Analysis-Fed's quandary: Can the economy keep motoring and inflation fall?

[February 21, 2023]  By Howard Schneider

WASHINGTON (Reuters) - A year into the U.S. Federal Reserve's most aggressive monetary crackdown since the 1980s the strength of the U.S. economy has befuddled policymakers now faced with an unexpected dilemma: Are things too good?

There's little sign the U.S. job market, currently sporting a more-than-half-century low 3.4% unemployment rate, is weakening. Consumers keep spending, and after seeming to flirt with recession last year the economy continues to grow and the risks of an imminent downturn diminish. Equity markets jumped to start the year.

The problem for the Fed is whether those conditions will allow inflation to slow gradually as policymakers say it must, or whether they will have to make good on a warning that taming inflation will require "pain" in the form of rising joblessness - and jack interest rates high enough that the economy does indeed buckle.

It's a debate already joined among officials still arguing for more urgent rate increases, those advocating more patience, and those in the middle trying to reconcile sometimes conflicting data in an economy still influenced by the Covid-19 shock.

"When you see a very strong economy and a strong labor market you do ask yourself ... whether that would put upward pressure on inflation and mean that you need to do more," Richmond Federal Reserve President Thomas Barkin said Friday.

He said he did not ascribe much "signal" to recent outsized data readings like January's 517,000 new payroll jobs that may have been influenced by one-off seasonal effects. But he also said inflation progress was "slow," still-present pandemic effects such as large household cash reserves may be undercutting Fed efforts to curb demand and spending, and a tight labor market's effects on wages and prices is a wild card.

Some officials argue low unemployment will mean little to the inflation battle; some argue it is central and needs to rise.

'ONGOING INCREASES'

Minutes of the Fed's Jan. 31-Feb. 1 policy meeting will be released Wednesday and are expected to reflect a broad discussion, with some officials still advocating then for aggressive half-point rate increases and others wanting to step more gingerly towards an end to hikes. While the Fed settled for a quarter-percentage-point rise, it also said "ongoing increases" would push the policy rate as high as needed.

Asked at a press conference afterward if officials actively discussed the conditions for a pause, Fed Chair Jerome Powell said Wednesday's minutes would offer "a lot of detail ... The sense of the discussion was really talking quite a bit about the path forward."

It's a path conditioned on economic data that lately has been hard to square, with fears of "stagflation" - stalled growth and persistent inflation - giving way to parsing what for now is a period of disinflationary expansion.

Based on recent strong job and retail sales outcomes, an Atlanta Fed GDP tracker put first-quarter growth at a 2.5% annualized pace, well above the economy's potential. Recent data also showed inflation continuing to slow, though by less than expected.

Between that momentum and the still-slowing pace of price hikes, financial markets last week snapped more closely into line with Fed arguments that the battle to tame inflation would take time, yet may be won without a serious economic downturn. For much of the time since the Fed began raising interest rates last March, investors have expected it to stop or even reverse course because of anticipated economic damage.

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst/File Photo

Today's 4.5%-4.75% policy rate is its highest since the eve of the housing crisis in 2007. With neither the job market cracking nor inflation cratering, investors now seem to be giving the Fed the benefit of the doubt.

A recent alignment of market pricing close to the Fed's most current set of policy projections has been a "welcome" development, St. Louis Fed President James Bullard said this week. After falling from November through January, counter to the Fed's hope to tighten financial conditions, the yield on the 2-year Treasury note has risen 43 basis points this month, the most since September.

The core issue now is whether progress on inflation continues despite the economy's momentum - and how quickly the Fed will need to see progress before it decides more effort on its part is needed.

'NOT TAKEN HOLD'

The easy gains on inflation may have been captured from things like improvements in business supply chains, a drop in global energy prices, and consumption switching from goods towards services - things Fed officials had in mind when they called inflation's initial outbreak back in 2021 "transitory."

Those have helped pull consumer inflation from a peak of 9.1% in June to 6.4% last month, with some goods prices actually falling now. The Fed's 2% inflation target is based on another measure last at 5% in December.

Upcoming data will show whether inflation can continue to decline alongside economic growth, but Fed officials were already keying on different points of emphasis.

"I don't see that indicating to me that we're slowing the economy," Fed Governor Michelle Bowman said of recent data, including strong retail sales and job growth. "The work that we've done to this point has not taken hold."

Richmond Fed's Barkin, by contrast, said he took little "signal" from recent data, anticipating inflation would continue falling.

Bullard said he felt businesses would drive "disinflation" by soon competing aggressively for market share, while Barkin said important industries including food, health care and still seemed to have pricing power.

Private economists were walking through the same thicket and coming to roughly the same conclusion - more persistent inflation, potentially higher Fed rate increases, but, at least so far, continued growth and a strong labor market.

"Activity data has been noisy and we are inclined to downplay some of its recent strength," Bank of America economists write, even as they raised their GDP forecast, raised their outlook for the Fed's policy rate, and pushed expectations of a rate cut into March of 2024.

More notable: The Fed will update its own projections next month.

(Reporting by Howard Schneider; Editing by Dan Burns and Nick Zieminski)

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