By Steven K. Beckner
(MaceNews) – Before Federal Reserve policymakers convened in mid-June, officials openly talked about wanting to “skip” raising interest rates at that Federal Open Market Committee meeting, and by all indications that’s just what the FOMC will have done.
After taking a break from raising the federal funds rate at their June 13-14 session, the FOMC seems highly likely to resume doing so at the July 25-26 meeting.
Whether you call the June hiatus a “skip” or a “pause,” Chair Jerome Powell and many of his compatriots have let it be known they’ve seen enough to convince themselves that monetary policy is not yet restrictive enough to cool demand and reduce inflation.
While inflation has moderated, it continues to run uncomfortably above 2%, with both wages and prices more than doubling the targeted pace. The economy has slowed but continues to chug along, and labor markets remain tight. What’s more, financial markets do not seem to be taking monetary tightening seriously, at least not judging from the behavior of the stock market.
So, as the July meeting rapidly approaches, another 25 basis point rate hike seems all but certain. Much less sure is what comes next.
There are several reasons for the FOMC not to pause longer: the risk of giving the economy an unwanted boost; the risk of getting behind the curve on fighting inflation; the risk of worsened inflation expectations, and the risk of giving financial markets a counterproductive jolt by providing false hope of easing.
Of greater moment than the July decision is the kind of signals Powell sends regarding subsequent rate hikes. While there seems to be substantial consensus for another 25 basis point rate hike on July 26, there is considerably more doubt about what happens at the remaining three meetings of the year -– Sept. 19-20; Oct. 31/Nov. 1, and Dec. 12-13.
When the FOMC left the funds rate in a target range of 5.0% to 5.25% on June 14 after 10 straight rate hikes totaling 500 basis points, participants projected the funds rate would need to rise an additional 50 basis points to 5.50% to 5.75% (median 5.6%).
The Fed has slowed the pace of tightening since late last year. So that further 50 basis points of tightening would presumably take the form of two 25 basis point rate hikes. Assuming the FOMC raises the funds rate 25 basis points on July 26, it could take it up another 25 basis points as early as Sept. 20.
That meeting would come after Fed officials have gathered at their annual Jackson Hole symposium, traditionally a time for the chair to signal impending policy changes.
A second 25 basis point move to 5.6% in late September would fulfill the FOMC’s June rate projections, or “dots,” but that wouldn’t necessarily be the end of rate hikes. Participants will be producing a revised, quarterly Summary of Economic Projections on Sept. 20, including compiling a fresh dot plot – another communications opportunity.
Whether the dots go higher or lower will depend largely on inflation. Will it continue to moderate, particularly the core measures? Or will elevated core inflation persist and further undermine inflation expectations?
For now, Powell and many of his colleagues want to tighten policy further to curb still high inflation. While they haven’t specifically said they will raise the funds rate again on July 26, officials have said nothing that indicates otherwise.
When the FOMC “paused” or “skipped’ raising rates last month, the justification was the need to give policymakers time to assess the cumulative lagged effects of past rate hikes, as well as the presumed credit tightening effects of stresses in the banking sector.
But, with one notable exception, officials across the spectrum have to varying degrees talked about the need to get back to tightening monetary policy to achieve the 2% inflation target within “a reasonable period of time.”
Following the June FOMC meeting, Powell twice dropped heavy hints of impending rate hikes, possibly in both July and September.
After noting that “nearly all” FOMC participants had projected higher rates and that the majority had anticipated two rate hikes, the Fed chief bluntly warned that one will be “on the table” on July 26. He “wouldn’t take…moving at consecutive meetings off the table.”
Equally significant was Powell’s worried tone. Observing that inflation “remains well above our longer-run goal of 2%,” he said, “inflation has moderated somewhat since the middle of last year. Nonetheless, inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go.”
Powell said “we see the effects of our policy tightening on demand in the most interest rate–sensitive sectors of the economy, particularly housing and investment,” but said “it will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.”
As for those “extremely tight labor markets,” Powell said, “there are some signs that supply and demand in the labor market are coming into better balance…,” but he said “labor demand still substantially exceeds the supply of available workers.”
Powell’s viewpoint was amply supported by colleagues.
Notably, New York Federal Reserve Bank President John Williams said, monetary policy is not yet restrictive enough to get inflation to 2% and said, “We still have more work to do.”
