Market Timing

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>>> The Fed Has No Good Options. The Risk of a Misstep Is Growing


Barron's

By Megan Cassella

April 28, 2023


https://www.barrons.com/articles/federal-reserve-interest-rate-hikes-economy-7c916f5c

https://investorshub.advfn.com/boards/read_msg.aspx?message_id=171815022


The Federal Reserve is struggling to cool inflation further without damaging the economy. The easy part is over

Since the Federal Reserve first kicked off its inflation-fighting campaign 15 months ago, it has raised interest rates nine consecutive times and wound down its pandemic-era bond-buying program, notching the fastest pace of monetary policy tightening in four decades. So far, it has achieved a balance that its critics thought nearly impossible, cutting headline price growth nearly in half while keeping the U.S. economy humming.

Since the Federal Reserve first kicked off its inflation-fighting campaign 15 months ago, it has raised interest rates nine consecutive times and wound down its pandemic-era bond-buying program, notching the fastest pace of monetary policy tightening in four decades. So far, it has achieved a balance that its critics thought nearly impossible, cutting headline price growth nearly in half while keeping the U.S. economy humming.

The problem is that the job is far from over, and the most difficult days lie ahead. As the central bank’s policy committee gears up for its May 2-3 meeting and what is widely expected to be a 10th rate hike, it will be embarking on a new and more volatile phase in its tightening cycle, marked by far less clarity than what has come before. The risk of a misstep is growing, and the consequences of over- or undershooting would be severe.

The central challenge for the Fed is that the economic outlook is souring at the same time that progress on reining in inflation is stalling out. Economic growth in the first quarter decelerated more than expected, data out this past week showed, while the Fed’s preferred inflation gauge is down less than a full percentage point from its peak and still more than double the bank’s 2% inflation target.

That contradiction will weigh on the Fed as it debates whether and when to pause its rate-hike campaign, forcing officials to decide how much economic pain is acceptable in the service of restoring price stability, and how much would be considered too much for the country to bear.

In a best-case scenario, the Fed will carve a winning path between two losing propositions: giving up the inflation fight too soon, which would risk a severe recession later, or pushing rates too deeply into restrictive territory and sending the economy into a tailspin as soon as the second half of this year. Success will depend on both skill and luck, and is by no means assured.

“They haven’t even gotten close to the hardest mile,” says Diane Swonk, chief economist at KPMG.

The Fed has lifted the federal-funds rate from near zero to a current range of 4.75%-5%, with more hikes likely from here. In doing so, it has ushered in an end to the easy-money policies that have defined the U.S. economy since the start of the 2008-09 financial crisis.

A continued transition to a more restrictive policy stance will ramp up the pain, further reducing demand for goods and services, weakening the labor market, and greatly increasing the cost of servicing debt—including mortgages, car loans, and the government’s more than $31 trillion in federal borrowings. And it will test the strength of a generation of companies that grew up in an accommodative policy environment and haven’t had to function under tighter monetary conditions.

At the same time, the financial sector is on increasingly unsteady footing. Higher rates have wreaked havoc with bank balance sheets; the industry’s unrealized losses on securities totaled more than $620 billion in the fourth quarter of 2022, according to the Federal Deposit Insurance Corp. The first quarter of this year saw two high-profile bank failures, which forced the Fed to establish an emergency lending facility. And Wall Street is rife with talk of impending chaos among nonbank lenders and alternative-asset managers, should interest rates move much higher.

Erring in either direction—by raising rates too much or not enough—would risk disrupting a fragile financial system and throwing millions of Americans out of work, erasing years of labor-market gains. Even an ideal outcome, cooling the economy without causing a deep recession, probably will lead to some painful fallout, so long as the Fed remains ironclad in its resolve to keep interest rates elevated even as joblessness rises, growth sputters, and a public backlash ensues.

“They’re walking a tightrope without a net,” Swonk says.

The Federal Reserve finds itself fighting inflation today partly because of policy decisions made more than a decade ago, when central banks around the globe grew worried about deflation in the aftermath of the financial crisis. While the U.S. economy recovered, price growth regularly undershot the 2% annual target that the Fed set early in 2012.

In response, Fed officials kept interest rates near zero to try to stoke demand and inflation. They also engaged in quantitative easing, a form of bond buying designed to increase the money supply and encourage lending and spending.

“It was the new abnormal,” says Ed Yardeni, a former Federal Reserve staff member and veteran investment strategist who now leads Yardeni Research.

The Fed had raised interest rates only modestly when Covid-19 hit in 2020, and it followed the same playbook it had written a decade before to cushion the blow from pandemic-related shutdowns. It slashed the federal-funds rate to zero and bought securities to increase liquidity in the financial system.

When inflation began to ramp up early in 2021, Fed Chairman Jerome Powell and other Fed officials, along with many economists, initially dismissed the trend as “transitory,” a temporary consequence of closing and subsequently reopening the global economy. The expectation was that price growth would naturally slow as supply chains healed, employees returned to work, and factories came back online.

Because the previous recovery had taken so long to gain traction, with more than 10 years passing before the labor market came close to what economists consider full employment, the Fed remained on the sidelines, loath to nip the post-Covid recovery in the bud. The central bank stayed put even as Congress passed another $1.9 trillion in pandemic-related fiscal relief and as state and local governments reported massive budget surpluses. By the time Powell announced the first rate hike in March 2022, the headline consumer price index had already reached 8.5%.

