The Federal Reserve will begin a month-long campaign to beat inflation this week that could see Chairman Jerome Powell act even more aggressively after Russia’s war on Ukraine further fueled prices.
Already pivoting to tighter monetary policy amid the fastest consumer price gains in four decades, Powell and his colleagues must now deal with the economic fallout from the war, which threatens to deliver the double blow of a weaker growth and even faster inflation.
With a 25 basis point hike all but certain on Wednesday after Powell made the rare step to publicly back such a move, futures markets are showing a tightening of around 165 basis points this year, the equivalent of at least minus six quarter-point increases.
There is certainly reason to worry about inflation, as Russia’s invasion compounds the pressures triggered by the pandemic. The cost of food, fuel and metals has skyrocketed since the war began with gasoline alone at an all-time high, when prices for many services were already higher.
Considering the first rate hike since 2018, Powell was allowed to be hawkish by President Joe Biden, lawmakers across the political spectrum and many other Fed officials, as businesses and households are increasingly anxious to avoid the damage of 1970s-style price shocks that crimp their purchasing power.
“Powell can’t really afford to be dovish at this point, that would be inconsistent with what sound policy is and where policy needs to go,” said Derek Tang, an economist at Monetary Policy Analytics in Washington.
Although he argued that the Fed would be nimble, Powell’s post-decision press conference on Wednesday will be analyzed for clues as to how high rates could ultimately move from around zero today and how quickly with which those in charge could act to achieve this. Goldman Sachs Group Inc. predicts officials will eventually stop raising rates to 3% over the next year.
A key insight will be provided by the Fed’s dot chart of rate projections through 2024 and how much Powell approves of it.
Last week’s meeting of the European Central Bank showed the potential for hawkish surprises when President Christine Lagarde announced an accelerated reduction in monetary stimulus. The Bank of England is also expected to raise rates this week for a third consecutive meeting.
US central bankers are beginning their tightening campaign with real interest rates – nominal inflation-adjusted rates – at the deepest negative level dating back to the 1970s. If longer-term inflation expectations rise, this means that there could be more to go to bring politics to a more neutral framework that neither speeds up nor slows down growth, even if the conflict makes the road harder to discern.
“It’s a real mess,” said Tim Duy, chief US economist at SGH Macro Advisors, who sees the risks of higher inflation outweighing the danger of slowing growth. “Powell would like to thread the needle, so as to maintain strong growth while bringing inflation down to something more reasonable,” Duy said. “If he can do that, he’s a legend.”
This puts the spotlight on whether Powell is signaling a shift to a more hawkish or easier path of tightening, or is keeping his options open as he talks about the need for flexibility amid uncertainty.
It’s not an easy call. Forecasters expect the economy to slow this year as fiscal spending cuts, and a University of Michigan survey on Friday showed consumer sentiment was at its lowest since 2011 following soaring costs. fuel and inflation, which doesn’t bode well for spending.
Fed officials will also want to see how their balance sheet liquidation plans impact financial conditions, which have tightened further in the wake of the war. They are expected to announce the pace at which they plan to reduce the toll at this meeting, although they have yet to set a start date for the process to begin.
A sharp slowdown in the level of hiring would encourage a reduction in the rate of tightening.
Powell “has made it clear that they’re going to be gradually transitioning to neutral,” said Julia Coronado, founder of MacroPolicy Perspectives. “The resilience of demand will be the leading indicator” of their speed.
At the same time, the Fed is on a mission to maintain price stability, and patience is running out both inside and outside the central bank.
Powell heard from lawmakers on both sides of the aisle earlier this month that their constituents wanted action on inflation. And his own committee has taken on a more hawkish slant.
St. Louis Fed President James Bullard, a political voter this year, called for a “swift withdrawal from political accommodation,” while Governor Christopher Waller said he wants a tightening of at least minus 100 basis points by mid-year, with a half-point hike an option. Governor Michelle Bowman said she was ready to take “strong action” to bring inflation back to its target.
No Fed official is talking about tipping the economy into a recession to control inflation. But their ability to exercise patience is only limited by public confidence in their ability to bring inflation down to around 2% a year.
“Given soaring commodity prices, inflation expectations are at a perilous point right now,” said Sarah House, senior economist at Wells Fargo & Co.. “They’re not above the Fed’s target, but they are dangerously close. This will keep the Fed’s hike plan on track.
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