“We think we still have some ways to go to get the policy to this sufficiently restrictive stance to get inflation to 2% …. not in over 10 years, but over a few years,” he told the Financial Times.
Other voters have echoed those sentiments.
Dallas Fed President Lorie Logan said, “the continuing outlook for above-target inflation and a stronger-than-expected labor market calls for more-restrictive monetary policy …..”
“In this environment, the FOMC needs to make policy more restrictive so we can return inflation to target in a sustainable and timely way,” said the one-time manager of the New York Fed’s open market trading desk. “In my view, it would have been entirely appropriate to raise the federal funds target range at the FOMC’s June meeting, consistent with the data we had seen in recent months and the Fed’s dual-mandate goals.”
Logan didn’t dissent from the FOMC’s decision to stand pat on June 14 because she thought that “in a challenging and uncertain environment, it can make sense to skip a meeting and move more gradually. And … financial conditions matter more for the economy than the precise path of the policy rate. Financial conditions depend not only on how fast rates rise but also on the level they reach, the time spent at that level, and, importantly, the factors that determine further increases or decreases. So, my hope was that the overall package of communications coming out of the June meeting would deliver a strong signal to financial markets and meaningfully tighten financial conditions.”
But now, Logan added, “it is important for the FOMC to follow through on the signal we sent in June.”
Logan said, “significant unexpected events could always provide a reason to change course,” but said “inflation and the labor market evolving more or less as expected wouldn’t really change the outlook. To have confidence that inflation will return to target on an appropriate timetable, we need to see more than some continued very modest re-balancing.”
She warned, “If we lose ground in our effort to restore price stability, we will need to do more later to catch up. The rate increases we’d need to keep inflation expectations anchored in that scenario would be far worse for workers, communities, households, busineses and banks than more modest increases now.”
Erstwhile “dove” Minneapolis Fed President Neel Kashkari warned that if the Fed doesn’t get inflation down to target, bank stresses could increase. So, the Fed must not only get inflation under control for the economy’s sake but also for the sake of the financial system. He strongly suggested this is likely to require more rate hikes as well as supervisory steps to help banks manage interest rate risks.
Echoing a phrase others have used, Kashkari said the Fed must get inflation down to 2% “in a reasonable period of time.” What that means is a little nebulous, but in the June SEP, FOMC participants didn’t see inflation getting close to 2% until late 2025 (2.1%).
Referring to bank failures that resulted in large part from anti-inflationary rate hikes, Kashkari warned, “if inflation proves to be more entrenched than expected, policy rates might need to go higher, which could further reduce asset prices, increasing pressure on banks. In such a scenario, policymakers could be forced to choose between aggressively fighting inflation or supporting banking stability.”
“(I)f inflation is entrenched, or if additional supply shocks hit the economy, policy rates might need to go higher, potentially causing the value of banks’ securities portfolios to fall further and keeping the yield curve inverted,” he continued. “Such a scenario could be considered stagflationary, perhaps including a recession where credit losses emerge.”
Fed Governor Christopher Waller, meanwhile, questioned whether the economy has yet to feel the lagged effects of past rate hikes and whether bank stress is intensifying credit restraint. He expressed dissatisfaction with progress on wages and prices.
“Despite welcome signs of softening, the labor market is still very robust,” he said. “Job growth is still well above the pre-pandemic average, the unemployment rate remains quite low, and wage growth continues to be above what would support returning inflation to 2%.”
Waller called the latest inflation readings “welcome news, but one data point does not make a trend. Inflation briefly slowed in the summer of 2021 before getting much worse, so I am going to need to see this improvement sustained before I am confident that inflation has decelerated.”
Reaching 2% inflation will require “setting the stance of policy at a level that will continue to help bring supply and demand in the economy into better balance,” he said. “While I expect inflation to eventually settle near our 2% target because of our policy actions, we have to make sure what we saw in yesterday’s inflation report feeds through broadly across goods and services and that we do not revert back to what has been persistently high core inflation.”
Waller said “the robust strength of the labor market and the solid overall performance of the U.S. economy gives us room to tighten policy further.” He called for “two more 25-basis-point hikes in the target range over the four remaining meetings this year as necessary to keep inflation moving toward our target.”
