Several Federal Reserve officials stressed the need for “flexibility and optionality” at its last policy meeting in March, as a string of bank failures injected new uncertainty into its fight against persistent inflation.
This approach will remain a priority for members of the Federal Open Market Committee at this week’s policy meeting, which could deliver the final interest rate rise of a historic monetary tightening campaign.
Markets anticipate another increase of a quarter of a percentage point, bringing the benchmark federal funds rate from close to zero just over a year ago to a new target range of 5 to 5.25 per cent. The focus for economists is not the rate decision itself but the guidance that Fed officials provide about their future intentions.
As recently as March, most Fed officials saw 5 to 5.25 per cent as this year’s peak rate. Officials this week are set to revive debate over whether it is time to pause further increases.
Enduring concern that inflation is still far too high has made it difficult to rule out further rate rises, even as turmoil in banking sparks worries over tougher credit conditions. The meeting concluding on Wednesday comes on the heels of the fourth US bank failure since March, with the shutdown of California-based First Republic.
“There’s little doubt that given how high inflation still is . . . they are going to need to keep policy tight, but I think there is a serious case to be made that we are reaching a peak with interest rates,” said Karen Dynan, a former senior Fed staffer. However, “it would not serve them well to tie their hands or be really specific about where they think things are heading”.
When the Fed last revised guidance in March, the policy committee signalled it was closer to ending its rate-rising campaign than just a few months ago. Rather than highlighting the need for “ongoing increases” in the benchmark rate, as had been the case for a year, the policy statement said “some additional policy firming may be appropriate”. Fed chair Jay Powell urged reporters at the time to focus on the words “some” and “may” in that phrase.
In a realm where subtle changes in wording are closely scrutinised, one option for the Fed is to repeat its March language or to make marginal tweaks, such as specifying that additional policy firming may “yet” be appropriate. This would suggest that while the Fed may not raise rates again at its meeting in June, it could still tighten policy further, economists said.
Some economists think the Fed will echo the language it used towards the end of a previous rate-raising cycle in 2006, when it declared that “the extent and timing of any additional firming that may be needed will depend on the evolution of the outlook for both inflation and economic growth”.
Striking the right balance is critical, said Şebnem Kalemli-Özcan, an economist at the University of Maryland and a member of the New York Fed’s economic advisory panel. If officials nod too clearly towards a pause and the economic data suggests even higher rates are necessary, it could force them to backtrack.
“That is very dangerous,” she said. “That is exactly the situation I think they should avoid.”
Inflation data has been somewhat mixed in recent weeks. First-quarter wage data came in stronger than expected, with the so-called employment cost index now up at least 1.1 per cent in each of the past seven quarters. Thomas Simons, senior economist at Jefferies, said Fed officials “have to be alarmed that there hasn’t been any material slowing here”.
Core US inflation has slowed per the personal consumption expenditures price index, but the underlying pace still remains elevated at nearly 4.5 per cent, estimates Tim Duy, at SGH Macro Advisors.
Jan Hatzius, chief economist at Goldman Sachs, said officials would guard against strongly signalling a pause given concerns that could then reinforce expectations for the Fed to abruptly reverse course this year and slash rates. Futures markets show most traders wagering the central bank will cut rates later this year to below 4.5 per cent by the start of 2024, an idea Fed officials have contested.
“There’s going to be a desire to keep the market from concluding that we’re about to see cuts and so I think the signalling is going to be that the risks are tilted towards additional hikes from here,” Hatizius said.
He does not forecast the Fed cutting rates until 2024, given his view that inflation will descend slowly from here and without a sharp downturn in the economy.
The biggest unknown stems from turbulence in the US banking system. After a tense weekend of negotiations, the Federal Deposit Insurance Corporation early on Monday orchestrated a deal with JPMorgan Chase for the country’s largest bank to acquire most of First Republic, resulting in the second-biggest bank failure in US history.
Aside from the threat of more banks going bust, regional lenders have retrenched, pulling back on lending and adopting a more conservative stance as they await harsher supervisory standards that the Fed has warned are on the way.
Fuelling further uncertainty is a looming deadline to raise the federal debt ceiling, which Treasury secretary Janet Yellen on Monday warned could be breached as early as June 1. A default would be an economic catastrophe, policymakers have warned.
Officials already appear divided over the intensity of the coming credit shock, which could mean future rate decisions are made by a more fractured monetary policy committee.
Ajay Rajadhyaksha, global chair of research at Barclays, said the Fed had made clear the process to get inflation under control would not be painless. “They want some jobs to be lost. They want some eggs to break. They do not want a widespread banking crisis because then the collapse in demand is non-linear and longer. But a credit contraction? Yes.”
Source: Economy - ft.com
