– Fed Faces Tricky Calculations, Choices as It Plots Policy Course
By Steven K. Beckner
(MaceNews) – As the Federal Reserve prepares for its sixth monetary policy meeting of 2023, the way forward for interest rates is hazy.
It seems likely the Fed’s policymaking Federal Open Market Committee will raise the federal funds rate further but not at the Sept. 19-20 meeting.
Increasingly, caution is the byword at the Fed. The predominant view favors a careful, meeting-by-meeting, data dependent approach. Top policymakers believe a “restrictive” monetary stance has been achieved, so that the FOMC can relax a bit and move more deliberately. There is an aversion to over-tightening in the face of uncertainty.
The sense is that, although inflation is still too high, much progress has been made and more moderation is likely, given tighter financial conditions, relatively slow growth and “anchored” inflation expectations. That’s provided the Fed maintains a “restrictive” stance for as long as necessary.
Although the labor market is still seen as too tight and wage gains excessive, the thinking is that considerable progress toward “rebalancing” labor demand and supply has been made with more in the cards.
Having reached a “restrictive” stance, the jury is out on whether the funds rate is “sufficiently restrictive.” But there is no rush to decide whether policy needs to be made tighter yet.
At the same time, there is no urgency about removing monetary restraint. It is thought rates will need to be kept high for a considerable time to ensure further progress is made on inflation reduction. There is talk about the eventual need to adjust nominal rates to prevent real rates from becoming too tight, but that’s not on the horizon.
For now, the FOMC is apt to stay on hold with a tacit tightening bias.
Some clarity may be provided when the FOMC releases not just a new policy statement but also a new set of rate projections and forecasts, and when Chair Jerome Powell elaborates to the press. But even then we will have to wait to see where policy is headed.
Going forward, policymakers will be looking not just at inflation, crucial as that is, but at whether economic activity and labor markets show the desired softening. The tone of financial conditions could also play an important role in future rate calculations.
At lower rate levels, it was relatively easy for Fed officials to agree on rate hikes, although there were sometimes disagreements over the appropriate pace. Now, after 11 increases, it’s no longer as obvious where rates should go the rest of this year and beyond.
Increasingly differences have emerged among Fed officials.
Virtually no one thinks the Fed needs to raise rates aggressively or frequently, but while some think the funds rate definitely needs to go higher to be “sufficiently restrictive,” others are more inclined to think the Fed has done enough and should wait a decent interval to allow the lagged effects of past tightening to manifest themselves before considering additional moves.
Central to this schism are varying understandings of what constitutes a “restrictive” monetary stance in real rate terms. Ultimately, only experience and observation, not theory, will reveal whether policy has been “sufficiently restrictive.” In the meantime, much of policymaking is guesswork.
The upcoming meeting will be a forum for debate between those who think the Fed needs to do more in coming months and those who think it’s arrived at its destination, with Powell struggling to forge a compromise.
What seems most likely is that the FOMC will skip this meeting but stand ready to push the funds rate modestly higher at one of the remaining meetings of 2023 — Oct. 31-Nov. 1 or Dec. 12-13. A second hike is unlikely though not impossible.
At its July 25-26 meeting, the FOMC raised the funds rate 25 basis points to a 5.25% to 5.5% target range — making a cumulative 525 basis points since the Fed left the zero lower bound in March 2022.
The FOMC also reaffirmed its strategy of shrinking the Fed’s portfolio of Treasury and agency mortgage-backed securities a combined $95 billion per month by declining to reinvest maturing securities.
The July minutes show little inclination to discontinue “quantitative tightening,” as “a number of participants noted that balance sheet runoff need not end when the Committee eventually begins to reduce the target range for the federal funds rate.”
The minutes said officials believed it “critical that the stance of monetary policy be sufficiently restrictive to return inflation to the Committee’s 2% objective over time” – a seemingly nebulous period for achieving “price stability.” No more specific are officials who have said inflation needs to be reduced to 2% “in a reasonable period of time.” As a group, officials don’t aren’t terribly ambitious about reaching that goal. Even by the end of 2025, they see inflation hovering over 2%.
