A “patient and resolute” Fed

The Federal Open Market Committee (FOMC) – the policy arm of the Federal Reserve voted to raise rates again in July after a brief reprieve in June. That increased the fed funds rate to a 5.25% - 5.5% range, the highest rate for short-term rates since 2001, before it cut rates to mop up in the wake of the dot.com bust. The vote to raise rates was once again unanimous, which underscored Chairman Powell’s finesse in corralling the cats in a key vote.

At least two meeting participants, Austan Goolsbee of Chicago and Raphael Bostic of Atlanta, had voiced their preferences to pause on rate hikes in July before this meeting. Powell hinted that they may have pushed back against this hike. He said that will be reflected in the minutes to this meeting, which will be released in three weeks. Debate is expected to intensify within the ranks of the Fed leadership about how far they should go on rate hikes given the cooling in inflation we have seen and the uncertainty about the path of inflation going forward.  

The statement following the meeting was little changed. It left the door open to additional rate hikes, much to the chagrin of market participants eager for an end to rate hikes. Chairman Jay Powell emphasized the Fed’s commitment to hold rates higher for longer at the press conference following the meeting; that will raise real rates as inflation cools. A cut in rates by year-end or at the start of next year is unlikely, barring a full-blown recession.  

The Fed worries that financial markets will front-run it on rate cuts and undo some of the progress made on inflation. The ground is fertile. The excess savings triggered by the pandemic are still significant, a GenAI bubble is taking root and earlier fiscal stimulus is boosting infrastructure investment. The construction of chip and EV plants is accelerating, while funds allocated to upgrade schools and roads during the pandemic are being deployed.

Chairman Jay Powell underscored that the Fed needs to see core inflation come down in a more “durable” way. The “historic record” is clear on the fact that the worst error would be to fail to fully derail inflation now. “Policy has not been restrictive enough for long enough” to ensure that inflation will come down and stay there.

Much of the cooling in goods inflation reflects a reversal of the supply chain problems triggered by an uneven reopening of the global economy. That is good news as it has alleviated inflation in the goods sector. However, supply chains remain fragile.

Concern is high that we could see a bump in inflation this Fall when a quirk in how medical insurance is measured plays out. The consumer price index (CPI) measure of medical insurance plummeted nearly 25% from a year ago in June; that measure reverses course and rises on both a month-on-month and year-over-year basis in October. That could prevent inflation from cooling as much as needed in the service sector. Nearly all other insurance costs are already rising rapidly, with extreme weather risks prompting insurers to pull out of some markets entirely.

Separately, recent improvements in inflation have likely emboldened the Fed to reach its 2% inflation target. There was an unspoken sense that the Fed would stop short of its actual target to avoid the pain – a rise in unemployment – necessary to get inflation back to its target. The resilience of the economy has helped alleviate those concerns, while simultaneously upping the risk of an overshoot on rate hikes by the Fed. Powell said, “We are determined to bring inflation down to 2% over time and no one should doubt that.” 

The bulk of the drag associated with earlier rate hikes is still ahead of us. Business loans that were taken out when rates were much lower are about to reset, while rejections for credit card, mortgage and vehicle loans have surged since the turmoil we saw in financial markets in the Spring. Powell acknowledged that bank lending conditions continued to tighten since the last report; bank lending standards were in recession territory in the first quarter. That data is due to be released on Monday, July 31.

Powell was careful to point out that the Fed would not need to reach the 2% level before cutting rates. The Fed is expecting to cut rates well before inflation reaches 2%; it only needs to be moving toward 2% over a sustained period.  Note: The Fed does not expect inflation to fall to 2% until 2025. Real or inflation-adjusted interest rates will rise as inflation decelerates. Those shifts coupled with the lags in monetary policy mean the Fed should cut rates before it hits the 2% target, or it will most definitely overshoot and trigger a much harder landing. He said that the Fed could keep reducing its balance sheet or what is known as quantitative tightening, even after starting to cut short-term rates.

Powell noted that the staff has a significant slowdown in the economy at the end of the year but no longer has a full-blown recession in their forecast. That is only one forecast. He cautioned that the historical record suggests some softening in labor market conditions, aka increases in unemployment, are likely before inflation is defeated.

Powell said that the short-term social costs of unemployment were less than the long-term social costs of inflation. He thinks some increase in unemployment will occur – the issue is how much.