– Must Decide Pace of Rate Hikes, Where Neutral Is, and Whether Neutral Is High Enough
– Fed Getting Closer to Balance Sheet Reduction But Funds Rate Primary Policy Tool
By Steven K. Beckner
(MaceNews) – It seemed virtually a foregone conclusion that the Federal Reserve would start raising short-term interest rates in mid-March after Jerome Powell’s two days of congressional testimony March 2-3, when the Fed chair left no doubt he would ask for a modest initial rate hike of a quarter percentage point.
As the waves of destruction and disruption from Russia’s invasion of Ukraine have widened beyond that country’s borders, doubts have crept in about how eager the Fed’s rate-setting Federal Open Market Committee is going to be to follow through with moving up from the zero lower bound at its March 15-16 meeting.
Having prepared the markets so thoroughly, the FOMC still seems likely to go ahead and raise rates, but “carefully,” as Powell told Congress. Calls for more aggressive moves have gone by the boards.
Beyond liftoff, the future path of monetary policy is murky.
Although there have been calls for aggressive “front-loading” of rate hikes, Powell told Congress he will ask the Fed’s rate-setting Federal Open Market Committee to pursue a “careful” course when it meets March 15-16.
Following the long-delayed “liftoff” of the federal funds rate from its two-year-old target range of zero to 25 basis points, Powell and other policymakers have signaled “a series” of rate hikes that will ultimately return that policy rate to a “more normal” or “neutral” level.
But no one can say how fast the FOMC will move rates up in a climate fraught with uncertainty since Russia’s invasion of Ukraine. Fed officials will also need to ask themselves just what “neutral” means.
Powell and New York Federal Reserve Bank President John Williams have referenced a “2 to 2 ½%” neutral range. That’s consistent with the FOMC’s estimated “longer run” funds rate of 2.5%, but whether that remains an accurate or appropriate level is open to question.
Nor is it clear whether merely getting back to “neutral” will be sufficient to rein in roaring inflation. Powell has acknowledged the funds rate may need to move into restrictive territory.
FOMC participants will be publishing a fresh set of economic forecasts and funds rate projections March 16, but while the revised Summary of Economic Projections will be revealing, it will provide nothing more than a snapshot of officials’ current economic and policy outlook. Seldom has the outlook been more subject to risk in both directions.
SEP dot plots are notoriously subject to radical change. A year ago, the median projection of FOMC participants was for a single 25 basis point rate hike this year. Not until the Sept. 22 meeting was the funds rate projection moved up and then only by another 25 basis points.
At the Dec. 14-15 meeting, by which time inflation had become alarming, FOMC participants further raised their funds rate projections, but still foresaw just three 25 basis point rate hikes in 2022 to a median 0.9%.
This time, the median projection is likely to rise further – possibly to at least 1.37%. That would imply five 25 basis point rate hikes – or some combination of 25 and 50 basis point moves – with some officials undoubtedly calling for more.
But the FOMC is not meeting in a vacuum, and the shape of the dot plot is less sure than before Feb. 24, when Russia’s invasion set off an economic and financial firestorm. As the Fed’s semi-annual Monetary Policy Report to Congress understatedly put it, “Recent geopolitical tensions related to the Russia–Ukraine situation are a source of uncertainty in global financial and commodity markets.”
Aside from lifting the funds rate, the FOMC will continue strategizing on balance sheet reduction, but actual implementation will only come later and gradually at first.
In the spirit of moving “with care,” as Powell said, the FOMC could try to substitute QT (“quantitative tightening”) for rate hikes, but it is by no means certain that trimming the Fed’s bond holdings would do much to counter wage-price pressures.
One thing the FOMC has going for it heading into its March meeting is a residually favorable economic environment. Policymakers maintain they are “in a good position” to withdraw accommodation.
Calling GDP growth “strong” and labor markets “very, very tight,” Powell said the economy “can take” “a series” of rate hikes, as he testified on the Monetary Policy Report March 2-3.
“With inflation well above 2% and a strong labor market, we expect it will be appropriate to raise the target range for the federal funds rate at our meeting later this month,” he told the House Financial Services Committee and Senate Banking Committee.
The February employment report served to confirm the Fed’s impression of economic strength and reinforce its determination to curb inflation. The unemployment rate fell from 4.0% to 3.8%, despite an increase in labor force participation to 62.3%…, and non-farm payrolls rose a greater than expected 678,000, on top of an upwardly revised January increase of 481,000. The one thing that raised eyebrows was flat average hourly earnings. They were up 5.1%, following a downwardly revised 5.5% in January.