Powell suggested then that the Sept. 19-20 FOMC meeting will be a “live” one, saying he and his colleagues had not moved to an “every other meeting” schedule and not taking rate hikes at “consecutive meetings” “off the table.” If the inflation data were not satisfactory by Sept. 20, the FOMC would “go ahead” and raise rates again but could “hold steady.”
In July, the staff pulled back from its prediction of a mild recession, and ensuing data showed some further moderation of inflation, but core inflation persisted well in excess of the Fed’s 2.% target.
After a period of slowing, prices reversed course somewhat in July. The consumer price index rose 3.2% compared to a year earlier, up two tenths from June. The core” CPI moderated further in July, but at 4.7% was still running far above target as wage pressures pushed service prices up much faster than goods prices.
The Fed’s preferred inflation gauge, the price index for personal consumption expenditures, also reaccelerated, rising 3.3% overall and 4.2% on a core basis from a year earlier. The “supercore” PCE of core service prices ex-housing, which the Fed has been watching closely, was up 4.7%.
When he reassessed the outlook at the Fed’s annual Jackson Hole symposium on Aug. 25, Powell wasn’t prepared to declare victory against inflation. He was ambiguous about the amount and timing of further rate hikes, but his keynote address embodied more asymmetry than some thought — a mild bias toward additional tightening.
Although the rate hikes of the past year and a half had brought the policy rate to a “restrictive” stance, Powell left doubt whether it is “sufficiently restrictive” to bring inflation down to the 2% target. So, he said the FOMC is prepared to do more, albeit “carefully,” depending upon how much more progress it makes in reducing inflation and upon evidence that sought-after “re-balancing” of supply and demand is occurring.
“Although inflation has moved down from its peak—a welcome development—it remains too high,” he said. “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
Powell seemed to steer away from a Sept. 20 move when he said, “Given how far we have come, at upcoming meetings we are in a position to proceed carefully as we assess the incoming data and the evolving outlook and risks.”
He was also seemed comfortable with current rates when he said “real interest rates are now positive and well above mainstream estimates of the neutral policy rate.” Therefore, “we see the current stance of policy as restrictive, putting downward pressure on economic activity, hiring, and inflation.”
But Powell declared he and his colleagues “are committed to achieving and sustaining a stance of monetary policy that is sufficiently restrictive to bring inflation down to that (2%) level over time.” And he cautioned, “we cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint.”
What’s more, Powell cited uncertainty about the length the lags with which monetary tightening affects economic activity and inflation.
Such uncertainties make it tricky to achieve “our task of balancing the risk of tightening monetary policy too much against the risk of tightening too little,” he said. “Doing too little could allow above-target inflation to become entrenched and ultimately require monetary policy to wring more persistent inflation from the economy at a high cost to employment. Doing too much could also do unnecessary harm to the economy.”
Employing “risk-management considerations.” Powell said the FOMC “will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.”
“We will keep at it until the job is done,” he vowed, but that could take awhile. The Fed wants to “slow the growth of aggregate demand, allowing supply time to catch up,” but “while these two forces are now working together to bring down inflation, the process still has a long way to go.”
Powell issued two important caveats:
1. Tighter financial conditions should be slowing the economy and softening labor market conditions, but “we are attentive to signs that the economy may not be cooling as expected.”
2. “Evidence that the tightness in the labor market is no longer easing could also call for a monetary policy response.”
Since Jackson Hole, continued strong demand for has sustained wage-price pressures. But while August data look worrisome enough to keep the Fed pointed toward eventual further tightening, they don’t seem so portentous as to provoke near term action.
The August employment report showed further cooling in the labor market and largely validated Powell’s “careful” approach to further tightening, but it presented a mixed picture. The unemployment rate rose three tenths to 3.8%, but that’s still a very low jobless rate and reflected an increase in the labor force participation rate rose to 62.8%, highest since February 2020,
Non-farm payrolls rose a more than expected 187,000. Average hourly earnings grew a less than expect 0.2%, but year-over-year, they were still up 4.3%. That’s a tenth less than in July, but still more than double the 2% inflation target.
