No happy dance in the cards as Fed ponders resilient US economy
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[July 25, 2023] By
Howard Schneider
WASHINGTON (Reuters) - With the Federal Reserve steaming toward another
interest rate hike this week, policymakers face a choice over how much
weight to put on recent economic data that has made hoped-for outcomes
on inflation and unemployment seem more likely while also posing a risk
the economy is too strong to keep prices in line.
Since the U.S. central bank's policy meeting in June, inflation has
slowed more than expected towards the Fed's 2% target, with many
analysts arguing a cycle of moderating price hikes is underway and
should continue without further rate increases beyond the
quarter-percentage-point hike broadly expected to be announced on
Wednesday.
But the sense of optimism in a Fed-orchestrated 'soft landing' - a
scenario in which inflation falls, unemployment remains relatively low
and a recession is avoided - has also buoyed financial markets in ways
that could counter the central bank's aims, something policymakers are
likely to guard against with a still-tough inflation-fighting message
despite where the data have been pointing.
The Fed "does not want to be head-faked by the recent deceleration in
inflation and declare victory too soon," Diane Swonk, chief economist at
KPMG, wrote on Monday, concluding that the central bank will leave its
options open for further increases in borrowing costs. "Financial
markets have consistently front-run the Fed ... That has already eased
credit conditions and could stoke an acceleration in growth."
The rate-setting Federal Open Market Committee is expected to lift its
benchmark overnight interest rate to the 5.25%-5.50% range when it
releases its latest policy statement at 2 p.m. EDT (1800 GMT) on
Wednesday. Fed Chair Jerome Powell will hold a press conference shortly
after to elaborate on the decision.
BALANCING RISKS
In the six weeks since their June 13-14 meeting, Fed policymakers have
digested data offering a mirror image of what they faced a year ago. At
that time, six months of contracting economic activity seemed to show a
recession developing, prices were rising fast, and central bankers had
accelerated rate hikes to a pace expected to make any downturn even
worse.
Now the issue is how much blue sky to acknowledge. Last summer's Fed
meetings, were conducted in an atmosphere of deep concern about a surge
in inflation to four-decade highs and the economy's fate as the Fed
tried to expunge it. Since then the unemployment rate has been little
changed at 3.6%, growth has run consistently above trend, and still the
Fed's preferred measure of inflation has fallen from 7% in June of 2022
to 3.8% as of this past May.
That's still nearly double the central bank's 2% target, and some
officials worry it will prove increasingly difficult to cover the
remaining ground if the economy remains as resilient as it currently
appears.
Signs of a slowdown are there, to be sure, and some policymakers expect
more weakness is coming - an argument for caution in considering further
rate increases.
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The U.S. Federal Reserve building is
pictured in Washington, March 18, 2008. REUTERS/Jason Reed/File
Photo
But with monthly job growth still above 200,000 as of June and wage
increases outpacing inflation, households may be able to keep
spending and foil the consumption slowdown some Fed officials feel
is needed to wring out the rest of the excess inflation.
NO 'SUDDEN STOP'
U.S. stock markets have been rising and other measures of financial
conditions show some conditions loosening even as the Fed tries to
restrict the economy. In fact, a new central bank financial
conditions index shows peak tightness may have been hit late last
year.
Over the course of the second quarter, an Atlanta Fed "nowcast" of
economic growth for that three-month period has jumped from a 1.7%
annualized rate to 2.4% on the basis of strengthened consumer
spending, stronger business investment, and a larger contribution
from government spending.
The change crossed a significant line, moving from just below the
Fed's 1.8% estimate of trend growth - and a level that should thus
continue to temper inflation - to significantly above it. The first
estimate for second-quarter gross domestic product will be issued on
Thursday, with economists anticipating a 1.8% rate of growth versus
2.0% in the first quarter.
Still, unless there's a sharp drop in activity soon, it could mean
Fed officials have underestimated the economy's strength and may
become doubtful about the prospect of a continued decline in
inflation.
Fed officials in June projected GDP would grow just 1.0% in 2023, an
outlook that "basically requires a sudden stop in the economy in the
second half of the year," wrote Tim Duy, chief U.S. economist for
SGH Macro Advisors. "We already have enough visibility on the third
quarter to know that isn't happening."
That will likely keep the door open to more rate increases - for
now. U.S. central bankers were caught out in 2021 when their initial
analysis of rising inflation attributed it to forces, like a supply
shock and pandemic-era spending, that they thought would pass with
time. Even if that now appears to be happening two years later,
they'll likely be slow to take the win.
"It's not clear yet how much growth the Fed will tolerate during a
period of softer inflation numbers," Duy said, with the focus
possibly shifting towards the evolution of the real economy
alongside the data on prices.
"We think that Powell will lead market participants to broaden their
focus beyond the inflation numbers by explaining that for the Fed to
be confident it will restore price stability, it needs to see
further cooling in demand evidenced by GDP growth slowing
substantially, softer job growth, and further downward pressure on
wage growth."
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)
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