The Federal Reserve is poised to leave the door open to another interest rate increase after it resumes its monetary tightening campaign this week, as officials debate how much more to throttle economic activity to get inflation under control.
The Federal Open Market Committee is widely expected on Wednesday to raise its benchmark rate by another quarter of a percentage point following a reprieve in June. That will increase the federal funds rate to a target range of between 5.25 per cent and 5.5 per cent.
Traders in fed funds futures markets believe this will be the final interest rate increase of what has become a historic campaign to squelch stubbornly high inflation. But economists say the Fed is unlikely to signal as much, as it wants to retain the flexibility to further tighten monetary policy should prices fail to ease as much as expected in the coming months.
“It’s unlikely that the committee would be willing to communicate that they expect to be on an extended hold,” said Kris Dawsey, the head of economic research at DE Shaw group, who formerly worked at the New York Fed. “There’s a great deal of scope for them to end up hiking more after the July meeting, if prompted by the data.”
Speculation that the Fed could be about to end its string of rate increases follows a recent batch of economic data which has shown a decisive slowdown in the most worryingly persistent portions of inflation, as well as a continued cooling of the labour market.
Monthly jobs growth, while still robust, has moderated from last year’s average pace and other signs of demand, including vacancies, continue to trend lower. Consumers are still spending but with less intensity and the monthly pace of “core” inflation, which strips out volatile food and energy costs, has slowed.
Christopher Waller, a Fed governor who is one of the most hawkish officials on the FOMC, recently signalled scope for another rate increase as early as the September gathering, but conceded that two more consumer price index reports that show meaningful progress “would suggest maybe stopping”.
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“It will be difficult to make the argument in the months to come that the backdrop needs any additional policy restriction placed on it,” said Tom Porcelli, chief US economist at PGIM Fixed Income. “In the context of an economy that is slowing down, prudence would demand that the Fed tread carefully here.”
Moreover, officials are still grappling with uncertainty about the effect not only of past interest rate increases but also the side effects of the banking turmoil that hit the financial system earlier this year. Midsized lenders have pulled back – albeit to a lesser degree than expected – making access to credit more expensive.
To reflect this, Julia Coronado, a former Fed economist who now runs MacroPolicy Perspectives, anticipates policymakers will revise lower their individual core inflation forecasts when new projections are released in September.
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In June, the last time these were published, officials predicted a slower descent this year towards the Fed’s 2 per cent inflation target, with the core personal consumption expenditures price index registering an annual 3.9 per cent pace. That was up from 3.6 per cent, according to estimates in March. Combined with a rosier growth outlook, most officials pencilled in half a percentage point more worth of monetary tightening this year to eventually push the fed funds rate to a peak of between 5.5 per cent and 5.75 per cent.
Ms Coronado expects a large enough decline in the core inflation forecast to compel policymakers to eventually remove the final quarter-point rate rise incorporated into their projections after a July increase, but she warns it is too premature to indicate that.
“One element of this strategy is to prevent the market from going crazy with the ‘Fed is done’ euphoria,” she said. “By holding the threat of rate hikes over the market for essentially most of the year, they can keep rate expectations in check.”
The Fed has succeeded in convincing market participants that it is not preparing to cut its benchmark rate anytime soon, after struggling to do so for the bulk of the tightening cycle. Traders’ forecasts for reductions are now aligned with officials’ for a 2024 start at the earliest, indicating less fear of an imminent recession that would require an abrupt about-face.
Having been wrong-footed in the past by the persistence of price pressures, officials would be even more careful not to take any policy possibilities off the table, said Karen Dynan, a former senior Fed staffer now at Harvard University.
One point of concern is a recent bottoming-out of house prices after a precipitous drop last year – a resilience that John Williams, president of the New York Fed, admitted had been a “bit of a surprise”. Lorie Logan of the Dallas Fed warned that it could even pose an “upside risk to inflation down the road”.
Ms Dynan said officials also need to be braced for additional shocks, including food and energy price rises.
“There’s a long way to go to get back to target and that’s something that’s weighing on them heavily,” she said.
– Copyright The Financial Times Limited 2023
