By Steven K. Beckner
(MaceNews) – To pause or not to pause may be the immediate question as the Federal Reserve rapidly approaches its May 2-3 monetary policy meeting, but ultimately the question is how much higher short-term interest rates will need to go and how long rates will need to stay high to bring down inflation.
The Fed’s policy-making Federal Open Market Committee could be headed for its last interest rate hike of this credit cycle, but we’ll only know that in retrospect at some date in the future. To answer that question, one would have to know where inflation is headed, and that’s what even our monetary experts are guessing at.
Equally mysterious is how willing the FOMC will prove to be to fight inflation. How much pain will it be willing to accept?
The FOMC’s “reaction function” is less than precise, especially now that an already worsening economic outlook has been clouded by banking system stresses and resultant tightening of financial conditions. It’s easier to talk about “doing whatever it takes” to fight inflation when you think that the economy is “strong”, that labor markets are “extremely tight,” and that financial headwinds are within normal parameters.
Increased “downside risks” have always made the Fed more hesitant to raise rates, and there’s no reason to think that tendency has changed, even after its easy money policies yielded 40-year high inflation. How high a price in terms of unemployment are Fed policymakers willing to pay to correct their mistakes? We just don’t know.
What we do know is that formerly bold talk about aggressively tightening monetary policy to defeat inflation has given way to much more tentative rhetoric over the past month or so, leaving in doubt the outcome of the upcoming meeting and subsequent meetings.
In the lead-up to the March 21-22 FOMC meeting Fed officials (and not just the most notorious hawks) were talking about the need to raise the federal funds rate higher and faster than previously thought in wake of a sequence of worrisome inflation data and other indicators.
But Fed thinking changed dramatically following a series of bank failures and emergency rescues.
Before the collapse of Silicon Valley Bank and other banks, Fed watchers were putting high odds on a 50 basis point rate hike, and Fed officials were publicly leaning toward raising their rate projections. But in wake of severe strains at SVB, Signature Bank, First Republic Bank and Credit Suisse, and now the failure of First Republic, the FOMC decided the better part of valor was to raise the funds rate only 25 basis points to a target range of 4.75% to 5.0%.
By way of explanation, the FOMC policy statement said, “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” Chair Jerome Powell said this anticipated credit tightening might well “substitute” for additional rate hikes.
Although the FOMC went ahead with a 25 basis point rate hike, it significantly altered its forward guidance. Instead of anticipating “ongoing increases,” it said, “some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.”
Instead of ratcheting up their rate projections to 5.3% or so, as expected, FOMC participants retained their December projection of a median 5.1% (5.0% to 5.25%) by the end of 2023.
As things now stand, the FOMC may well take the funds rate up another 25 basis point notch on May 3, but judging from what Fed officials have been saying, that may be it for a while.
Indeed, after a “pause,” the next step could be to lower rates at some point if some have their way. At least, financial markets are hoping that will be the case.
Powell appeared to dash those hopes in his March 22 press conference, asserting, “rate cuts are not in our base case” in 2023, but of course that’s subject to change, as we’ve so often seen.
Suffice it to say that the outlook is highly uncertain, as Fed officials have continually emphasized.
Of one thing there is no doubt: there has been a noticeably bigger focus on downside risks since the SVB and other bank failures intensified financial strains.
A number of officials have said the Fed “has more work to do” to reduce inflation to the 2% target. but in the next breath they often talk about how “uncertain” the outlook is. Thus, the FOMC policy statement said that ”the extent of these (bank failure) effects is uncertain.”
Powell reiterated the point after the March meeting, telling reporters that, in taking a more incremental tightening step, he and his colleagues had been “trying to reflect the uncertainty about what will happen.”
“It’s possible that this (series of bank failures) will turn out to have very modest effects on the economy, in which case inflation will continue to be strong, in which case, you know, the (rate) path might look different,” he continued. “It’s also possible that this potential tightening will contribute significant tightening in credit conditions over time. And in principle, that means that monetary policy may have less work to do. We simply don’t know…..”
Minutes of the March meeting show that the Board staff “judged that the uncertainty around the baseline projection was much greater than at the time of the previous forecast.” They lowered their growth forecast and projected a “mild recession” this year.
FOMC members and non-voting officials thought “the developments in the banking sector that had occurred late in the intermeeting period affected their views of the economic and policy outlook and the uncertainty surrounding that outlook,” according to the minutes.
Even with the actions the Fed and other banking authorities had taken to bolster financial institutions, FOMC participants “recognized that there was significant uncertainty as to how those conditions would evolve.”