Manufacturing continued to contract in August, but the Institute for Supply Management’s manufacturing index improved, rising 1.2 percentage points to 47.6. The ISM’s non-manufacturing index rose 1.8 points to 54.5, as the service sector kept expanding.
The Fed’s “beige book” survey of economic conditions provided some anecdotal evidence that the Fed may be getting some of the kind of cooling it’s been seeking: “Retail spending continued to slow, especially on non-essential items. Some Districts highlighted reports suggesting consumers may have exhausted their savings and are relying more on borrowing to support spending….”
The beige book suggested the labor market “rebalancing” the Fed is seeking may still be wanting, though. “Job growth was subdued across the nation. Though hiring slowed, most Districts indicated imbalances persisted in the labor market as the availability of skilled workers and the number of applicants remained constrained. …..”
Inflation findings were a mixed bag, as “most Districts reported price growth slowed overall, decelerating faster in manufacturing and consumer-goods sectors…. Contacts in several Districts indicated input price growth slowed less than selling prices, as businesses struggled to pass along cost ……”
The August CPI was a good news-bad news tale. The core slowed further to a 4.3% year-over-year pace, but the headline index be rate picked up again to 3.7%.
There are contrary indications to the economic resilience narrative. The latest JOLTS report showed a decline in opening, hires and quits. The Conference Board’s August consumer conference survey took a surprise plunge.
The momentum of the economy and employment, as well as perceived downside risks, will obviously be key to how much higher rates go. But officials will also be looking closely at financial conditions. To the extent equity prices weaken, hurting household wealth, and to the extent rising bond yields push up mortgage rates and hurt interest-sensitive spending, the FOMC will feel less need to tighten.
As Dallas Fed President Lori Logan, an FOMC voter observes, “To the extent that tighter conditions from this source persist, they should slow the economy and, potentially, require less additional tightening of monetary policy.”
At the July meeting, minutes say “a couple of participants indicated that they favored leaving the target range for the federal funds rate unchanged or that they could have supported such a proposal,” but said “a number of participants judged that, with the stance of monetary policy in restrictive territory, risks to the achievement of the Committee’s goals had become more two sided, and it was important that the Committee’s decisions balance the risk of an inadvertent over tightening of policy against the cost of an insufficient tightening.”
Official viewpoints have continued to diverge since Jackson Hole, complicating Powell’s job of forging a policy consensus. Some have become more outspoken in opposition to further tightening.
“Absent any alarming new data between now and mid-September, I believe we may be at the point where we can be patient and hold rates steady and let the monetary policy actions we have taken do their work,” voting Philadelphia Federal Reserve Bank President Harker said. “Should we be at that point where we can hold steady, we will need to be there for a while. I do see us on the flight path to the soft landing we all hope for and that has proved quite elusive in the past .”
Likewise, Atlanta Fed President Raphael Bostic: “ I feel policy is appropriately restrictive. I think we should be cautious and patient and let the restrictive policy continue to influence the economy, lest we risk tightening too much and inflicting unnecessary economic pain.”
Bostic saw “inflation on a clear path downward” and said, “a case could be made that if it were not for stubborn (and lagging) housing services prices, the core CPI would be running at 2.6% on a year-over-year basis… So, essentially, given the lagging nature of rental prices in the calculation of the CPI—and the PCE for that matter—underlying inflation may well be close to our target already.”
Nor did Bostic see price pressure coming from labor markets, where “there appears to be a measured cooling afoot….”
So there is “a convincing case that the rate of inflation will continue declining toward our objective of 2%: reductions in planned price increases, cooling in the labor market, and, ultimately, a measured tempering of economic activity that will bring supply and demand into closer alignment,” he contended. “Our restrictive monetary policy stance is having a clear moderating effect on economic activity that should put further downward pressure on prices and thus promote a return to our 2% inflation target.”
