By Steven K. Beckner
(MaceNews) – Since raising short-term interest rates more aggressively in mid-June, misgivings have cropped up among Federal Reserve officials about raising rates too far, too fast, but such sentiments must contend with worsening inflation news that has made it all the more imperative in most minds to demonstrate the central bank’s commitment to restoring some semblance of price stability.
And so, despite reservations about unduly large rate hikes, the Fed’s policy-making Federal Open Market Committee appears to be on track for another 75 basis point increase in the federal funds rate to a target range of 2.25% to 2.50%.
Some have speculated the FOMC might take the funds rate up a full percentage point, but that seems less likely. Moving rates up that much could complicate the Fed’s crucial communications task and risk destabilizing financial conditions with potentially negative economic repercussions.
After raising the funds rate by 75 basis points for the first time since 1994 on June 15, Chair Jerome Powell told reporters the FOMC would be choosing between a “50 or 75” basis point move at the July 26-27 meeting enroute to a “moderately restrictive” 3-3.5% funds rate range by year’s end. He repeated that guidance when he testified on the Fed’s semi-annual Monetary Policy Report to Congress in late June.
Minutes of the June 14-15 FOMC meeting conveyed a strong unity of purpose in the pursuit of lower inflation: “In discussing potential policy actions at upcoming meetings, participants continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate to achieve the Committee’s objectives. In particular, participants judged that an increase of 50 or 75 basis points would likely be appropriate at the next meeting.”
“Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist,” the minutes added.
However, it emerged in recent weeks that there was considerable sentiment for tempering the Fed’s “expeditious” path toward more “normal” rates. Rather than taking big strides toward the 3-3.5% range or higher, it was believed the FOMC should feel its way along to avoid disrupting financial markets and in turn hurting the economy. Moving too rapidly, it was felt, could set back the Fed’s effort to get inflation under control.
Some Fed officials went on record to make that more incrementalist approach explicit in advance of the June inflation reports.
Notably, Kansas City Federal Reserve Bank Esther George said, “the case for continuing to remove policy accommodation is clear-cut,” but “the speed at which interest rates should rise, however, is an open question.”
George, who dissented against the 75 basis point June rate increase in favor of 50 basis points but who traditionally has been thought of as one of the more “hawkish” FOMC members, cautioned that “moving interest rates too fast raises the prospect of oversteering.”
Though “sympathetic to the view that interest rates need to increase rapidly,” she warned that “the rate of change in tightening policy can affect households, businesses, and financial markets particularly during a time of heightened uncertainty.”
“Policy changes transmit to the economy with a lag, and significant and abrupt changes can be unsettling to households and small businesses as they make necessary adjustments,” George said. “It also has implications for the yield curve and traditional bank lending models, such as those prevalent among community banks.”
Noting that financial conditions had already tightened at a “historically swift pace,” she said, “more abrupt changes in interest rates could create strains, either in the economy or financial markets, that would undermine the Fed’s ability to deliver on the higher path of rates communicated.”
Citing the “growing discussion of recession risk,’ George said, “such projections suggest to me that a rapid pace of rate increases brings about the risk of tightening policy more quickly than the economy and markets can adjust.”
George also recommended the Fed should proceed cautiously because “the transmission of higher policy rates and the associated tightening in financial conditions to spending, employment, and inflation is subject to considerable uncertainty,” George said.
“For example, the shift in spending away from services to housing and durable goods during the pandemic may make the economy more sensitive to higher interest rates,” she continued. “Another possibility is that the significant accumulation of liquid savings during the pandemic will dampen the effects of higher interest rates on spending and ultimately inflation.”
“Given this range of outcomes, it is unclear just how high rates will need to move in order to bring inflation down,” she went on. “These dynamics suggest it will be particularly important to observe how the economy is adapting to changes in monetary policy.”
Finally, George warned “the pace of increases in the federal funds rate could have implications for balance sheet runoff” in a time of market volatility. ”Limiting the extent to which uncertainty about the pace of interest rate adjustments contributes to this volatility could be important especially as balance sheet runoff gets underway.”
And she added that “raising short-term rates much faster than longer-term rates could further invert the yield curve and challenge traditional bank lending models as a consequence. To the extent an inverted yield curve has historically preceded recessions in the United States, such a scenario could pose yet another challenge to achieving a significant reduction in the balance sheet.”
George was not alone in her concerns. Richmond Fed President Thomas Barkin said, “We want to get back to somewhere in the range of neutral as expeditiously as we can without inadvertently causing damage we don’t want to cause.” Atlanta Fed chief Raphael Bostic has also cautioned against monetary “recklessness.”
