What’s Next for the Fed?
After neglecting to address inflation throughout 2021 and into 2022, the Federal Reserve has now raised its interest rate targets 10 consecutive times, to the highest level since 2007.
At his press conference to announce the change, Fed Chair Jerome Powell emphasized the Fed’s priority of reducing inflation and stressed that the Fed will maintain high interest rates as long as is needed to achieve this goal.
Given the turmoil in the banking system and softening of the labor market, is the Fed likely to fulfill this commitment? What factors might cause the Fed to revise its monetary policy?
Will interest rates remain elevated? Powell has repeatedly stated that the Federal Open Market Committee (FOMC), which determines the stance of monetary policy, has no plans to cut interest rates in the current year. Several FOMC members, however, have expressed views that the committee should pause its rate hikes for now to evaluate the effects of its recent policy changes.
While not committing to a pause, Powell pointed out the FOMC had removed from its new monetary policy statement a note in previous statements that “some additional policy firming may be appropriate.”
One reason for Powell’s emphasis on keeping interest rates high is his fear that if the public believes the Fed will cut rates, then they will expect more inflation, and that change in expectations could actually cause inflation to rise. The FOMC must signal that they are willing to keep rates high since their priority, at least for now, is to stamp out inflation.
What are market participants expecting? Despite Powell’s insistence that the Fed has no plans to reduce its interest rate targets, it appears that financial market participants do not believe him. Financial markets indicate that the Fed is expected to stabilize interest rates through the summer and begin cutting in the fall. This might happen for one of two reasons.
First, the Fed’s ideal scenario is that inflation continues to slow, in which case, they could reduce interest rates slightly to what they consider to be the “normal” range with little negative side effects to the economy. Falling inflation implies an increase in real interest rates, so the FOMC may need to reduce interest rates in order to maintain a neutral policy rather than becoming overly restrictive.
Second, most economists are predicting a recession this year. If it happens soon, the Fed will be stuck with two bad options: either keep interest rates high to prevent inflation or cut interest rates to address the recession. Given the Fed’s history and Powell’s past reluctance to address inflation, the markets may be betting on the latter.
What will determine the Fed’s decisions? Chair Powell said that, going forward, the Fed will be data dependent in its monetary policy decisions. Three important factors they will likely consider are inflation, unemployment, and the prospect of further bank failures.
The Fed is hoping inflation, and especially inflation expectations, will continue to fall. High inflation has been harmful to average Americans, and getting it down has become the Fed’s top priority. Falling inflation would give the Fed more room to cut rates without pushing up expectations.
Employment remains strong but may be slowing slightly, which is fine since the Fed wants it to calm to a sustainable pace. If unemployment rises substantially, indicating a likely recession, it is not clear how the Fed will respond, especially if inflation remains high.
Despite the negative effects of high interest rates on the banking sector, the Fed is reluctant to lower rates for fears of perpetuating inflation. It has sought to address banking problems with emergency lending facilities rather than through monetary policy. That has worked so far. If more bank failures threaten the financial system or put the economy at risk of recession, however, the Fed may choose to reverse course and lower interest rates to address these issues.
The economy is stable for now with low unemployment, falling inflation, and interest rates expected to remain stable, at least for a while. A wide range of outcomes are still possible for 2023, ranging from stagflation to a “soft landing.” The Fed’s response to economic conditions in the coming months may tell us which of those outcomes is most likely.