– Williams Blames Demand, Shocks for Inflation – Not Past Monetary Ease
– Fed Policymakers Divided on Where Funds Rate Needs To Go
By Steven K. Beckner
(MaceNews) – Federal Reserve Chairman Jerome Powell renewed the Fed’s commitment to reducing inflation Friday, but gave no clear indication whether he thinks the central bank will need to raise short-term interest rates further to achieve its 2% objective.
Powell did say, as he has before, that bank lending restraint in response to the recent series of bank failures may well mean that “our policy rate may not need to rise as much as otherwise.”
Powell, whose fellow policymakers seem to have become less and less unified the higher they have raised short-term interest rates, said the Fed must be “steadfast” in pursuit of “price stability,” but gave no indication whether that will entail raising the federal funds rate at the Fed’s mid-June Federal Open Market Committee or beyond.
But he emphasized that the outlook is “highly uncertain” and that the Fed will have to carefully assess the appropriate funds rate level “meeting by meeting” as he discussed monetary policy with former Fed Chairman Ben Bernanke at a Fed-sponsored conference.
Powell acknowledged that financial markets have lower interest rate expectations than the Fed, but he attributed this to different economic forecasts rather than to a misreading of the Fed’s “reaction function.”
Meanwhile, other Fed policymakers have been sending mixed signals about prospects for further rate hikes.
New York Federal Reserve Bank John Williams, appearing at the same event, seemed to suggest the Fed should not lean too heavily on tighter monetary policy to reduce inflation by blaming its acceleration primarily on pandemic-related shocks to supply and demand and inflation, not on holding interest rates too low for too long.
On Thursday, Fed Governor Phillip Jefferson and Dallas Fed President Lorie Logan professed to be undecided about the outcome of the June 13-14 meeting of the Fed’s rate-setting FOMC but while the former sounded hesitant to raise rates further, the latter seemed more inclined to do so.
Powell and his colleagues were speaking just over two weeks after the FOMC raised the federal funds rate for a tenth time since it stopped holding that key money market rate near zero in March of 2022. The 25 basis point hike took the funds rate to a target range of 5.0% to 5.25%, which is the level which FOMC participants had projected for the end of 2023 in their March Summary of Economic Projections.
In announcing the rate hike on May 3, the FOMC was less “anticipatory” of further rate hikes, as Powell noted at the time, but still left open that possibility.
Thus, in the March 22 policy statement, the FOMC said it “anticipates that 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.”
By contrast, in its softer May 3 statement, the FOMC said, “In determining the extent to which additional policy firming may be appropriate to return inflation to 2% over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Powell did not add a lot of clarity in mixed comments after the May meeting. On one hand, he told reporters the funds rate “may not be far off” from a “sufficiently restrictive” level, given the “headwinds” from bank lending restraint, he asserted that no “pause’ decision had been made. On the other hand, he said the Fed still had “a long way to go” to reduce inflation in the face of “very tight” labor markets, and vowed the FOMC is “prepared to do more if greater monetary policy restraint is warranted.”
In his latest remarks, Powell did not go beyond what he said on May 3, leaving the funds rate path very much in doubt.
The Fed chief again stressed that the FOMC is “stronglyk committed to returntng to our 2% inflation goal.”
“We think that failure to get inflation down would, would not only prolong the pain but also increase ultimately the social costs of getting back to price stability, causing even greater harm to families and businesses, and we aim to avoid that by remaining steadfast in pursuit of our goals,” he said, adding, “that’s why we intend to be steadfast in pursuit of our goals.”
Powell indicated he is concerned that tight labor market could keep upward presssure on wages and prices.
Asked about the relationship between labor market tighteness and inflation, Powell said he does “not think labor market slack was important in the initial rise in inflation” in 2021, but said, “it’s likely to be an increasinly improtant factor going forward..”
While goods prices and to some extent housing prices have moderated, he noted that core service prices, excluding housing have not done so, and he blamed continued labor market tightness.
