The Federal Reserve finds itself in an especially tough spot: raising interest rates at a time when economic growth is slowing. The rationale for tightening policy is that inflation is surging and so pricing pressure overrides any concerns for growth.
Fed funds futures are pricing in high odds for a 25-basis-point increase in the Fed’s target rate at today’s policy announcement (2:00 pm eastern, Mar. 16). The expected increase will lift the Fed funds target rate to a 0.25%-0.50% range, which is far below the 7.9% annual pace of consumer inflation through February – a 40-year high that looks set to hold steady if not increase as blowback from the Ukraine war spills into the data in the months ahead.
US economic activity, meanwhile, has peaked. After a blowout 7% gain in last year’s fourth quarter, first-quarter growth is expected to post a sharp slowdown. Output is projected to increase 1.2% in the first three months of the year (seasonally adjusted annual rate), based on the median estimate for a set of nowcasts compiled by CapitalSpectator.com. That’s a slow pace that raises a warning flag for the in the quarters ahead. (Today’s estimate reflects a slight downgrade from the previous 1.4% estimate for Q1 published two weeks ago.)
The wisdom (or folly) of raising interest rates now and in the months ahead can only be determined with the benefit of hindsight. If inflation is set to remain high or rise further, the case for tightening policy is on solid ground. The question is whether the rising forces of demand destruction, in part due to headwinds unleashed by the Ukraine war, will take a bite out of inflation in the months ahead?
Even if slowing growth cools inflation, raising interest rates slightly today looks like an easy decision. A 25-basis-point hike would still leave Fed funds close to a record low. Meanwhile, given the huge gap between the target rate and inflation, the evidence appears overwhelming that monetary policy is in dire need of playing catch-up to macro events as it applies to pricing pressure.
None of this negates the possibility that a policy mistake may be lurking. In effect, two sets of monetary policies are needed simultaneously — one to address slowing growth and another to deal with surging inflation. Unfortunately, only one policy can be implemented and in the current environment the risk is high that the Fed will choose the wrong one, or try to hedge the risk and take a middling path that addresses neither macro threat effectively.
Perhaps the worst-case scenario from an economic-growth perspective: the Fed continues to hike rates, perhaps aggressively, as economic activity slows or dips into a recession. Alternatively for inflation risk: policy tightening is insufficient to nip inflation expectations and pricing pressure in the bud. The possibility of some combination of the two can’t be dismissed either. Meanwhile, the odds that the Fed will get policy exactly right (or something close to it) in the months to come seems dangerously low.
Low, but not zero. The good news is that while the US economy continues to slow, as it has been for several months, recession risk remains a low-probability event at the moment and for the immediate future. Several business cycle indicators currently show that a growth bias endures. But as a pair of proprietary metrics tracking US economic activity show, the trend continued to weaken through February. (For details on how these indicators are designed, see The US Business Cycle Research Report – you can find a sample issue here.)
Projecting values for these indicators through April suggests the growth deceleration will continue.
A key factor – perhaps the only relevant factor for the near-term future — for deciding how the Fed should adjust policy in the weeks and months ahead is the evolution of the war in Ukraine and how it affects supply and demand. Unfortunately, the future is virtually completely unclear on this front, given the uncertainty of war.
The Fed, in short, is flying blind, as we all are. Changing monetary policy in real time is always vulnerable to imperfect information linked to future events. In “normal” times this risk is manageable in the sense that relatively standard economic conditions apply and modeling provides useful guidance. In such periods, the risk and blowback of a policy mistake is relatively moderate compared to current conditions. Adding to the complication in 2022 is the fact that the Fed appears to be far behind the curve in terms of managing expectations for inflation.
The central bank may get lucky in the sense that inflation pulls back sharply in the near term and/or the US avoids a recession. But if one or both of those scenarios don’t apply, the Fed will find itself in one of the most challenging crises in its history with no easy solutions.
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