“Participants assessed that the developments so far would likely lead to some weakening of credit conditions, as some banks were likely to tighten lending standards amid rising funding costs and increased concerns about liquidity,” the minutes continued. “Participants noted that it was too early to assess with confidence the magnitude of the effect of a credit tightening on economic activity and inflation, and that it was important to continue to closely monitor developments and update assessments of the actual and expected effects of credit tightening.”
Those sentiments have not substantially changed since the last FOMC meeting.
More recently, Chicago Federal Reserve Bank President Austan Goolsbee, who is voting on the FOMC this year, said, “Given how uncertainty abounds about where these financial headwinds are going, I think we need to be cautious. We should gather further data and be careful about raising rates too aggressively until we see how much work the headwinds are doing for us in getting down inflation …..”
Although the FOMC repeated on March 22 that it intends to raise rates to a level that is “sufficiently restrictive to return inflation to 2% over time,” it was deliberately vague about what that means.
The answer hasn’t become any less nebulous since then.
One thing the pledge to make policy “sufficiently restrictive” clearly does not mean is achieving 2% on the near-term horizon. Indeed, in their March 22 Summary of Economic Projections, FOMC participants increased their 2023 inflation forecast from 3.1% to 3.3%. They didn’t expect to near 2% inflation until 2025 – quite a contrast to the December 2021 SEP, which projected inflation returning to target in 2024 – much less the March 2021 SEP, which imagined 2% inflation in 2022.
So, it’s hard to say how much more the Fed has — and is willing — to do. Policy thinking has never been monolithic, but it has become even less so since the bank panic.
Comments vary widely, but among FOMC voters, the differences are stark between what needs to be done to get inflation to 2% and what is deemed feasible or “prudent.”
Minneapolis Fed President Neel Kashkari, once considered one of the most dovish Fed presidents, acknowledged recently that the Fed’s fight against inflation, together with a bank-induced credit crunch, could lead to recession, but seemed prepared to accept that.
“It could be that our monetary policy actions and the tightening of credit conditions because of this banking stress leads to an economic downturn,” he said. “That might even lead to a recession.” But Kashkari added, “We need to get inflation down …. If we were to fail to do that, then your job prospects would be really hard.”
Waller has also continued speaking in his usual hawkish voice, though not as much as prior to the SVB blow-up.
Alluding to the 5% March rise in the consumer price index (5.6% core), he said inflation “is still much too high and so my job is not done …. we haven’t made much progress on our inflation goal, which leaves me at about the same place on the economic outlook that I was at the last FOMC meeting, and on the same path for monetary policy.”
“Because financial conditions have not significantly tightened, the labor market continues to be strong and quite tight, and inflation is far above target, so monetary policy needs to be tightened further,” Waller continued. “How much further will depend on incoming data on inflation, the real economy, and the extent of tightening credit conditions.”
Waller said his interpretation of the economy’s prospects and the slow progress against inflation is that “as of now, monetary policy will need to remain tight for a substantial period of time, and longer than markets anticipate.”
“I would welcome signs of moderating demand, but until they appear and I see inflation moving meaningfully and persistently down toward our 2% target, I believe there is still work to do,” he declared.
Other voters seem less inclined to push toward a more “sufficiently restrictive” stance.
Goolsbee sounded nearly as dovish as his predecessor Charles Evans, whom he succeeded on Jan. 9 often sounded. He cautioned against raising rates “too aggressively,” because probable bank credit tightening is likely to make the Fed’s anti-inflation job “easier” and leave it with fewer rate hikes to have to implement..
“(A)t moments like this, of financial stress, the right monetary approach calls for prudence and patience—for assessing the potential impact of financial stress on the real economy,” he said.
Citing estimates that the anticipated credit tightening could be the equivalent of as much as 75 basis points, Goolsbee said, “If they develop, the Fed would need to account for these potential headwinds when setting monetary policy.”
“In some ways, it’s almost mechanical; we’ve been tightening financial conditions to bring inflation down, so if the response to recent banking problems leads to financial tightening, monetary policy has to do less,” he added.
Philadelphia Fed President Patrick Harker has suggested the FOMC may not even want to raise the funds rate on May 3, even as he conceded that there is “a lot of room for improvement” on inflation in an economy he deemed to be “effectively, at full employment.”
Given “promising signs” that past rate hikes are working and given that “the full impact of monetary policy actions can take as much as 18 months to work its way through the economy,” Harker sid “we will continue to look closely at available data to determine what, if any, additional actions we may need to take.”
New York Fed chief John Williams sounded ambivalent. “I am confident that we will attain and maintain a sufficiently restrictive stance to bring inflation down to our 2 percent longer-run goal,” the FOMC Vice Chairman said, but added that “these (banking) developments will likely lead to some tightening in credit conditions for households and businesses, which in turn will weigh on spending.”