“Furthermore,” he said, “I believe we will need to keep policy restrictive for some time in order to have inflation settle down around our 2% target”
Waller saw “no reason why the first of those two hikes should not occur at our meeting later this month,” and he opened the door to a September move. “If inflation does not continue to show progress and there are no suggestions of a significant slowdown in economic activity, then a second 25-basis-point hike should come sooner rather than later…”
Michael Barr, who usually confines himself to bank supervision issues as vice chairman for that bailiwick, testified, “We’ve made a lot of progress in monetary policy, the work that we need to do, over the last year. I would say we’re close, but we still have a bit of work to do.”
Austan Goolsbee has been on the more dovish side of things since becoming Chicago Fed president in January, but recently he said hadn’t “seen anything that says that (projections of two more 25 basis point rate hikes) is wrong.”
Endorsing a “golden path” to reducing inflation without inducing recession, Goolsbee said, “That would be a Fed triumph and that can involve a couple of rate increases over this year.” He called June inflation data “promising,” but said “it’s still higher than where we want it.”
Non-voters also seem to be on board with a July rate hike with potentially more thereafter.
Cleveland Fed President Loretta Mester conceded “the FOMC has come an appreciable way in moving policy from a very accommodative stance to a restrictive one. We are closer to the end of our tightening phase than the beginning.”
“Because monetary policy affects the broader economy with a lag, some of the tightening already in place will help to further moderate demand in both product and labor markets, thereby easing price and wage pressures…,” she added.
But Mester said “the economy has shown more underlying strength than anticipated earlier this year, and inflation has remained stubbornly high, with progress on core inflation stalling. In order to ensure that inflation is on a sustainable and timely path back to 2%, my view is that the funds rate will need to move up somewhat further from its current level and then hold there for a while as we accumulate more information on how the economy is evolving .…..”
Employing “risk management considerations,” she said, ‘while policy is now in restrictive territory, it is less restrictive compared to many historical tightening cycles. That partly reflects the fact that when we started tightening in March 2022, policy was very accommodative; so much of the tightening was to move policy to a neutral stance.”
Mester also deplored the facts that “inflation has surprised us on the upside for some time” and that officials “expect inflation to to remain slightly above 2% at the end of 2025, which is the farthest out the projections go. If so, then inflation will have been above our goal for over 4 years. And that is ignoring the risks that could play out, which most participants see as tilted to the upside for inflation.”
Mester said “a more timely path back to 2% inflation, which would be encouraged by somewhat tighter monetary policy, is desirable because the longer inflation remains elevated, the higher the risk that inflation expectations could become unanchored from our 2% goal….” She added that “a somewhat tighter policy stance will help achieve a better balance between the risks of tightening too much against the risks of tightening too little.”
San Francisco Fed President Mary Daly has a more dovish reputation, but she sounded pretty much on the same page in calling “a couple of more rate hikes” a “very reasonable projection.”
The main outlier has been Atlanta Fed President Raphael Bostic, who thinks “we can be patient — our policy right now is clearly in restrictive territory. We continue to see signs that the economy is slowing down, which tells me the restrictiveness is working.”
Bostic believes “policy has been restrictive for only eight to nine months. Therefore, the real economic effects of tighter monetary policy are only just beginning to take hold.“ So, “policy may now be sufficiently restrictive, but we have not yet seen its full effects on the macroeconomy. So, let’s pause and give policy time to work and assess how rapidly it is gripping the real economy. Under this view, the bar to justify further rate hikes is higher than it was a few months ago.”
Whether right or wrong, Bostic is getting to the heart of the issue: is the Fed’s stance “sufficiently restrictive, as the FOMC was wont to say until fairly recently?
Powell and others have taken to calling policy “restrictive,” but is it “sufficiently restrictive?” Although the Fed has raised the funds rate a lot, some question whether it is.
Making that determination depends on how one evaluates the real funds rate. Mester noted that “until recently, the real policy rate, i.e., the nominal rate adjusted for inflation, has been below −0.5%.”
Some prefer to measure the real rate prospectively, relative to the forecast inflation rate. If one is confident the price index for personal consumption expenditures (PCE) will fall to 3.2% by the end of 2023 (3.9% core), as FOMC participants project, a 5.1% funds rate does look restrictive. It can also look restrictive relative to the “longer run” funds rate, which the Fed estimates at 2.5% , including a half point real equilibrium or “natural” rate plus the 2% inflation target.
