Fed officials remain split on level of interest rate hike as US central bank picks up pace

A jogger walks past the Federal Reserve building in Washington, August 22, 2018.CHRIS WATTIE/Reuters

US Federal Reserve officials have aligned themselves with plans to accelerate the pace of interest rate hikes this year, but remain divided on what could be the decisive decision on where to stop to avoid dragging the economy in recession.

This debate is just beginning but will become more critical this summer as policymakers assess how quickly their initial rate hikes are causing households and businesses to slow spending and whether that, in turn, is slowing the pace of inflation. at levels not seen since the 1980s.

A recent hike in long-term interest rates has yet to improve the outlook for inflation and has left the Fed in a risky environment – ​​torn between an even more aggressive pace of rate hikes that could drag the economy down. , or moving too slowly and allowing an inflationary psychology to take hold.

“Ultimately, it’s about making a decision… ‘this is a path that seems consistent (with controlling inflation)’…or judging that it isn’t,” Chicago Fed Chairman Charles Evans said last week, describing the difficulties Fed officials anticipate in figuring out how high rates may need to be raised to bring inflation down to the US level. central bank’s 2% target.

“That’s a devilishly difficult question,” Evans said.

The current economic expansion hinges on the right response from Fed policymakers, and not everyone thinks they will.

Former Treasury Secretary Lawrence Summers, who forcefully argued that the Fed waited too long to react to price hikes, recently wrote that inflation so high – the latest at 6.4% by the preferred measure of the Fed – coupled with low unemployment makes a recession likely within two years .

The Fed will take the next step in its policy shift at a May 3-4 meeting where officials are expected to raise the target policy rate by half a percentage point.

Even the most dovish policymakers, including Evans, now agree that incremental rate hikes beyond the familiar quarter-point-per-meeting are necessary, given the strength of inflation. They also coalesced around an overall increase in the federal funds rate to at least 2.5% by the end of the year from the near-zero level set to combat the steep but brief recession caused by the coronavirus pandemic.

Consumers, businesses and financial markets have largely accepted this tightening in stride.

But that may not be enough. Analysts note that periods of high inflation can generate their own momentum, raising the effective level of rates needed to dampen price increases.

The rate at which interest rate increases significantly influence the economy “could be higher than it otherwise would be because of what’s going on with inflation, and that’s part of what’s driving them.” pushes you to be more comfortable going higher, faster,” said Robert Dent, economist at Nomura Research. . “This is an extremely important debate that will command more of the Fed’s attention over the next six months.”

When they last met in March, the range of rates policymakers projected as appropriate by the end of 2023 was 2.1% to 3.6%, a cavernous spread reflecting pandemic-related risks, to the war in Ukraine and other largely uncontrollable forces. , but also highlights uncertainty about how businesses and consumers might react to higher borrowing costs.

Stock markets have been partly rocked by volatility in recent days, Bank of America economists explained in an analysis, because the distance around the Fed’s possible policy paths is currently so wide, with options contracts indicating that the central bank’s policy rate could reach anywhere between 2 percent and 4.5 percent over the next two years.

In the monetary policy debate, Fed officials use a concept known as the “neutral” or “natural” interest rate to judge whether the rate they set for overnight lending between banks , a key figure that influences borrowing costs more broadly, encouraging or discouraging economic growth. activity.

Over the long term, this is the rate considered to balance the economy on a number of fronts while maintaining full employment, inflation at the Fed’s target, and output growth at a pace consistent with underlying productivity, demographic and other trends.

Fed officials currently estimate the neutral rate at around 2.4% and have pledged as a group to reach that level “quickly” in one of the fastest monetary policy shifts ever undertaken by the US central bank. .

But if the next few weeks or months deviate from the Fed’s baseline outlook – if consumers change their spending or if businesses start setting wages and prices differently than expected because their own expectations or preferences have changed – policy makers may need to become more aggressive.

The markets are already betting that they will. Futures tied to the Fed’s key rate on Thursday reflected overwhelming bets on the fastest monetary policy tightening in decades, with traders setting prices in a path that would put short-term rates in that range. 2.25% to 2.5% by September.

As a short-term concept, “neutral” may have risen due to the very dynamics of inflation the Fed is trying to combat, potentially forcing the central bank to catch up. Some, like St. Louis Fed President James Bullard, say they are actually already “behind the curve” and may need to move rates faster and higher than expected.

Fed officials want to keep the recovery on track and in particular avoid any significant rise in unemployment from the current 3.6%, arguably the strongest labor market since the 1950s.

But that means they have to take advantage of some of the extremes of the current economy, whether it’s the 35% rise in the median house price during the pandemic or the salary increases that the president of the Fed, Jerome Powell, called “unsustainably hot”.

This week’s inflation data will show whether progress has been made, and the April jobs report released next week will provide an update on wage growth.

It looks like the housing market is starting to cool down, with mortgage rates rising above 5%, down from around 3% last year.

But issues related to the Fed’s policy trajectory are still far from resolved. Many economists have recently raised their estimates of what the Fed will need to do and are looking to next week’s meeting for guidance.

The labor market and associated wage growth remain strong, and unemployment could fall below 3% this year, Jefferies economists recently predicted. So far, consumers have been oblivious to “Omicron, the invasion of Ukraine, soaring gas prices and a sharp rise in interest rates,” wrote economists Aneta Markowska and Thomas Simons.

For the Fed, that could mean pushing rates above 4%, a level not seen since before the 2007-2009 financial crisis and which would likely increase recession risks.

“The US economy is climbing the wall of worry,” they wrote, with inflation widening and the underlying strength of the economy meaning “the Fed will need to be even more aggressive.”

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Leslie M. Gill