But that kind of go-slow talk got sublimated, not to say suppressed, after the Labor Department released a pair of gruesome inflation reports on successive days July 13-14.
First came the report that the consumer price index rose a bigger than expected 9.1% from a year earlier in June – up from the prior 40-year high of 8.6% in May. The month-on-month rise of 1.3% translates into a staggering annualized rate of 15.6%. The year-over-year core CPI moderated from 6.0% to 5.9%, providing some small measure of comfort, but not nearly enough to assuage Fed worries about inflation.
The June producer price index looked even worse – rising 11.3% from a year earlier.
These reports came on the heels of a stronger than expected June employment report, which showed non-farm payrolls rising by 372,000 and the unemployment rate staying at 3.6%. That report tended to underscore the Fed’s belief that the economy and the labor market are strong enough to withstand higher interest rates as the Fed seeks to reduce “excess demand” in the face of supply constraints.
Here too there were signs of moderation in wage inflation, as average hourly earnings rose 5.1% from a year earlier – down from May’s 5.3%. But that is still too fast for Fed comfort. Though outstripped by price increases, such a pace of wage increases is seen as “inconsistent” with 2% inflation, as Powell has said.
The beige book survey prepared for the upcoming meeting showed spreading signs of slower economic activity, but little moderation of inflation.
“Substantial price increases were reported across all Districts, at all stages of consumption, though three quarters noted moderation in prices for construction inputs such as lumber and steel…,” the summary of findings by the 12 Federal Reserve Banks stated.
“While several Districts noted concerns about cooling future demand, on balance, pricing power was steady, and in some sectors, such as travel and hospitality, firms were successful in passing through sizable price increases to customers with little to no push-back,” the report continued. “Most contacts expect pricing pressures to persist at least through the end of the year.”
On the labor compensation front, the beige book said “one third of Districts indicated that employers were considering or had given employees bonuses to offset inflation related costs while in two Districts, workers requested raises to offset higher costs. A quarter of Districts indicated wage growth will remain elevated for the next six months, while a few noted that wage pressures are expected to subside later this year.”
These kinds of anecdotal and statistical data on inflation fueled calls for aggressive rate hike by the leading Fed hawks in ensuing days.
Most prominently, Fed Governor Christopher Waller and his former boss St. Louis Fed President James Bullard both renewed calls for a second consecutive 75 basis point rate hike on July 27.
“(W)ith inflation so high, there is a virtue in front-loading tightening so that policy moves as soon as is practical to a setting that restricts demand,” Waller said. “Getting there sooner will bolster the public’s confidence that we can get inflation down and it will preserve options for adjusting the pace of tightening later.”
Another 75 basis point rate hike to a target range of 2.25 to 2.5% would bring the funds rate “close to neutral,” said Waller, who added that he expects “further increases in the target range will be needed to make monetary policy restrictive, but that will depend on economic data in the coming weeks and months.”
“Between the end of July and the FOMC’s September meeting, we will get two employment and CPI reports with data for July and August,” Waller continued. “I will be looking for signs that inflation has started its move down toward our 2% target on a sustained basis.”
Bullard, a voting member of the FOMC this year, said a 75 basis point hike “has a lot of virtue to it” and said raising the funds rate above 4% by the end of the year is “possible.”
Bullard and Waller will no doubt prove prophetic about the outcome of the FOMC vote on July 27. It does seem highly likely that the FOMC will move rates up by 75 basis points for the second straight meeting.
But a word of caution is in order. We should not necessarily expect a continuation of aggressive monetary tightening in the second half or for that matter in 2023.
Though she has been most vocal in warnings against “oversteering” or overtigthening of monetary policy, George is not alone in worrying about raising rates so rapidly as to cause financial market ructions that could throw the economy off balance and force the Fed to shift its focus away from the anti-inflationary job at hand. Even Waller has said, “You don’t want to overdo the rate increases.”
Assuming the FOMC does move the funds rate up by 75 basis points on July 27, it seems likely that Powell & Co. will look for an opportunity to slow the pace of tightening at their next meeting of Sept. 20-21 – if the data will permit it.
If, by then, there are further signs of slowing and if core inflation shows further signs of having peaked and turned lower, the FOMC may be able to raise the funds rate by smaller amounts and still arrive in the 3-3.5% range by the end of the year.
The Fed could get help from improvements in supply chain performance and from the efforts of its fellow central banks to reduce global inflationary pressures. It has to hope that inflation has not gotten too entrenched at these levels.