Fed hardens commitment to ‘higher for longer’ interest rates

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For months, Jay Powell has tried to scotch hopes that the Federal Reserve will perform an abrupt about-face when it reaches the apex of its historic rate-rising campaign.

The US central bank chair on Wednesday hammered home the point in a press conference after the Fed decided to hold its benchmark rate steady at a 22-year high. His remarks, which were buttressed by a new set of economic projections, sent a clear message: any relief from high borrowing costs will be neither swift nor generous.

The projections, which also include a ‘dot plot’ of individual interest rate estimates, showed that after one more increase this year — lifting the federal funds rate to between 5.5 per cent and 5.75 per cent — most officials see a much slower path of rate cuts in 2024 and 2025. Despite the Fed keeping monetary policy tight, they predicted economic growth would remain relatively robust and the unemployment rate would not rise materially.

The forecasts showed policymakers hardening their commitment to a “higher for longer” approach to interest rates. The median estimate of the Fed’s 19 policymakers is for the bank’s benchmark rate to fall to just 5 per cent to 5.25 per cent next year. That was significantly higher than the 4.5 per cent to 4.75 per cent they signalled when the dot plot was last updated in June. By 2026, it was still forecast to be between 2.75 per cent and 3 per cent.

“What they’re saying there is if you have stronger growth for this year and next, it increases the risk that core inflation does not descend as much as they hope and expect,” said Daleep Singh, an ex-New York Fed official who is now chief global economist at PGIM Fixed Income.

“Therefore there is a potential need to keep nominal interest rates somewhat higher than they previously forecast,” he added.

Economists on the whole find the “higher for longer” stance plausible. But they are less convinced by Powell’s warning that the Fed could implement another quarter-point rate rise this year as it probes a monetary policy setting that is “sufficiently restrictive”.

Powell’s caveat that the Fed would proceed “carefully” with future rate decisions as well as looming economic headwinds — including a potential government shutdown and the resumption of student loan repayments — fuelled their scepticism.

“The inflation data is going to surprise them in a favourable direction, and I also think that fourth-quarter growth is likely to look quite a bit weaker than the third quarter,” said Jan Hatzius, chief economist at Goldman Sachs, who is among those who thinks the Fed is done raising rates.

However, Hatzius said he was far more “sympathetic” to the idea that rates will stay elevated for a significant period of time.

Underpinning that argument is an economy that has proven far more resilient to elevated borrowing costs than had been expected.

“Broadly, stronger economic activity means we have to do more with rates,” Powell said when pressed about officials’ prediction for fewer rate cuts next year even though the expected trajectory for inflation, compared with June, has not gotten worse.

Policymakers forecast that inflation after food and energy prices are stripped out will ease to 3.7 per cent by the end of this year before falling to 2.6 per cent and 2.3 per cent in 2024 and 2025, respectively. As of July, this measure, known as the core personal consumption expenditures price index, hovered at 4.2 per cent.

Moreover, Powell hinted that a higher-for-longer approach was warranted because estimates of the so-called “neutral” interest rate — a level that neither speeds up nor slows down growth — could be higher than thought at least in the shorter term.

Singh reckons the neutral rate could be as high as 3.5 per cent. An increase in the number of workers returning to the labour force and the continued unfurling of other pandemic-era supply chain snarls could sow the seeds for higher productivity and, in turn, a “higher equilibrium of growth”, he added.

Other economists are much less optimistic, warning that officials’ forecasts for growth and unemployment are far too rosy. Policymakers reckon the economy will expand 2.1 per cent this year followed by 1.5 per cent in 2024 and 1.8 per cent in 2025. The unemployment rate, meanwhile, is projected to peak at no higher than 4.1 per cent over the next couple years. 

Aditya Bhave, senior US economist at Bank of America, said these were the “most Goldilocks of forecasts you can imagine”, likening it to “Goldilocks without the bears”.

Diane Swonk, chief economist at KPMG, said: “They’ve been emboldened by how well the economy has cooled and strengthened simultaneously. I hope they’re right, but I worry they’re wrong.”