But real rates look a lot less restrictive if the nominal funds rate is simply compared to current rates of inflation, particularly core inflation. There is also disagreement whether the real component of the “longer run” rate is that low. If the real rate is closer to 2%, as once believed, then the funds rate needs to be a lot higher when inflation is factored in to be positive in real terms.
Only recently have annual rates of inflation fallen below 5%. range, which means the real funds rate was zero or negative, leaving policy in a stimulative stance for an extended period. Even now, inflation remains close to 5%, as do wages. The core PCE index was still rising a 4.6% annual pace in May. In June, the core consumer price index was up 4.8% from a year earlier. Much talked about “super core” measures – service prices excluding housing – are even worse. Wages are also growing at a 5% clip.
Mester recently observed that “progress has stalled.” Referring to core PCE prices ex-housing, Powell himself admitted last month that “there are “only the earliest signs” of disinflation “We’re just not seeing a lot of progress.”
The moderation of monetary tightening was premised on two key assumptions: that the FOMC needed to take into account the lagged impact of past rate hikes and that it needed to take into consideration probable bank credit tightening effects stemming from March bank failures.
Both of those premises have been called into question.
Waller set out to “push back against the view that the bulk of the effects from last year’s policy hikes have yet to hit the economy.
For one thing, he cited the sharp climb in 2-year Treasury note yields well ahead of rate hikes and said the FOMC’s “forward guidance effectively shaved off about 6 months from the usual 12- to 24-month lag that one might conjecture would be needed to see the 200 basis points of actual tightening affect the economy. That is, forward guidance shortens the lag time between when the policy rate changes and when the effects of actual policy tightening occur…..”
What’s more, pointing to last year’s four consecutive 75 basis point rate hikes, Waller said, “Big changes in policy rates will tend to cause more rapid changes in behavior, which implies monetary policy lags will be shorter when changes to the policy rate are large and rapid.”
Waller also maintained the so-called Phillips Curve trade-off between employment and inflation has steepened so that unemployment doesn’t have to increase a lot to reduce inflation.
“This steepening implies that monetary policy will affect inflation faster and with less effect on the unemployment rate than would occur if price changes were slower,” he said. “So once again, the lags between changes in monetary policy and inflation should be shorter than historical experience tells us…”
Waller concluded that “the effects of the large policy changes that we undertook last year should hit economic activity and inflation much faster than is typically predicted.”
“If one believes the bulk of the effects from last year’s tightening have passed through the economy already, then we can’t expect much more slowing of demand and inflation from that tightening,” he went on. “To me, this means that the policy tightening we have conducted this year has been appropriate and also that more policy tightening will be needed to bring inflation back to our 2% target.”
And he warned, “Pausing rate hikes now, because you are waiting for long and variable lags to arrive, may leave you standing on the platform waiting for a train that has already left the station.”
There has also been an important change in Fed perceptions of bank lending. At the March, May and June FOMC meetings, the presumption was that more cautious bank loan terms and conditions would restrict credit availability and supplement Fed credit tightening or even “substitute’ for it.
That belief has changed noticeably. Daly, whose 12th district supervisory role was tarred for failing to curb risk exposure at Silicon Valley Bank, now downplays the impact of bank stresses on the credit availability.
“Back in March. I actually was thinking (bank) credit tightening….could end up with maybe a 25-50 equivalent rate hike,” she said, “but at this point it seems to be less than that… It’s not really different than what you’d expect given the slowing of the economy.”
Based on survey findings and other information showing slower loan growth and tighter lending standards, Daly said banks are looking at their balance sheets and interest rate risks and are acting “exactly how you’d want them to behave.”
Williams, who closely monitors the largest banks, is having a hard time distinguishing bank stress effects from monetary tightening effects. “The hard part here is both are happening and, of course, monetary policy tightening is also going to lead to some tightening of credit availability. That is part of how it works. So it’s hard for me to know how big the additional effects of the credit tightening from the banks are…”
“If you go back to March, the distribution of possible outcomes in terms of banking stress was quite wide,” he said. “It could have been that banking stress had more of a contagion effect and spilled over to other institutions and into confidence in the economy. We have not seen that….”
Waller said he has become “more confident that the banking turmoil is not going to result in a significant problem for the economy, and I see no reason why the first of those two hikes should not occur at our meeting later this month.”
Ultimately, the Fed is proudly “data dependent,” and the recent economic data do not seem to support an extension of the June pause. While suggestive of some cooling of labor market conditions and moderation of inflation, they don’t make a solid case for abstaining from further tightening.