Bank credit conditions could play a key role in how much more the FOMC has to raise rates, Powell indicated.
“The financial stability tools helped to calm conditions in the banking sector,” he said. “Developments there, on the other hand, are contributing to tighter credit conditions and are likely to weigh on economic growth, hiring and inflation.”
“So as a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals,” he went on, adding, “Of course, the extent of that is highly uncertain.”
Speaking of the Fed’s forward guidance, Powell took note of the FOMC’s language shift.
After 500 basis points of rate hike, he said monetary policy has “come a long way” and is now “restrictive.” Therefore, he said, the FOMC was able to “adjust” its policy statement to communicate that in future it will go “meeting by meeting” and make “careful assessments” of a range of factors in determining how much higher rates need to go.
The FOMC’s aim is to do enough to reduce inflation without doing too much, said Powell, who said the Committee will be assessing the lagged effects of past rate hikes and the impact of bank credit tightening.
Powell said financial markets are pricing in lower rates than the FOMC because they “have a different forecast, one in which one in which inflation comes down more quickly,” whereas the Fed views is that “bringing down inflation will take some time.”
Williams, in his keynote address to the conference, seemed to suggest that the Fed should not rely too heavily on tighter monetary policy to beat back inflation, saying that the r-star model of the real equilibrium short-term interest rate which he helped develop shows that the inflation surge of recent years was primarily due to demand shocks, not to excessively low interest rates.
Asked why inflation is as high as it is and whether the r-star model is telling the Fed to be patient about raising rates, Williams responded that the model shows that “significant” increases in demand and “shifts in the output gap” occurred in the 2021-22 period that “were not explained by monetary policy.”
By the end of that period, he said “monetary policy, though very low real interest rates of the past few years did contribute to an even higher output gap as you would expect … the inflation was in part driven by significant positive output gaps…along with significant inflation shocks. So, part of it was driven by shocks to demand outside of monetary policy. Some of it is monetary policy, but a lot of it is some shocks to inflation.”
“I’m not going to opine on what monetary policy should or should not do,” Williams went on, “but I would say that in this model clearly how you feel about how these shocks evolve is very important, because they are a significant driver of what’s happening (with inflation) at least according to this model.”
Williams, the FOMC vice chairman who usually reflects the policy mainstream, hasn’t overtly shown his hand, but has not sounded eager to continue raising rates – at least not as soon as the June meeting.
“Inflation remains too high….,“ he said last week, noting that core service prices excluding housing have been slow to come down because they are “driven by a continued imbalance in overall supply and demand, and it will take the longest to bring down,”
But Williams added, “I am confident we are on the path to restoring price stability. As always, I’ll be monitoring the totality of the data and what it implies for the achievement of our goals.”
And he said he “will be particularly focused on assessing the evolution of credit conditions and their effects on the outlook for growth, employment, and inflation.”
Williams suggested the full impact of past rate hikes haven’t been felt. “Because of the lag between policy actions and their effects, it will take time for the FOMC’s actions to restore balance to the economy and return inflation to our 2% target,” he said. Other officials have suggested those “lags” are a reason for the FOMC to wait and see how much more monetary tightening needs to be done.
Since the FOMC raised the funds rate for a tenth time on May 3, divisions have appeared in its ranks. Some seem more prepared to tighten monetary policy further to reduce inflation, while others seem more inclined to believe that bank credit tightening can do much of the Fed’s work for it.
For example, Jefferson, who President Biden has nominated to succeed Lael Brainard as vice chairman, sounded cautious and hesitant on Thursday about further rate hikes as he outlined the factors he will be looking at to determine the “appropriate” level of the funds rate.
“On the one hand, inflation is too high, and we have not yet made sufficient progress on reducing it,” he said. “On the other hand, GDP has slowed considerably this year, and even though the effect has been muted in the labor market so far, demand clearly has begun to feel the effects of interest rates that are 5 percentage points higher than they were a little over a year ago.”