Other data have also been broadly indicative of an economy in good shape, but there have been signs of slowing. For instance, the Institute for Supply Management’s purchase managers index for non-manufacturing industries dipped 3.4 points in February to 56.5.
Of course, most of the data reflect conditions that prevailed before the Ukraine war.
So, the Fed is rapidly approaching a moment of truth, although some would say it hasn’t gotten to the point of withdrawing emergency monetary stimulus rapidly enough. The FOMC is about to start down the road toward a less profligate monetary policy, but where that road takes us — and how fast — is a matter of considerable uncertainty.
After many months of denial, supposedly “transitory” inflation has risen to a 40-year high 7.5%, forcing the FOMC to belatedly move away from extraordinarily low interest rates and from a balance sheet that the Fed doubled over the past two years through massive bond buying.
The FOMC strongly telegraphed a coming departure from the zero lower bound in its Jan. 26 statement: “With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”
The only question since then was how much the FOMC will raise the funds rate – 25 basis points or 50 basis points as some have urged.
Actually, that’s not the only question. We will also be learning how many further rate hikes FOMC participants expect this year and next. And we will likely get a signal as to when the Fed will start shrinking its bloated balance sheet.
Even after Russia’s invasion precipitated massive financial turbulence and exacerbated economic uncertainties, Fed Governor Christopher Waller was still making “a strong case” for a 50 basis point rate hike.
But that was never very likely, at least as initial step, and the Fed leadership has pretty much ruled it out. In his congressional testimony, Powell said he intends to “propose and support” a 25 basis point hike.
FOMC Vice Chairman Williams had previously asserted he sees “no compelling argument” for a larger move.
So, it now seems certain the FOMC will move gradually to withdraw monetary stimulus, at least in the early going. It could act more aggressively later if inflation doesn’t moderate, as Fed officials still believe it will.
Now that a 25 basis point liftoff is probably just days away, how far and how fast will the funds rate rise? And how will the monetary trajectory be affected by the war in Ukraine and its knock-on effects – soaring energy, wheat and other commodity prices, plunging stock prices?
At this writing, the average price of regular gas had risen more than 70 cents per gallon to $4.173, which compares to $2.774 a year ago. Rising transportation costs add to the costs of all kinds of products – not to mention the fact that petroleum and natural gas are key inputs in plastics, fertilizer and other goods. With oil soaring close to $130 per barrel and expected to go much higher, those costs seem sure to keep surging.
What’s more, companies are discovering the “pricing power” to pass higher costs on to consumers. The Fed’s beige book survey of conditions prepared for review at the upcoming meeting, says, “Firms reported an increased ability to pass on prices to consumers; in most cases, demand has remained strong despite price increases. Firms reported they expect additional price increases over the next several months as they continue to pass on input cost increases.”
The beige book also found that “firms continued to increase compensation and introduce workplace flexibility to attract workers—especially in historically low-wage positions—with mixed success.”
These trends add to Fed concerns that inflation is becoming “embedded” and threatening to increase inflation expectations. Officials comfort themselves that longer run expectations remain “anchored,” but they may just be whistling past the graveyard.
These “supply shocks” don’t just add to inflationary pressures; they are also contractionary. Money spent on buying gasoline is money not available to purchase other things. And that’s not even considering negative wealth effects from plunging asset values.
The specter of “stagflation” is looming.
So far, Fed policymakers believe the economy and labor markets are strong enough to withstand rate hikes despite the Ukraine crisis. Indeed, far from impeding rate hikes, some think the inflationary impulses arising from the Russian invasion reinforce the need for them.
Cleveland Federal Reserve Bank President Loretta Mester, speaking on the morning of Powell’s second day of congressional testimony, said the Ukraine fall-out makes it “even more necessary” to remove accommodation because it raises inflation risks.
“The situation in Ukraine adds uncertainty to the economic outlook,” Mester said, but “the uncertainty about the outlook doesn’t change the need to get inflation under control in the U.S. In fact, it actually adds upside risk that high inflation might continue, and that makes it more important to take action.”
But even more hawkish policymakers are pulling their punches a bit. Mester said the FOMC should start with a 25 basis point hike, then continue to raise rates in a “deliberate” and “thoughtful” way. Only if inflation fails to moderate would the FOMC need to raise rates more aggressively, she said.
