By Howard Schneider
(Reuters) – The Federal Reserve’s latest financial stability report was good news for those who feared that a record series of interest rate hikes could overwhelm the banking system or trigger a recession in which a sweeping crackdown on lending pushes businesses and households into default would.
None of this happens.
Instead, the Fed is grappling with an economy that has eased tight monetary policy so much that U.S. central bank officials have no clear idea of what to expect and are fretting over issues like productivity, the economy’s underlying potential and even on the question of whether this is the case, the current key interest rate is as restrictive as was imagined when further interest rate increases were canceled.
Rate cuts that would surely begin in early 2024 now appear to be on hold until at least September, with the risk of tapering off later in the year or into 2025 as inflation remains stubborn.
A wave of tight credit appears to have come and gone – bank lending is increasing, corporate credit spreads are tight and household balance sheets are largely healthy – and the economy is still growing above its potential and creating new jobs. A recently updated Fed index of general financial conditions showed that the central bank’s monetary policy or the general credit conditions it is designed to influence currently have virtually no impact on economic growth.
Contrary to Fed officials’ assessment that policy is hawkish, current credit conditions in the economy are “consistent with above-trend growth.” This tells me that the transmission of monetary policy to the real economy has been “much less effective” in the US than elsewhere. said Joe Kalish, chief global macro strategist at Ned Davis Research.
Fed officials themselves aren’t sure whether they need another slowdown in the economy for inflation to fall or whether the “impeccable” impact of productivity and other factors will be enough – an important issue since one view tends to be one monetary policy tends to be more restrictive, the other tends to be more easing. The release of key inflation data on Friday is expected to show that the Fed’s preferred measure of price pressures remains well above the central bank’s 2 percent target, a possible sign that progress has stalled.
It’s a situation that may have left the Fed pretending to be dependent on data but relying largely on intuition and instinct in deciding whether the U.S. has found a new balance of higher growth and lower unemployment More pressure from the central bank is needed to ensure inflation is eased.
Given doubts about the role of wages in driving inflation, questions about whether more demand needs to be squeezed out of the economy, and controversy over what interest rates might be if that were the case, “there is no clear inflation framework and no clear set of measures to assess policy stance,” said Ed Al-Hussainy, senior analyst in the global rates and currencies team at Columbia Threadneedle Investments. “The judgment ‘politics is restrictive’ has to come from somewhere… They really struggled to articulate it.”
NOT AS TIGHT AS THINKING
The intellectual shocks have been profound in recent years, from a surprising surge in immigration that bolstered the U.S. labor supply to the partial slowing of globalization and a reallocation of consumer spending toward services. Unlike previous tough political times, the housing market will not collapse and has recently boosted inflation. Concerns about the impact of massive government deficits on financial markets have been reignited, and there are open questions about productivity and the “neutral” interest rate that guides whether or not policy is restrictive.
Gross domestic product figures released on Thursday are expected to show the economy grew 2.4% annually in the first three months of the year, marking another quarter in which GDP grew faster, according to a Reuters poll of economists the 1.8% rate that Fed officials set nearly eight years ago as the median estimate of the economy’s noninflationary growth potential.
The U.S. has only missed that mark in five of the 30 quarters since then, and two of those were related to the outbreak of the COVID-19 pandemic.
The question is whether the economic potential is higher than expected, whether sustained strong growth is possible without high inflation, or whether growth in recent years has been boosted by a series of “temporary” shocks – for example, tax cuts during the Trump administration, or federal transfers and infrastructure spending under President Joe Biden — that could mean faster price increases and higher interest rates.
Joseph H. Davis, chief global economist at Vanguard, said in a recent study that national debt and an aging population have pushed up the neutral interest rate by perhaps a percentage point, meaning the Fed’s policy is not as hawkish as thought . That would explain the continued growth, but also make it more difficult to reduce inflation.
“When you look out, the evidence is mounting that the Federal Reserve is not as hawkish as they think,” said Davis, who currently expects the central bank will not cut interest rates at all this year. “You can draw conclusions from financial conditions, the labor market and inflation – if you look at all three, the neutral rate is higher… If someone had been asleep for ten years, they would wonder why they are so confident in an easing cycle “If you consider how the economy is developing.
Fed officials currently say they are content to wait and see whether the 5.25% to 5.50% range set in July pushes inflation back toward the 2% target and are not considering further rate hikes. With interest rates expected to be held steady again at the Fed’s policy meeting next week, observers will be looking to either the latest Fed statement or Fed Chair Jerome Powell’s press conference for clues as to which direction things are headed.
Powell may be the first to admit he’s not sure.
“At some point they kind of threw up their hands and gave up on the idea that they would be able to predict where inflation and the economy was going, given how much was in flux,” said Luke Tilley, chief economist at Wilmington Trust.
“They said there has to be pain…Then they said jobs are good and growth is good, we just want good inflation numbers,” Tilley said. “It’s very difficult for them to understand.”
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)