What’s more, Jefferson implied that the FOMC might want to delay further rate hikes, given that the full effect of past rate hikes hasn’t been felt and given stress in the banking system that has tightened bank credit.
“History shows that monetary policy works with long and variable lags, and that a year is not a long enough period for demand to feel the full effect of higher interest rates,” he said. “Another factor weighing on my thinking is the uncertainty about tighter lending standards…”
Jefferson said he “intend(s) to consider all these factors in the coming weeks as I contemplate the appropriate stance of monetary policy going forward.” He noted that “over the next few weeks, we will receive a considerable amount of data on economic activity for April and May, including the employment report for May and a report on May CPI inflation.”
Jefferson’s latest comments were consistent with those he made a week ago, when he suggested the FOMC need not be in any hurry to to supplement bank credit tightening with more central bank credit tightening by saying monetary policy is “on track.”
“Is inflation still too high?” he asked. “Yes. Has the current disinflation been uneven and slower than any of us would like? Yes. But my reading of this evidence is that we are ‘doing what is necessary or expected’ of us.”
“Furthermore, monetary policy affects the economy and inflation with long and varied lags, and the full effects of our rapid tightening are still likely ahead of us,” Jefferson continued. “We are balancing the directives of the dual mandate given to us by the U.S. Congress. This is not an easy task in these uncertain times, but I can assure you that I and my colleagues on the FOMC take it quite seriously and with great humility.”
“It is in this sense that I believe that we are well ‘on track,’” he added.
By contrast, Logan sounded somewhat somewhat more inclined to vote for further rate hikes — in her Thursday remarks. While saying she has an “open mind” as the mid-June FOMC meeting approaches and allowed for the possibility that the Committee could “skip a meeting,” she made clear she is uncomfortable with the lack of progress on reducing core inflation.
Logan, who formerly ran the New York Fed’s open market trading desk, also seemed to put less emphasis on the slowing effect of bank failures and bank lending restraint.
“Inflation remains much too high…,” she said. “(I)nflation in recent months has been lower than the worst peaks last year. The labor market has cooled somewhat. And activity in some sectors, such as housing, has slowed dramatically. The economy is not nearly as far out of balance as when the FOMC began raising rates 14 months ago.
However, Logan continued, “the question for monetary policy is not whether there has been some progress. It’s whether inflation is on track to return all the way to our 2% target and to do so in a sustainable and timely way …..”
“I’m keeping an open mind and a close watch on economic developments as we head toward the next FOMC meeting in mid-June,” she went on. “As of today, though, I remain concerned about whether inflation is falling fast enough.”
Logan said, “part of the slowdown in inflation in recent months has been due to lower prices of oil and other commodities,” and noting that core PCE inflation was still an annualized 4.9% in the first quarter, she said “We haven’t yet made the progress we need to make. And it’s a long way from here to 2% inflation….”
And while acknowledging that the labor market has cooled somewhat, she said it is “still very strong” and subject to upward pressure on wages. “If labor productivity tracks historical trends, wage growth of 4.5–5 percent just isn’t sustainable, because it isn’t consistent with keeping inflation at 2% over time…”
Logan sounded less perturbed about bank lending than many of her colleagues.
“I am also attentive to the potential for nonlinear and unexpected deterioration in financial conditions,” she said. “(But) even now, they (banks) say the main reason for the latest tightening is restrictive monetary policy, not stress in the banking system. Analytical models that try to calculate the incremental effect of banking stresses predict only a modest further drag on the economy. Most calculations so far suggest an effect comparable to raising the federal funds rate by 25 or 50 basis points. And it’s worth noting that other aspects of financial conditions have eased since March….”
While there are “downside possibilities,” Logan said, “there are upside risks as well: The data could come in hotter than expected, or other lenders could substitute more for bank credit.”
Logan stressed that the FOMC must be mindful of its credibility and about the danger of inflation expectations getting out of control.
“(I)f the FOMC doesn’t stay committed to restoring price stability, the public could come to expect persistently high inflation,” she warned. “A self-fulfilling spiral of unanchored inflation expectations would require much larger rate increases to stop….”