Waller acknowledged fall-out from fighting in Ukraine could change the economic outlook and “may mean a more modest tightening is appropriate.”
Powell is fully on board with starting to take away monetary stimulus, but in a cautious way. Rates will be raised “carefully,” he repeatedly emphasized.
Asked how FOMC decision making would be affected by Ukraine, Powell responded, “Coming into this meeting, let’s say before the Ukraine invasion, the Committee was set to raise our policy rate – the first of what was to be a series of rate increases expected for this year. Every meeting was live; decisions would based on incoming data and the evolving outlook. We also expected to make great progress on our plan to shrink the balance sheet.”
Powell said, “the question now really is how is how the invasion of Ukraine, the ongoing war, the response from nations around the world, including sanctions, may have changed that expectation.”
“It’s too soon to say for sure, but for now I would say that we will proceed carefully along the lines of that plan,” he continued. “The thing is the economic effects of these events are highly uncertain. So far we’ve seen energy prices move up further, and those increases will move through the economy and push up headline inflation and also (impact) spending We’re seeing effects on other commodities and perhaps undermining risk sentiment and weaker growth abroad.”
“The thing is we can’t know how large or persistent those effects will be…,” he added.
But how much of “a series” of “careful” rate hikes? And over what time frame? We’ll see what FOMC participants anticipate in the new dot plot, but that will only provide a momentary snapshot in a rapidly changing environment.
Key to watch for will be the language the FOMC uses to signal the pace or frequency of further rate hikes. Williams and Richmond Fed President Thomas Barkin have said rates need to be raised “steadily.” Kansas City Fed President Esther George has used the word ”deliberately.”
One phrase that seems unlikely to be employed is “measured pace” or, more precisely, “a pace that is likely to be measured,” as the FOMC put in when it was raising the funds rate at sequential meetings in 2004-05. It seems doubtful the FOMC will want to revert to language that became code for hiking the funds rate by 25 basis points at every meeting en route to a 5.25% funds rate by mid-2006.
A better choice might be the language the FOMC adopted in January 2006, when it stopped using the word “measured”: “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”
Or it could use something like the June 29, 2006 language: “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”
Whatever the “forward guidance” chosen, it seems almost certain the FOMC is going to embark on an incremental approach to raising the funds rate while letting balance sheet reduction operate ‘in the background,” as Powell has said.
Now, incrementalism has its potential pitfalls. An incremental approach works fine if you’re a chef, adding a little seasoning to the sauce at a time to avoid overdoing the salt or spices. But making monetary policy is different than cooking. Some call for bolder action.
The reality is that the FOMC is going to be picking its way along, hoping to get some moderation of inflation while sustaining growth. This will probably mean at least three successive rate hikes, then perhaps a pause to reassess.
As Mester put it, “we have to be looking at the data and using the data to inform our outlook.” She expects inflation to moderate, but “if we don’t see inflation moving back down that would be a signal to me that we need to remove accommodation at a faster pace .…”
“We have to be forward-looking and use incoming data to inform our outlook …,” she went on. “We have to take actions and (can’t just) say, ‘oh, inflation is going to come down on its own.’”
There is more art than science to rate setting. There is no hard-and-fast formula. And so, as Powell has often said, the FOMC isn’t “on a preset course.”
The FOMC has often said it is prepared to “adjust” policy, and that is even more true in wake of the invasion and its unpredictable consequences.
The exact pace of rate hikes matters less to the Fed than to Wall Street. If 125 basis points of rate hikes are coming this year, policymakers are less concerned about whether the sequence goes 50 bp, 25 bp, 25 bp, 25 bp or five 25 bp rate hikes.
More important, in officials’ minds, is clearly communicating Fed intentions and having that signal affect financial conditions and in turn the economy.
Unlike rates, balance sheet reduction will be more predictable. The FOMC will be getting more staff presentations on the balance sheet and going beyond the set of “principles” already announced in January.
Powell said the FOMC is unlikely to finalize its balance sheet reduction strategy at the upcoming meeting, but by the May 3-4 meeting, it could be ready to announce a plan which could be implemented in June.
As in the previous QT episode, it will likely involve steadily increasing caps on the amount of maturing securities the Fed will allow to run off. But while that will tend to remove accommodation by allowing upward pressure on bond yields, there is no magic formula for how much balance sheet reduction equals how many basis points of funds rate hikes.