Fed Governor Lisa Cook said that, in “looking at what rate will be sufficiently restrictive to bring inflation down to 2%, over time,” she is “weighing the implications of stronger momentum in the economy apparent in economic indicators over the past few months against potential headwinds from recent banking developments.”
“If tighter financing conditions are a significant headwind on the economy, the appropriate path of the federal funds rate may be lower than it would be in their absence,” she continued. “But if data show continued strength in the economy and slower disinflation, we may have more work to do.
Non-voting Fed presidents also diverge.
Some, such as St. Louis Fed President James Bullard have continued to speak hawkishly.
Cleveland Fed President Loretta Mester said that despite “progress” on reducing it, “inflation is still too high. And it is proving to be stubborn. Some measures of underlying inflation, such as the median and trimmed-mean PCE inflation rates, have shown little improvement since their peaks.”
So now is no time to pause rate hikes, much less cut them, in Mester’s opinion. “We have moved interest rates up significantly over the past year and it is yielding progress. Yet demand is still outpacing supply in both product and labor markets and inflation remains too high.”
“In order to put inflation on a sustained downward trajectory to 2%, I anticipate that monetary policy will need to move somewhat further into restrictive territory this year, with the fed funds rate moving above 5% and the real fed funds rate staying in positive territory for some time,” she went on. “Precisely how much higher the federal funds rate will need to go from here and for how long policy will need to remain restrictive will depend on economic and financial developments.”
But others seem much more hesitant about further rate hikes.
San Francisco Fed President Mary Daly, whose staff has been accused of being asleep at the supervisory switch as SVB’s interest rate risk problems festered, said “the strength of the economy and the elevated readings on inflation suggest that there is more work to do.”
However, she added, “how much more depends on several factors, all with considerable uncertainty attached to their evolution. For one, there is the banking stress and the impact that it could have on credit conditions. History tells us that as banks evaluate the changing economic outlook and manage their liquidity and balance sheets, they are likely to tighten credit availability……”
Daly added that “tighter credit conditions translate into less spending and investment by households and businesses, resulting in a slower pace of economic growth. So we will need to monitor this impact carefully as we determine our own policy path.”
A slowing global economy is another “headwind” that the Fed will have to consider, she said.
Besides, Daly said “the FOMC has increased the policy rates considerably over the past year, and it will likely take some time for those increases to take their full effect. But how much more time and how much additional slowing is coming is unclear. So like the other factors I have mentioned, we will need to carefully monitor the situation as we assess what it means for policy….”
While the Fed feels ““an urgency to restore balance” between supply and demand, Daly argued “that urgency must be coupled with an awareness of the uncertainty we are facing, and the risks it poses to the economy.”
Like Harker, she suggested, the FOMC may not need to raise rates any higher. “Looking ahead, there are good reasons to think that policy may have to tighten more to bring inflation down. But there are also good reasons to think that the economy may continue to slow, even without additional policy adjustments….”
“So, we will need to make decisions calibrated by data…,” Daly said. “Looking back and looking ahead as we navigate the uncertainty that surrounds us. This is what prudent policy making requires, and what restoring price stability and achieving both of our mandates demands.”
The biggest factor in determining the funds rate path on May 3 is the FOMC’s perception of how much progress it is really making toward its inflation goal. The picture is fuzzy.
Fed officials, of course, have been pointing to the progress they have made in reducing inflation from last year’s 40-year highs, and they are forecasting further moderation.
Conveniently the slower pace of price and wage increases, allows policymakers to not so subtly shift their focus to the tightening of financial conditions that has followed in the train of March bank failures.
This putative “credit crunch” has permitted Powell & Co. to argue that the Fed doesn’t need to do as much of its own credit tightening to cool demand and reduce inflation. At least the Fed can and should proceed more cautiously, they contend.
It sounds like a sensible argument, but it’s an unproven one and raises bad memories of the 1970s, when the Fed relaxed its anti-inflation efforts prematurely. After former Fed Chairman Paul Volcker finally took the bull by the horns in 1978, he warned, “failure to carry through now in the fight on inflation will only make any subsequent effort more difficult, at much greater risk to the economy.”
There’s a certain schizophrenia in the modern day Fed. Although Powell and his colleagues belatedly desisted from calling elevated inflation “transitory” in late 2021, a faint echo of that attitude persists. For one thing, Fed officials continue to absolve themselves of responsibility by pointing to a variety of special factors – the Covid pandemic; supply chain disruptions, Russia’s invasion of Ukraine – anything but monetary or fiscal policy.