“So, even as we consider how best to manage the risks, they must not stop us from doing what’s necessary to achieve 2% inflation,” she continued.
“The data in coming weeks could yet show that it is appropriate to skip a meeting,’ Logan went on. “As of today, though, we aren’t there yet.”
Overall, Logan seems more inclined to raise the funds rate further than some others.
Bowman has also been more inclined to raise rates further. A week ago, she said that with the FOMC’s 10 rate hikes, combined with balance sheet reduction, “our policy stance is now restrictive,” but quickly added, “whether it is sufficiently restrictive to bring inflation down remains uncertain….”
“(I)inflation remains much too high, and measures of core inflation have remained persistently elevated, with declining unemployment and ongoing wage growth…,” she said. ““Should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate to attain a sufficiently restrictive stance of monetary policy to lower inflation over time.”
“I also expect that our policy rate will need to remain sufficiently restrictive for some time to bring inflation down and create conditions that will support a sustainably strong labor market,” Bowman added.
Minneapolis Federal Reserve Bank President Neel Kashkari, one of this year’s FOMC voters, also sounded much more “hawkish” than his erstwhile reputation, observing that core inflation numbers were still running uncomfortably high for his taste.
“Inflation has come down but it’s still well above our 2% target,” he said. We have seen some softening in wage growth nationally, but it’s very mixed.”
Kashkari admitted that higher interest rates could cause further problems for banks, but strongly suggested the Fed may have to keep monetary policy tight anyway. “If inflation is going to stay high and it’s embedded in our economy, and we have to run tight monetary policy and an inverted yield curve for an extended period of time, that creates real problems for banks of all sizes.”
Others have sounded more sanguine about achieving the Fed’s 2% inflation goal – to the point of suggesting that the FOMC can afford to hold off on further rate hikes, at least for a while.
Austan Goolsbee, voting president of the Chicago Fed, said Monday that his vote in favor of the May 3 rate hike had been “a close call” and strongly suggested he would hesitate to hike again at the June 13-14 meeting.
For one thing, he said, “there’s still a lot of the impact of the 500 basis points we did in the last year that’s still to come.”
So Goolsbee said the FOMC ‘’should be extra mindful, we want to get inflation back to target path without starting a recession.”
Like Goolsbee, Governor Lisa Cook voted for the latest 25 basis point rate hike, but it’s not obvious how eager she will be willing to raise rates further.
In the weeks leading up to the FOMC meeting, after the SVB and other bank failures, Cook was implying she will want to move judiciously.
She said “the incoming data would suggest a somewhat higher inflation rate for this year and stronger economic growth, but added, “I am closely watching developments in the banking sector, which have the potential to tighten credit conditions and counteract some of that momentum….. (I)f tighter financing conditions restrain the economy, the appropriate path of the federal funds rate may be lower than it would be in their absence.”
Carefully keeping her options open, Cook added, “On the other hand, if data show continued strength in the economy and slower disinflation, we may have more work to do.”
Among non-voters, Atlanta Fed President Raphael Bostic has indicated he favors a pause in rate hikes.
But Cleveland Fed President Loretta Mester was emphatic earlier this week in saying the funds rate needs to keep moving higher. How high she did not say.
After saying the FOMC should raise the funds rate to a level where the next move could go either up or down and hold it there, she said, “The question in my mind is: have we gotten to that rate yet? At this point, given the data we’ve gotten so far, I would say no.”
“I need to see more evidence that inflation is still moving down,” added Mester, who will return to the FOMC voting ranks next year.
St. Louis Fed President James Bullard was customarily more hawkish. He lamented that core inflation has declined only modestly from the peak levels observed last year, and while he took comfort from the fact that inflation expectations “have now returned to levels consistent with 2% inflation,” he questioned whether the funds rate is high enough.
Citing Taylor Rule estimates, Bullard said, “Monetary policy is now at the low end of what is arguably sufficiently restrictive given current macroeconomic conditions.”