Hence, Bostic argued, the Fed should take “a patient, resolute, and cautious approach to monetary policy,” because “we now risk overtightening and inflicting unnecessary damage on the labor market and wider economy.” He warned against “‘passive tightening,’ as falling inflation means real interest rates rise even as the nominal rates the Fed influences remain stable.”
Boston Fed President Susan Collins also sounds very risk averse: ”in my view, this phase of our policy cycle requires patience, and holistic data assessment, while we stay the course.”
Collins “expect(s) we’ll need to hold rates at restrictive levels for some time.” but it was clear she would not support raising rates at the upcoming meeting.
“The risk of inflation staying higher for longer must now be weighed against the risk that an overly restrictive stance of monetary policy will lead to a greater slowdown in activity than is needed to restore price stability,” she said. “This context calls for a patient and careful, but deliberate, approach to policy, allowing time to assess the effects of policy actions to date, and then acting appropriately.”
Collins emphasized “patience does not mean indecision, or a change in the commitment to the 2% target, but rather time to ensure that the economy is on a clear trajectory to achieve price stability … (We are well positioned to proceed cautiously in this uncertain economic environment, recognizing the risks while remaining resolute and data-dependent, with the flexibility to adjust as conditions warrant.”
Others, such as Gov. Michelle Bowman and Cleveland Fed President Loretta Mester have continued to lean emphatically toward further rate hikes. But even the “hawk” camp seems tamer these days.
Minneapolis Fed President and FOMC voter Neel Kashkari, who had developed a more hawkish reputation, seems to have mellowed.
“Are we done raising rates?” he asked recently. “I’m not ready to say that we’re done, but I’m seeing positive signs that say, “hey, we may be on our way. We can take a little bit more time to get some more data in before we decide if we need to do more..”
Kashkari “want(s) to see convincing evidence that inflation is well on its way back down to 2%,” but added, “then we can allow it some time to run. We don’t need to get there tomorrow. We can allow it to gradually get there over time.”
He said the FOMC is “a long way from cutting rates, because core inflation is still around 4%. It’s still around twice what our target is, and we need to be confident that its going all the way down to 2%..” But he said “there will come a point in time – we’re not there yet – … when one could reasonably argue ‘hey, maybe we ought to back off the nominal rate just to keep monetary policy at a stable point, not keep tightening. Could that happen next year? It’s certainly possible, or the year after that, but we have to see how the data come in.”
Mester favors one 25 bp hike, though not necessarily this month. “Although there has been some progress, inflation remains too high.”
She said “the monetary policy questions are whether the current level of the federal funds rate is sufficiently restrictive and how long policy will need to remain restrictive to keep inflation moving down in a sustainable and timely way to our goal of 2%.”
“Future policy decisions will be about managing the risks and the intertemporal costs of over-tightening vs. under-tightening monetary policy,” Mester continued. “This assessment will require close monitoring of economic, banking, and financial market developments and using all of that economic reconnaissance to determine whether the economy is evolving in line with the outlook or not….”
Logan has established a fierce inflation-fighting image since taking office last year, but in her latest remarks she exercised restraint. While indicating the Fed probably needs to tighten more, she made clear she’s prepared to “skip” the September meeting.
Logan began hawkishly enough, saying, “The significantly lower inflation in recent months is encouraging. But lower inflation isn’t necessarily low-enough inflation. We have to ask whether monetary policy is now sufficiently restrictive to return inflation all the way to 2% in a sustainable and timely way or whether the FOMC still needs to do…”
Logan also feared labor market conditions “suggest we haven’t finished the job of restoring price stability. To sustain low inflation, supply and demand need to be in balance… To sustain 2% inflation over time, wage growth will need to fall, or trend productivity growth will need to rise.”
Logan’s “base case… is that there is work left to do.”
Nevertheless, she said the Fed should “proceed carefully,” because “the economic outlook isn’t certain. Tighter financial conditions might slow the economy without much further action by the FOMC. And there are risks to doing both too little and too much….”