The June employment report was softer than expected, with non-farm payrolls increasing
209,000 instead of 225,000. Prior months’ payrolls were revised down by 110,000. But the household survey showed more strength. The unemployment rate fell a tenth to 3.6%., even as labor force participation remained unchanged at a post-pandemic high 62.6% for the fourth straight month. Average hours worked bounced back strongly.
Most importantly, average hourly earnings grew at a faster pace, rising 0.4% last month – up from 0.3%. They rose 4.4% from a year earlier — faster than is “consistent with” the inflation target and depressed productivity growth, as Fed officials keep noting. The Atlanta Fed’s Wage Growth Tracker had wages up 5.6% in June.
From the Fed’s perspective, relatively rapid wage gains reflect “excessive demand” for labor, particularly in services, which in turn put upward pressure on crucial service prices.
Wall Street, ever hopeful for lower rates, was elated when the headline CPI ‘s year-over year pace decelerated from 4% to 3%, thanks to one-time drops in airfares and prices for lodging away from home and used cars. But the core CPI was up 4.8%, a bit better than in May, but still far too fast for comfort.
Other data suggest a bifurcated economy. The Institute for Supply Management’s manufacturing index declined by 0.9 percentage points in June to 46.05 marking an eighth consecutive month of contraction. However, the ISM’s non-manufacturing index surged 3.6 percentage points to 53.9% in June, reflecting six straight months of expansion.
The Fed’s “beige book” survey conducted for the upcoming meeting also had mixed findings. While five districts reported “slight or modest growth,” five noted no change, and two reported slight and modest declines. There was growth in consumer spending on services, “but some retailers noted shifts away from discretionary spending.”
In labor markets, the beige book said “employment increased modestly… with most districts experiencing some job growth.” Labor demand was described as “healthy,” and “employers continued to have difficulty finding workers,” although “many districts reported that labor availability had improved and that some employers were having an easier time hiring.” It said “wages continued to rise, but more moderately.”
The survey found “prices increased at a modest pace overall, and several Districts noted some slowing in the pace of increase. Consumer prices generally increased, though reports differed in the extent to which firms were able to pass along input cost increases.” In some places, there was “reluctance to raise prices because consumers had grown more sensitive to prices, while others reported that solid demand allowed firms to maintain margins.”
There’s not much question the economy is slowing, which is what the Fed has consciously sought. Powell has repeatedly said “reducing inflation is likely to require a period of below-trend growth and softening of labor market conditions.”
But the economy is skating clear from recession. GDP grew an upwardly revised 2% in the first quarter – two tenths higher than the Fed’s estimated longer run growth trend — and is believed to have done at least as well in the second quarter.
The Fed’s strategy is premised on the belief that demand exceeds supply and needs to be brought “back into balance.” Powell & Co. are also counting on continued improvement in supply chains. Ancillary belief is that the Fed can curb inflation by keeping inflation expectations under control. Fed officials continue to hope for a “soft landing.”
But this strategy raises questions. If inflation is “always and everywhere a monetary phenomenon,” as Milton Friedman taught, then simply dampening demand, hoping for supply-side improvements and containing inflation expectations may not be enough.
Slowing growth –- even to the point of outright recession – doesn’t necessarily bring inflation under control. Hence, “stagflation.”
In the 1970s, many blamed inflation on the OPEC engineered oil price spikes, ignoring the fact that the Fed accommodated higher oil prices. It tried to prevent higher energy costs from having an unduly contractionary effect on non-energy consumption by running a stimulative monetary policy – until Paul Volcker finally lowered the boom late in the decade.
In the current era, government-mandated shutdowns to combat the pandemic unquestionably put upward pressure on wages and prices – particularly once consumers were able to resume spending with accumulated savings and Treasury checks. But the Fed played a big role in driving inflation to 40-year highs. Not only did it keep the funds rate near zero until long after inflation had accelerated, it held down long-term rates and facilitated unprecedented federal deficit spending.
Preventing the development of inflationary psychology and keeping inflation expectations “well-anchored” are obviously important, but that begs the question of what generated the higher inflation and in turn inflation expectations in the first place. Ultimately then, the Fed must reckon with the consequences of monetary and fiscal stimulus, much of which is still in the pipeline.
Those are the key issues the FOMC will have to confront at its upcoming meeting and beyond.