeting.
How much the FOMC decides to move at each meeting matters less than the ultimate level and how long it stays there.
The median 5.1% projection for this year is not sacrosanct, of course. It is merely a projection, based on certain assumptions, and as we’ve seen repeatedly, funds rate projections are notoriously subject to change. After all, in December 2021, FOMC participants were projecting the funds rate would end 2022 at 0.9%, premised on an expectation that inflation would remain tame.
But let’s say the FOMC raises the funds rate another 50 basis points on Feb. 1. From then on it gets interesting. If the median projection of 5.1% is to hold we could be looking at a Fed pause and a peaking of rates by June, if not earlier, with the next step a presumed rate cut at some point. That’s exactly what financial markets appear to be expecting later this year.
And that’s possible, but let’s face it: FOMC projections that the funds rate can peak just above 5% are predicated on some pretty rosy assumptions — chiefly that PCE inflation will moderate to just 3.1% this year (2.8% core) — still above the 2% target but apt to be deemed acceptable progress en route to that goal.
But again, the Fed’s forecasting track record, not to mention its behavior, has been abysmal. The FOMC held the funds rate near zero until last March, well after inflation had taken off, in the belief that it was “transitory” and kept monetary policy wildly stimulative for months thereafter, as the CPI zoomed to a 9.1% year-over-year pace in June.
The Fed is hoping for continued supply side improvements, along with reduced demand for goods and services, to perpetuate the recent moderating trend in inflation. They are also hoping that inflation expectations will remain anchored and that elevated inflation won’t become entrenched in wage-setting behavior. But they can’t count on any of that, especially with the federal government continuing to pump money into the economy aggressively.
The FOMC’s other forecasts will become increasingly important as the year wears on. In the December SEP FOMC participants forecast that real GDP growth will slow to 0.5% and that unemployment will rise from 3.7% to 4.6%. Powell described such a rate as still reflecting “a strong labor market.” In other words, Powell is still hanging on to a relatively “soft landing” scenario, even though recent Federal Reserve Bank research has pointed toward recession, and even though a downturn is widely expected by macroeconomists.
But if GDP begins to contract and/or unemployment goes higher, that’s when the real test of the Powell Fed’s willpower (and credibility) will come. As political pressure mounts on the Fed, dovish voices on the FOMC will become louder, including Brainard. One has to wonder whether Powell himself will stick to his hawkish guns.
If the Fed flinches, as primary dealers and others expect it will, then it could find itself in the situation it claims to dread – a pre-Volcker style stagflation and a much more difficult path back to price stability, economic stability and financial stability.