Logan warned, “In this environment, the stance of policy needs to be calibrated carefully. Tightening too little would allow above-target inflation to persist. If high inflation becomes entrenched, restoring price stability could require much larger and more costly rate increases. However, excessively restrictive policy would also hurt households and businesses and might even lead inflation to undershoot our 2 percent target…..”
“So, at this stage, I believe we must proceed gradually, weighing the risk that inflation will be too high against the risk of dampening the economy too much…,” she added.
Noting the FOMC had “skipped a rate increase” in June, Logan said “another skip could be appropriate when we meet later this month.”
But she emphasized “skipping does not imply stopping. In coming months, further evaluation of the data and outlook could confirm that we need to do more to extinguish inflation. The FOMC will need to keep the water bucket close at hand, and we must not hesitate to use it as necessary. But we must also gather the necessary information to use our tools well…”
New York Fed President John Williams also indicated the FOMC will “skip” September and suggested not a lot more tightening will be needed.
“Inflation is moving in the right direction, though it’s still too high,” said
the FOMC vice chairman. “We’re seeing movement in the right direction to bring supply and demand more into balance. …I think right now we’ve gotten monetary policy into a good place,” but “we’ll have to keep watching the data” and assess whether policy is restrictive enough.”
Aside from the wording of the policy statement and Powell’s comments, a key feature of the upcoming meeting will be a fresh quarterly Summary of Economic Projections, most notably including funds rate projections.
In the last June 14 SEP, FOMC participants anticipated the funds rate would end this year at a median 5.6% (5.5% to 5.75%). With the July 26 hike taking the funds rate to a median 5.3%, the FOMC has room within its own parameters for another 25 basis point move in 2023.
But it’s not a foregone conclusion the revised “dot plot’ will look the same. It will be interesting to see if rate projections are raised or lowered for this year and next.
Also important to watch will be how officials’ forecasts for inflation, GDP growth and unemployment may have changed from June, when they increased their 2023 GDP growth forecast to 1.0%, lowered their unemployment forecast to 4.1% and raised their core PCE forecast to 3.9%. Based on recent trends, it seems likely the growth forecast will be raised and the unemployment forecast lowered.
The inflation forecast may or may not be changed for better or worse, but typically the Fed sees faster growth and lower unemployment as boding higher inflation.
Another thing that will bear watching is whether officials keep their “longer run” or “neutral” funds rate projection at 2.5%, where it’s been since June 2019, when it was lowered from 2.8%. Before the financial crisis it was estimated at 4%.
The estimated neutral rate, though “longer run,” is highly relevant to how policymakers think about the appropriate monetary stance. The 2.5% rate assumes a 2% inflation target plus a 0.5% real equilibrium short-term interest rate or “r*”, sometimes called the “natural rate of interest.”
After the financial crisis, the Fed’s r* estimate was steadily lowered toward zero, if not lower, to justify launching several rounds of “quantitative easing.” If the real rate is still just 0.5% and the overall neutral rate is really still 2.5%, it’s easy to claim the 5.3% funds rate is “restrictive,” even though core inflation is much higher.
Arguably, the nominal funds rate is only 50-60 basis points into “restrictive” territory relative to core inflation, but the predominant Fed view is that the nominal funds rate should be judged relative to projected inflation, not to current or lagged inflation rates.
To further complicate the Fed’s calculations, the assumption that the real rate (r*) is still in the zero to 50 basis point range is coming into question. In a paper presented at Jackson Hole, University of California-Berkeley Professor Barry Eichengreen gave Powell & Co. something to think about when he said, “Real interest rates, having trended downward for an extended period, now show signs of ticking back up, if for no other reason than that more public debt must now be placed with
investors.”
Kashkari and others say the Fed will need to cut the funds rate at some point to keep moderating inflation from pushing up the real funds rate and inadvertently tightening policy. But if the theoretical real rate is rising at the same time inflation is declining calculations become trickier.
That’s not a conundrum the FOMC needs to resolve on Sept. 20, but it’s something policymakers are already thinking about.