“They were right to gamble on running the economy hot,” says Adam Posen, president of the Peterson Institute for International Economics and a former Bank of England official. But once inflation took off, “what I fought them on was a failure to pivot.”

The historical context is relevant for two reasons: For one, it offers cause to question whether a Fed that was caught flat-footed by inflation two years ago will be able to recognize when it is time to shift gears again. The fear among Fed critics is that the central bank will be inclined to keep policy restrictive for longer than necessary to compensate for having let price growth get out of hand in the first place.

But the back story also serves as a reminder that the current economy has long grown used to low rates, and some aspects of the economy have become dependent on them. Some economists warn that moving back to a world of tighter policy—or returning to the old normal—will be a major shock to the system.

“Are we going to be able to make this transition…and absorb the shock of having all that happen basically in one year?” Yardeni asks. “That’s the big debate.”

Economists who think the Fed should pause say the economy is already sputtering. Because monetary policy operates with a lag, their view is that the amount of tightening to date will be sufficient to bring inflation back to target.

Some recent data support this view. Unemployment claims are rising materially, with the share of Americans receiving jobless aid up nearly 45% from a September low. The manufacturing sector is slowing, with factory activity contracting for five straight months. And first-quarter gross domestic product, which rose at an annual rate of 1.1%, fell short of economists’ expectations of 1.9% growth.

Credit conditions, meanwhile, are tightening, spelling trouble for the small-business sector, which so far has propped up the labor market and needs access to loans to keep hiring. Some economists expect further chaos in the banking sector as well.

“From my view, another rate hike is dangerous,” says Bill Spriggs, chief economist at the AFL-CIO and a Howard University economics professor. “[The Fed] got the yellow card several months ago. Now it’s time for the red card.”

Still, inflation remains far above the Fed’s target. A long-awaited slowdown in shelter costs has been elusive. Services prices, which the Fed is eager to see cool, have barely budged, and goods prices, which had been falling, are now turning upward again. Wage growth, too, remains hot: Compensation costs for all civilian workers climbed 1.2% in the first quarter of 2023, accelerating from the 1.1% pace set during the previous quarter, data released on Friday showed.

The core personal consumption expenditures, or PCE, deflator, the inflation gauge that the Fed watches most closely, stood at 4.6% in March and slowed less during the month than economists had expected, according to a separate data set released Friday. Viewed on a quarterly basis, which smooths out volatile month-to-month changes, core PCE has more or less been moving sideways since the middle of last year. And that is after the factors that initially had been considered the root causes of inflation—supply-chain snarls, pandemic shutdowns, generous fiscal stimulus—have mostly subsided.

“There was always at least some transitory component to inflation,” says Jason Furman, a Harvard University economist and former Obama White House economic adviser. “Getting rid of underlying inflation is a lot harder.”

That leaves the Fed, which has vowed to prioritize a return to price stability even at the expense of economic pain, with more work to do. Very few of what economists consider primary indicators of tightening monetary policy are showing significant deceleration, Posen notes. Factors such as wage growth, construction employment, and credit spreads all look fairly strong.

Nor have the risks of an upside inflation surprise disappeared. Labor markets remain tight. Semiconductors are still scarce. And fiscal stimulus continues to flow out to areas such as defense and green infrastructure.

“Inflation could well continue to be stubborn,” Furman says. “The Fed could have to raise rates more later this year. The market still isn’t fully prepared for that.”

Given the cards on the table, the Fed is poised to keep tightening for now. But will officials know when it is time to stop? Perhaps the greatest risk to the economy in the coming months is that they won’t.

For one, bank officials are reliant on economic data that are backward-looking and difficult to assess, given the ways in which the pandemic has altered consumer behavior and scrambled seasonal-adjustment calculations. They are also determined to secure a slowdown in services inflation before easing up on rate hikes, and that means waiting for spending categories such as airline travel, daycare, and recreation services to show signs of price deceleration.

Yet those areas are some of the last to feel the impact of interest-rate hikes, which work primarily by making goods, especially homes and cars, more expensive. “By definition, you have to overshoot in other sectors that are more interest-rate sensitive to get at [services] inflation,” Swonk says. “The system is rigged to overshoot.”

Fed officials have emphasized their fear of repeating history, specifically the painful inflation fight of 40 years ago during which then-Fed Chairman Paul Volcker hiked rates dramatically, slashed them when recession hit, and then pulled them up again months later when inflation proved more entrenched than anticipated. Public comments from Powell and other top officials in recent months suggest that they would rather keep rates high and weather the economic pain than lower rates only to have to lift them again in relatively short order.

“They’ve been studying past instances of when the Fed let inflation get out of control, and reached the conclusion that the common mistake was giving up too soon,” says Bill Nelson, chief economist at the Bank Policy Institute, who spent more than 20 years at the Fed’s Board of Governors. “I worry that is going to leave them somewhat dug in.”

There is a more recent historical lesson to learn, too. The Fed’s primary policy error in the past two years was misreading the economic situation and thus failing to act quickly enough to change course, a blunder that allowed inflation to spiral out of control.

Now we will see whether they make the same mistake again.

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