Posted on November 1, 2022
- The Fed doesn’t want to overdo tightening.
- But backing off too early carries risks.
- The Fed is likely to leave its options open.
The Federal Reserve is expected to continue its fight against the fastest inflation in 40 years on Wednesday by raising rates three-quarters of a percentage point for the fourth time in a row. What officials signal about the central bank’s future plans is likely to be even more important.
Jerome H. Powell, the Fed chair, and his colleagues have been rapidly increasing interest rates this year to try to wrestle inflation lower. Rates, which were near zero as recently as March, are expected to stand around 3.9 percent after this meeting.
Wednesday’s move would be the sixth consecutive rate increase by the Fed. The last time it moved this quickly was during the 1980s, when inflation peaked at 14 percent and interest rates rose to nearly 20 percent. Fed officials have suggested that at some point it will be appropriate to dial back their increases to allow the full economic effect of these rapid moves to play out. The question now is when that slowdown might happen.
The Fed’s most recent economic projections, released in September, suggested that it could begin next month. But prices have remained uncomfortably high since those estimates were published. That could make it difficult for Mr. Powell and his colleagues to explain why backing down in December makes sense — even if they think it still does.
Officials do not want investors to conclude that the Fed is easing up on its inflation fight, because market conditions could become more friendly to lending and economic growth as a result. That would be the opposite of what central bankers are aiming for: They are trying to slow conditions down so companies will lose their ability to charge more.
“There are good reasons to believe that the Fed should pause relatively soon,” Tiffany Wilding, a U.S. economist at PIMCO. “There are going to be communication challenges to manage with this.”
It’s a challenge that could be on full display when the Fed releases its rate decision at 2 p.m. and Mr. Powell holds his news conference at 2:30 p.m.
The Fed doesn’t want to overdo tightening.
The Fed wants to slow its brisk rate increases at some point for a simple reason: It has already adjusted policy by a lot.
Before this year, central bankers had not raised interest rates by three-quarters of a point since 1994. The jumbo rate moves in 2022 have rapidly made it more expensive for consumers and businesses to borrow money.
While those moves are already ricocheting through financial markets, they take time to trickle into the real economy. The housing market has slowed as mortgage rates have jumped, but for now, companies are hiring rapidly and the labor market remains hot. That could begin to change in the months ahead as firms find that business loans are pricier and demand is starting to wane.
Plus, there are already good reasons to expect inflation to begin to slow next year. Supply chains, tangled for years, are now swiftly healing. Housing costs have been a major driver of inflation in recent months, and many economists think they will begin to cool by mid-2023, based on moderation that is already taking hold in the rental market.
The Fed does not want to lift rates more than it needs to in order to bring inflation down. Doing so could result in slower economic growth and a weaker job market than is necessary — a mistake that would leave people out of work and families with less money, diminishing lives and livelihoods.
But backing off too early carries risks.
Just as the risks of overdoing it are immense, underdoing the policy response to inflation could also come with grave consequences.
If central bankers fail to bring price increases back under control quickly, businesses and consumers may come to expect permanently higher inflation. Workers could factor that into their wage negotiations, businesses into their pricing decisions. Inflation could begin to fuel itself.
If that happened, the Fed might need to stage an even more aggressive response to stamp inflation out — and that would come at a greater economic cost to society.
“The best thing they can do is try to balance the risks,” Bill English, a former director of the Fed’s monetary affairs division who is now a professor at Yale University.
Policymakers at this meeting will probably want to set themselves up to slow down in the future, he said, while leaving their options open in case data between now and the Fed’s December meeting suggest that the economy and inflation will remain hot.
While inflation is expected to slow eventually, that process is likely to take time. Consumer demand is chugging along, job openings remain plentiful, and wages are still rising quickly. Energy shocks stemming from the war in Ukraine could easily push prices higher. Central bankers will want to keep an eye on those developments.
The Fed is likely to leave its options open.
Given the risks that Mr. Powell’s central bank is staring down, many careful Fed watchers expect it to leave the door open to a slowdown in rate increases in December without committing to one.
“I’m not even sure they’ve decided: I think they really just want optionality to step down in December,” said Michael Feroli, chief U.S. economist at J.P. Morgan. Of Mr. Powell, he said: “I do think he wants to make sure that December is considered a meeting where they actually go in and have a debate.”
Most Fed officials have predicated slowing and eventually stopping rate increases more on the level of interest rates than on what is happening with inflation. The logic: If officials have moved rates high enough that they are clearly weighing on growth and hold them there, that will pull inflation lower over time.
“Holding the economy in a restrictive stance of policy also continues to bridle it,” Mary C. Daly, president of the Federal Reserve Bank of San Francisco, said during a Yahoo Finance interview last month. “So we’ll end at a rate that we think is appropriate and in terms of where to stop and look around.”
Given that, a slowdown might be possible before inflation moderates, especially if growth pulls back and the labor market begins to soften.
The Fed will release a fresh set of economic predictions next month. If it does pare back the pace of rate increases then, it could simultaneously project a slightly higher path for interest rates in 2023, Mr. Feroli from J.P. Morgan noted
Such a setup would allow the central bank to communicate that it is both committing to crushing inflation and cognizant that its policy changes to date are still taking hold.
And it would underline that the Fed will need to be nimble next year if price increases are slow to fade. So far, inflation has shown no obvious response to the Fed’s campaign to cool the economy.
“Inflation is likely to remain uncomfortably high for a while, and this could make continuing to hike in small increments for a bit longer the path of least resistance,” David Mericle at Goldman Sachs wrote in a recent research note. Plus, with wages picking up and consumers hanging in there, “more rate hikes might eventually be needed to keep the economy on a below-potential growth path.”