Is the Fed Done? Not Likely: Interest Rate Predictions

Wall Street loves cryptic sayings.  One advises that investors not “try to catch a falling knife,” meaning wait to buy when prices have a strong falling momentum.  Another advises investors not to “fight the Fed (Federal Reserve).”  That is do not bet on an easing when the Fed is in the processes of tightening monetary policy.  A third and somewhat more philosophical saying holds that investors should “never confuse their expectations with their hopes.”

This last bit of advice came to mind as the media and the investment community responded to Fed Chairman Jerome Powell’s last press conference.  The Fed had just raised its benchmark federal funds target a modest 25 basis points into the rage of 5.00-5.25 percent.  In response to questions, Chairman Powell told the assembled members of the press that the Fed’s policy team, the members of the Federal Reserve Open Market Committee (FOMC), had not discussed a pause in rising interest rates at this latest meeting but that they would determine future moves according to the flow of information on inflation trends and the economy.  He could say little different.  Unlike now retired Chairman Ben Bernanke, Powell has exhibited a wise reluctance to forecast how the Committee would respond to information it has not yet received.  Vague and non-committal as his remarks reasonably were, the media and Wall Street commentors almost universally declared in response that the Fed was likely to pause its rate increasing and begin to bring interest rates down again before the year ends.

Such conclusions certainly reflect Wall Street’s hopes.  Interest rate hikes and tight credit tend to depress asset prices, whereas falling rates and easy credit tend to boost prices.  But if there is reason to expect the Fed to pause in its tightening trend, there is little to conclude that such a pause would signal an end to the Fed’s tightening trend and even less reason to look for the Fed to promptly bring interest rates down.

The Powell comment that likely did the most to bring Wall Street hopes to the fore, was his judgement that “policy is tight.”  Certainly, policy is tighter than it was.  The Fed, after all, has raised the target federal funds rate some five percentage points in a little over a year.  Even at that Powell did not say that policy is tight enough.  Indeed, there is reason to conclude that despite all the Fed has done, policy is not especially tight.  Consider that before all this started, the Fed maintained a target federal funds rate of about 0.25 percent in an inflation that was running about 1.5 percent a year.  That was an easy policy.  Borrowers paid one-quarter of a percentage point in interest with dollars that were worth 1.5 percent less a year.  In real terms, lenders were paying borrowers 1.25 percent a year.  Today with rates at 5-5.25 percent and  inflation averaging 5-6 percent a year, borrowers still pay in real terms somewhere near zero for the use of the lender’s money.  Things are tighter than the were but still far from longer-term historical averages in which lenders paid 1-2 percent in real terms.

Of course, Powell made a slightly different calculation than this.  He quoted inflation from the Fed’s preferred measure, the core consumer price deflator, which in March had eased to a 4.6 percent yearly inflation rate, down from over 5 percent previously.  On this basis he could announce that real rates were above 1.0 percent.  These kinds of figures made for easy listening at the press conference and presented the Fed as having done its job, but Chairman Powell knows — and everyone else should know — that inflation is never this well-behaved.  The economy and Fed decision-makers are as likely to see additional pressure in coming months as they are to see more relief.  Meanwhile, the economy continues to grow, albeit slowly, and the jobs market remains strong, with robust rates of hiring and wage gains of over 4 percent a year.  With labor productivity hardly expanding, such wage figures suggest near-term inflationary pressure not relief, and certainly not of the sort that would prompt the Fed to declare victory and reverse policy.

In this milieu the Fed still might pause in its pattern or interest rate hikes.  Such a pause, however, would not, as the current consensus seems to think, signal victory and a turn to easing.  Instead, it would reflect an effort to assess the effect of what policy has done to date.  Members of the FOMC are well aware that the rapid tightening actions they have engaged in since March of 2022 will affect the economy and ultimately inflation only after a time.  A pause could give an indicator of how far past actions can take the counter-inflationary campaign.  Once policymakers make such an assessment, future actions will, as Chairman Powell tried to make clear, depend on the future flow of information.

Two possible events, however, could play into market hopes and force a near-term policy shift.  One is the ripple effects of recent bank failures.  A restriction of credit by bank managements, if strenuous enough, would advance the Fed’s inflation fight without the need for further rate hikes.  The other is a lapse into recession.  If an economic downturn suddenly began to cause layoffs and an uncomfortable rise in the unemployment rate, monetary policymakers could suddenly reduce interest rates to help the economy, no doubt with plans to resume the counter-inflationary fight once the worst recessionary effects abate.

Right now, it does not look as though the ripple effects from past bank failures will get severe enough to do the Fed’s inflation fighting for it.  Recession is entirely possible, maybe even likely.  Chairman Powell told the media that the Fed’s staff expects recession.  But the staff expects it to be mild, not enough to change the Fed’s underlying counter-inflationary campaign.  Chairman Powell announced that he differs from his own staff and thinks the nation will avoid even a mild recession.  On these bases, and the other signs outlined here, it would seem that the Fed, though it may pause its rate hikes, will continue its counter-inflationary stance for the foreseeable future and not likely reverse policy until 2024 at the earliest.

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