We have to think about not just the pace of rate hikes but the ultimate destination.
Echoing Williams, Powell said the Fed eventually wants to get the funds rate to a “more normal” or “neutral” level of rates. Williams spoke of getting there “by the end of next year.”
“We’ve talked about getting to a neutral rate, which would be somewhere between 2 and 2 ½,”
Powell said. “It may well be we need to go higher than that. We just don’t know.”
But what is “normal” or “neutral” at this stage? And what will “normal” look like six months or a year from now?
FOMC participants’ median projection for the longer run” funds rate, a proxy for the neutral rate, is 2.5%, but that’s not set in stone. It has been held at 2.5% for going on three years, but as recently as 2015, it was estimated at 3.8%.
The downward revisions in Fed estimates of the neutral rate reflect Fed economists’ belief that the real equilibrium short-term interest rate (“r*”) has fallen precipitously due to demographic, productivity and other forces.
The 2.5% estimate assumes inflation will average 2% over the longer run and that the real rate will be no more than 0.5%. But obviously inflation is now running far above the 2% target, and there’s no guarantee it will return to 2% or even 3% anytime soon.
So presently and for the foreseeable future it is questionable whether a 2.5% neutral rate makes sense, except in the much longer run. At this point it looks like more of a pipe dream.
Assuming the “longer run” funds rate projection stays at 2.5%, getting back to “normal” “by the end of next year” implies 250 basis points of rate hikes in 21 months. But is 2.5% really “neutral,” and will neutrality alone be sufficient to bring inflation back under control?
Those are tough questions to answer, and the answers will evolve with economic and financial conditions.
The real component of that 2.5% “longer run” rate is still believed to be very low, if not negative, but obviously the inflation component is much higher. Even if the real rate stays down, the FOMC will have to decide whether the nominal neutral rate needs to be adjusted higher if inflation doesn’t moderate significantly. The Ukraine situation could impede progress toward whatever neutral is.
The history of the relationship between the funds rate target and the longer run funds rate estimate is interesting to consider, though not necessarily instructive for present circumstances.
The last time the funds rate was above neutral was in late 2007. before the FOMC slashed the funds rate to zero in 2008 to counter the financial crisis and Great Recession. The funds rate began 2007 at 5.25%, but was cut to 4.75% in September of that year and to 4.25% in December. The longer run rate was then estimated to be about 4%.
More recently, as the FOMC was contemplating “normalization” after holding the actual funds rate near zero for seven years following the financial crisis, the longer run rate was estimated at a relatively high level. In June 2015, the longer run rate stood at 3.8% while the funds rate target was still 0-0.25%. In December 2015, when the funds rate was raised 25 basis points to 0.25-0.50%, the longer run rate estimate was lowered from 3.8% to 3.5%.
The FOMC waited a whole year before raising the funds rate target another 25 basis points to a range of 0.50-0.75% in December 2016. In the meantime, the longer run funds rate estimate was revised down twice – to 3.3% in March 2016 and to 3.0% in June 2016.
In December 2018, by which time the FOMC had raised the funds rate target another four times to 2.25-2.50%, the longer run funds rate was lowered to 2.8%. In June 2019, the longer run rate was cut from 2.8% to 2.5%, where it has stayed ever since, even as the FOMC was in the process of cutting the funds rate three times back down to 1.5-1.75%..
These downward revisions of the longer run neutral rate took place at a time when r* and its policy implications were all the rage among Fed researchers. Leading the way was Williams, and the basic conclusion was that a globally falling r* put central banks at risk of spending more time near the zero lower bound, limiting the ability of conventional monetary policy to counter recessions.
The policy prescription, which was ultimately enshrined in the Fed’s new policy framework in August 2020, was that the Fed should let inflation overshoot the 2% target to compensate for past undershooting and to allow for more ‘inclusive” “maximum employment.”
Now inflation has overshot in a way no one at the Fed imagined.
The prevailing 2.5% longer run funds rate projection is based on a big assumption – that inflation is going to return to the FOMC’s average 2% target. If it doesn’t then the whole concept of neutrality will have to be reassessed.
If inflation fails to moderate, Powell & Co. will face tough choices between fighting inflation and supporting growth. Taking them at their word, the dilemma would be resolved in favor of doing more to curb inflation. But this Fed is not exempt from political influence and may find it hard to ignore downside risks.