Take Cook’s recent analysis of the inflation process for example:
“The pandemic-related economic shutdown created rapid shifts in demand, which continued through the reopening process and reflected people’s wants and needs during that time. For instance, there was a sharp move away from in-person services and toward goods. This was coupled with disruptions to supply, both in global supply chains and the labor force. Russia’s invasion of Ukraine last year further restricted access to commodities, and the subsequent surge in energy prices drove a spike in consumer price inflation to a peak in mid-2022, reaching levels not seen since the 1980s.”
Cook neglected to mention the fact that the FOMC kept the federal funds rate near zero for two years, held down long-term rates through $120 billion per month of “quantitative easing” bond purchases, vastly expanding the money supply; delayed “quantitative tightening” until it finally began raising the funds rate in March of 2022, and even then kept the real funds rate negative for a long period.
Seldom, in fact, does any Fed official talk about the Fed’s monetary culpability. They much prefer to point the finger at idiosyncratic, one-off factors and supposedly underlying supply-demand forces
Arguably, the real funds rate remains negative.
To be sure, measured Inflation numbers have indeed improved since their peak last June, and FOMC participants forecast, in the March 22 Summary of Economic Projections, that their favorite price index for personal consumption expenditures will decline to 3.3% by the end of this year (up from 3.1% in the December SEP).
But while the Inflation data are looking better, they are not nearly as good as they look. True, , the headline consumer price index, which rose to a 9.1% year-over-year pace last June, rose just 5% in March. And yes, the overall PCE index has fallen from a peak of 7% to 5%.
However, various inflation gauges that strip out volatile food, energy and other prices, are still registering unacceptably high, well-above-target levels. The core PCE was up 4.6% from a year ago in the latest reading – the same pace as the Dallas Fed’s trimmed mean index.
Mester said “the disaggregated data show that the stubbornness is due mainly to the prices of services. Inflation in core PCE services excluding shelter has not improved. It tends to be sticky, is correlated with wage inflation, and is a much larger share of the overall index than goods or housing, since consumers spend a larger share of their income on these services.”
Cook observed that “much of the decline so far has been driven by the moderation in energy prices, and there is evidence that the path back to our low and stable inflation goal could be long and is likely to be uneven and bumpy.”
A major reason why inflation remains a thorn in the Fed’s side, as Mester and others have indicated, is the upward pressure on wages growing out of a taught labor market and the knock-on effect on core service prices.
Policymakers have made no secret of their desire to see a softening of the labor market (translation: higher unemployment) and smaller wage gains, but so far they have been somewhat disappointed.
Wage pressures have also moderated. Average hourly earnings have slowed to an annualized 4.2% in March of this year, compared to 5.9% a year earlier. But a familiar refrain continues to be that wage gains are “not consistent with” the achieving the Fed’s 2% target.
The Fed keeps a close eye on the Employment Cost Index, and the fact that it rose a greater than expected 1.2% in the first quarter (an annual 4.8% pace) can only add to impulses to keep raising rates.
To reach a safer speed, Powell and his colleagues realize – and have stated – that they need to see slower economic growth and softer labor market conditions. That in turn is likely going to require more restrictive financial conditions, which can come from a higher “destination” funds rate or from tighter bank credit or some combination of the two.
With regard to the former, the FOMC has raised the policy rate by 475 basis points over the past year, but judging from both prices and wages it hasn’t been “sufficiently restrictive.”
That should hardly be surprising. After all, until this year, the real funds rate remained deeply negative and arguably still is, even after another 75 basis points of “tightening.”
Ahead of the May FOMC meeting, the nominal rate is 4.9% — one tenth below the PCE inflation rate. At best, the funds rate is only a hair above PCE inflation and is below CPI inflation, leaving it negative in real terms.
The real funds rate is positive only if the nominal rate is compared to the projected rate, and that is how many Fed officials prefer to look at it, but the FOMC has continued to acknowledge that the funds rate it is not yet “suficiently restrictive.”
Monetary policy and fiscal policy are inextricably linked. Fed officials heatedly deny that monetary policy has come under the sway of “fiscal dominance” (or financial dominance), but the reality is otherwise. Whether or not it was its motive, the Fed’s massive purchases of Treasury securities had the effect of accommodating deficit spending by holding debt funding costs lower than they would otherwise have been.
Now, with the Fed reversing its asset purchases the Treasury’s interest rate bill has mounted considerably. That, along with a cooling labor market, financial instability risks and mounting odds of recession, seem likely to add to political pressure on the Fed to “call off the dogs” in the battle against inflation.
So one more 25 basis point rate hike, bringing the funds rate to its projected 2023 peak, may be all that can be realistically expected for the time being.
Fed forecasts and projections won’t be revised until the June 13-14 meeting. So, the FOMC statement and Powell’s press conference comments will have to suffice for Fed “communication” this time.