The Federal Reserve finds itself in a particularly difficult situation: raising interest rates at a time when economic growth is slowing. The rationale for the tightening policy is that inflation is soaring and therefore price pressure outweighs any concerns about growth.
Fed funds futures are pricing a 25 basis point increase in the Fed’s target rate at high odds at today’s policy announcement (2:00 p.m. EST, March 16). The expected increase will take the target federal funds rate to a range of 0.25% to 0.50%, which is well below the 7.9% annual pace of consumer inflation through February – a 40-year high that is expected to hold steady if not rise as a backfire from the war in Ukraine will ripple through the data in the months ahead.
US economic activity, meanwhile, peaked. After a meteoric gain of 7% in the fourth quarter of last year, growth in the first quarter is expected to show a marked slowdown. Production is expected to rise 1.2% in the first three months of the year (seasonally adjusted annual rate), based on the median estimate of a set of nowcasts compiled by CapitalSpectator.com. It’s a slow pace that raises a warning flag for quarters to come. (Today’s estimate reflects a slight decline from the previous estimate of 1.4% for the first quarter released two weeks ago.)
The wisdom (or folly) of raising interest rates now and in the months ahead can only be determined with hindsight. If inflation is expected to remain high or continue to rise, the case for policy tightening is strong. The question is whether the growing forces of demand destruction, partly due to the headwinds unleashed by the war in Ukraine, will reduce inflation in the coming months?
Even though slowing growth is cooling inflation, raising interest rates slightly today seems like an easy decision. A 25 basis point hike would still leave the fed funds near a record low. Meanwhile, given the huge gap between the target rate and inflation, the evidence seems overwhelming that monetary policy urgently needs to catch up with macroeconomic events as far as price pressure is concerned.
None of this excludes the possibility that a policy error may be lurking. Indeed, two sets of monetary policies are needed simultaneously – one to deal with slowing growth and the other to deal with soaring inflation. Unfortunately, only one policy can be implemented and in the current environment there is a high risk that the Fed will choose the wrong one, or attempt to hedge the risk and take a middle path that does not effectively address any of the macro threats.
Perhaps the worst-case scenario from an economic growth perspective: The Fed continues to raise rates, perhaps aggressively, as economic activity slows or plunges into a recession. Alternative for inflation risk: Policy tightening is insufficient to nip inflation expectations and price pressure in the bud. The possibility of a combination of the two cannot be ruled out either. Meanwhile, the odds of the Fed getting policy perfectly correct (or something close to it) in the coming months look dangerously low.
Weak, but not zero. The good news is that if the US economy continues to slow, as it has for several months, the risk of recession remains a low probability event for now and in the immediate future. Several indicators of the economic cycle currently show that a growth bias persists. But as two proprietary metrics that track U.S. economic activity show, the trend continued to weaken through February.
The projection of the values of these indicators until April suggests that the slowdown in growth will continue.
A key factor – perhaps the only factor relevant to the near-term future – in deciding how the Fed should adjust policy in the weeks and months ahead is the evolution of the war in Ukraine and how it affects supply and demand. Unfortunately, the future is virtually entirely uncertain on this front, given the uncertainty of war.
The Fed, in short, is flying blind, as we all are. Changing monetary policy in real time is always vulnerable to imperfect information related to future events. In “normal” times, this risk is manageable in the sense that relatively standard economic conditions apply and modeling provides useful guidance. In such times, the risk and reward of a policy error is relatively moderate compared to current conditions. Adding to the complication in 2022 is the fact that the Fed appears to be way behind the curve in terms of managing inflation expectations.
The central bank could be lucky in that inflation falls sharply in the near term and/or the US avoids a recession. But if one or both of these scenarios do not apply, the Fed will find itself in one of the most difficult crises in its history with no easy solutions.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.