The Fed increased rates, signaling there’s still work to be done
As widely expected, the Fed’s decision to raise their benchmark funds rate by a half percent today reinforces three key points: 1) policymakers see the progress being made in lowering inflation and cooling labor market conditions, 2) that progress was sufficient to allow them to ratchet back the pace of tightening modestly, and 3) they’re not done.
It’s clear that the Powell Fed doesn’t want to make the same mistake as their counterparts in the 1970s and collectively remain committed to continuing to tighten conditions until they are certain that the inflation boogeyman is dead.
Coming off a succession of 0.75% interest rate hikes, a stepdown in the pace of tightening to 0.5% was a positive sign but one that may still be overshadowed by indications that policymakers now see the need to tighten even more than previously forecast in 2023. The Fed’s September forecast called for the funds rate to effectively rise to a range of 4.5–4.75% next year. Today’s updated projections raised the stakes, pushing that terminal rate up to a range of 5.0–5.25%.
The Fed may slow down, but policymakers now see the need to do even more.
Labor market conditions have eased this year, as evidenced by the increase in weekly jobless claims since March and the notable slowdown in the pace of job creation. Directionally, this has been a welcome development for Fed policymakers looking to loosen up what had been an incredibly tight job market. It’s notable that in their statement today, policymakers still characterized recent job creation as robust. That’s a strong indication that the Fed is looking for layoffs to increase to a much greater degree than has been the case this year. Their projection that unemployment should reach 4.6% next year also indicates that the slight uptick in the jobless rate from its recent 3.5% low has barely scratched the surface of what they believe is needed.
Fed Chair Powell has previously stated that there would need to be “pain” ahead for the U.S. economy. A slowdown in growth would be uncomfortable but likely falls well short of “pain.” That appears to come in the form of job losses sufficient to raise the unemployment rate to well above the recent level. The Fed’s updated unemployment forecast raised the stakes further, holding in the 4.5% range out into 2025. That would seem to fit the description of “pain” more closely than does a mere slowdown in growth.
The big question in all of this is whether the Fed will have the ability to stick to their script, continuing to tighten and hold interest rates in restrictive territory. With recession risk growing — and their own forecasts calling for job losses in the coming year — there appears to be a disconnect. History suggests that it’s exceptionally difficult for central banks to successfully engineer a slowdown. Economic momentum can be hard to slow, and monetary policy is a blunt tool that can’t be executed with precision.
Could the Fed be talking tougher to manage expectations, while anticipating the need to reverse course more quickly than their published forecasts indicate? That’s certainly plausible. The pressure to ease rates will only build if recession risk becomes reality, which could force the Fed to reverse course.
At the same time, the markets have been actively looking for a Fed pivot for some time. The primary catalyst for the recent stock market rally was a better-than-expected report on consumer inflation. Any indication that rates might be close to topping out had prompted a “risk-on” attitude for investors, driving equity markets higher. That’s not what a still-hawkish Fed is looking for.
The Fed’s message today seems clear. In their estimation, inflation is still a problem. And while it’s expected to continue to gradually recede, it will remain a problem for the next few years. That leaves policymakers with no choice but to continue to raise short-term rates and tighten conditions more than most have expected — even if that results in more pain in the form of a meaningful increase in job losses and an economy in recession.
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