Fed tries to reconcile economic risk with market rush for tightening

It is possible that the Federal Reserve (Fed) won’t raise interest rates until March, but its authorities’ tougher tone on inflation is already having an effect, with borrowing costs rising for everyone from homebuyers to the government, and with stock markets starting the year in losses.

The pace of that tightening now raises an unexpectedly urgent issue for US central bankers at their two-day policy meeting this week: Are financial markets tightening too quickly for what the Fed intends in its battle against the inflation, or is the Fed underestimating what it will ultimately take to slow the pace of price rises?

In their most recent projections, released in December, policymakers said they expected up to three quarter-point rate hikes this year, and more in 2023 and 2024. But the projections never raise the interest rate from reference to a Fed day above the “neutral” level, which would actually contain the economy.

And yet, inflation continues to fall, the best possible outcome but one that some analysts consider unrealistic.

“The United States is facing the highest inflation since 1982, and there is compelling evidence that much of it will persist. The Fed has never been so slow to respond and even today is signaling a cycle of benign hikes,” wrote Ethan Harris, head of global research at Bank of America.

“The biggest short-term risk is right in front of us: that the Fed is seriously behind the curve and has to act seriously.”

That could mean as many as six quarter-percentage-point rate hikes this year, he said, and a quick push toward a 3% fed funds rate from the current near-zero level.

That would be the toughest policy rate since the Fed began cutting borrowing costs at the start of the 2007-2009 financial crisis, and enough, by current estimates, to actually slow economic growth, employment and inflation.

In current Fed projections, officials are simply doing less.

Fed officials will not update their formal outlook at the January 25-26 policy meeting.

However, Fed Chairman Jerome Powell will hold a press conference after the release of Wednesday’s monetary policy statement to talk in more detail about the Fed’s plans, current view of the economy, and recent progress. of yields and the decline in stock shares, which has included a decline of more than 7% in the S&P 500 index since December 31.

“Shadow” rate hikes

For a central bank that just a few months ago was still promising unlimited support until the economy fully recovered from the coronavirus pandemic, rising inflation in the United States to a 40-year high kicked off a change high-risk policy move away from economic support.

An interest rate “liftoff” has been marked for March, years earlier than thought likely at the start of the health crisis. At the same time, the Fed is planning to reduce its investments in Treasuries and mortgage-backed securities, using a second lever to increase the cost of credit.

How the two tools interact remains a subject of analysis and debate, as does the possible influence on inflation, the variable that the Fed ultimately tries to control.

Even with three rate hikes and a smaller balance sheet in the offing, investors so far assume the Fed will have to work harder to bring price increases back in line with its 2% inflation target. Futures contracts linked to the interest rate of the fed funds foresee, for example, four rate hikes this year, and are close to five.

Interest rates on home mortgages, corporate loans and US Treasury debt are already rising on the back of Fed policymakers’ comments and the tone of the 14th central bank meeting minutes. and December 15.

Indicators of general financial conditions – which show how easy or difficult it is for households and businesses to borrow – have tightened slightly since the Federal Reserve began cutting its monthly bond purchases last fall and as talks about inflation became more urgent.

An estimate of the “shadow” federal funds rate maintained by the Atlanta Fed shows that by the end of 2021 market changes had already produced the equivalent of a 0.6 percentage point rise in interest rates.

The omicron ballast

Still, overall financial conditions remain comfortable by historical standards. Although they may not seem in line with inflation, there are reasons for the Fed to be reluctant to change too quickly.

The pandemic continues. Although some health authorities hope that the current outbreak fueled by the omicron variant will subside soon, for now it has held back hiring and economic recovery.

Some analysts are now predicting that the US economy will end up losing jobs in both January and February. That would leave the Fed with the difficult decision to raise interest rates in March with employment falling.

Even a temporary omicron-related “slump” keeps concerns alive that the Fed will face the worst of both worlds this year, in the form of a slowing economy and inflation that needs even harsher medicine than the one the Americans are willing to take. officials prepare to administer.

In an interview this month ahead of the Fed’s suspension period, Atlanta Fed President Raphael Bostic indicated that the depth of the dilemma depends in part on the degree to which inflation falls on its own, without the need for a restrictive policy from the Fed to force it down through slower growth and slower employment.

That could happen if, as some economists hope, the virus recedes and more workers return to work – boosting the supply of goods and services and easing the pace of wage increases – or if supply chain disruptions worldwide decrease. However, there is no guarantee.

Before the appearance of the coronavirus, the Federal Reserve was fighting against a dynamic that kept inflation below its 2% target and “there is a narrative that says that once we have passed the pandemic those forces take control, so such an aggressive political stance is not needed,” Bostic said.

But “none of us contemplated that inflation would be as high as it is now. So the question is really how forceful or withering we have to respond.”