Clock on the Fed's 'soft landing' may already be ticking
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[July 31, 2023] By
Howard Schneider
WASHINGTON (Reuters) - Throughout the Federal Reserve's drive to kill
inflation, policymakers have focused on raising the benchmark overnight
interest rate high enough to do the job and getting it there fast enough
to keep the public from losing faith.
But in the quest for a "soft landing," where inflation falls without a
recession or big job losses, the other half of the conversation - of
when to cut rates and lighten the pressure on households and businesses
- will be just as important and perhaps even harder to get right.
In the three recessions prior to the coronavirus pandemic - 1990-1991,
2001 and 2007-2009 - the U.S. central bank reached its peak rate level
and had begun reducing borrowing costs anywhere from three to 13 months
ahead of what proved to be the start of a downturn. That shows both how
hard it is to arrest a slide once it begins, and how difficult it is to
match the slow-moving effects of monetary policy with what the economy
might need months in the future.
Allowing high inflation to become embedded in the economy is central
banking's cardinal sin, and Fed officials would still rather make the
mistake of going too far to be sure inflation is controlled than stop
short and risk its rebound, said Antulio Bomfim, head of global macro
for the global fixed income team at Northern Trust Asset Management and
a former special adviser to the Fed's board of governors.
"We all wish we could slow the economy 'just enough,'" Bomfim said. "The
margin of error is quite high ... You are seeing an economy that is
resilient in terms of activity but also stubborn on underlying inflation
... The risks of doing too little - that asymmetry - is still there."
That may point to at least one more rate hike even as investors bet the
Fed is finished, with rate futures markets reflecting no more than a
roughly one-in-four chance of another increase. The Fed last week raised
its policy rate to the 5.25%-5.50% range, the 11th increase in the last
12 meetings.
'PUZZLE' PIECES COMING TOGETHER
Recent data on wages, growth and prices show the dilemma facing
policymakers as they consider whether to push borrowing costs even
higher and how long to leave rates elevated, a discussion that could
determine the economy's broad direction - growing or shrinking, with
rising joblessness or still-strong job markets - in 2024, a presidential
election year.
After sixteen months of rapid monetary tightening, the economy still
grew at a faster-than-expected 2.4% annualized rate in the second
quarter, above what's considered its non-inflationary trend, with that
momentum seen continuing into the current quarter. Employment
compensation costs rose 4.5% for the 12-month period ending in June,
another decline from pandemic-era highs but also above what the Fed
would regard as consistent with its 2% inflation target.
While headline inflation has fallen sharply from the highs of 2022,
measures of underlying price pressures have moved more slowly. The
personal consumption expenditures price index stripped of food and
energy costs slowed notably in June to 4.1% on a year-over-year basis
after being lodged for months near 4.6%, but is still more than double
the 2% target.
Fed Chair Jerome Powell said last week that the pieces of the low
inflation "puzzle" may be aligning, but he doesn't trust it yet.
"We need to see that inflation is durably down ... Core inflation is
still pretty elevated," Powell said in a press conference after the end
of the Fed's two-day policy meeting. "We think we need to stay on task.
We think we're going to need to hold policy at restrictive levels for
some time. And we need to be prepared to raise further."
[to top of second column] |
U.S. Federal Reserve Chair Jerome Powell
speaks during a news conference following a two-day meeting of the
Federal Open Market Committee on interest rate policy in Washington,
U.S., July 26, 2023. REUTERS/Elizabeth Frantz/File Photo
Powell acknowledged the touchy calibration needed to vanquish
inflation without restricting activity more than necessary and to
stay ahead of any downturn with lower rates as inflation falls and
activity ebbs.
"You stop raising long before you get to 2% inflation and you start
cutting before you get to 2% inflation," Powell said, noting how
long it takes for changes in the Fed's benchmark rate - up or down -
to be felt. The Fed's policy rate influences the economy by changing
what lenders charge consumers for credit card, auto, and home loans
or what businesses pay on bonds or for credit lines.
'NORTH STAR'
Powell would not give direct guidance on how the Fed will assess
when it's time to move policy lower, saying "we'd be comfortable
cutting rates when we're comfortable cutting rates." Still, he
contended inflation would not return to target until the economy
slows to below its potential for a time, with direct implications
for the number of jobs.
Things have been edging that way. Though the unemployment rate
remains low, workers are quitting less frequently, job openings have
fallen, and wage increases have slowed, suggesting an employment
market cooling from pandemic years characterized by labor shortages
and large wage increases.
But with inflation down from its peak without any major job
disruptions, some economists wonder whether Powell - in focusing on
the need for economic "slack" to finish the task - isn't making the
same mistake as his predecessors and setting the stage for an
unneeded recession.
"Exploring just how compatible low unemployment and low inflation
are should be the North Star ... This is a vast border we could
test," said Lindsay Owens, executive director of Groundwork
Collaborative, a labor-focused economic policy group. "The timeline
for discussing cuts is probably like October."
While the latest Fed policymaker projections, issued in June, show
rates falling by the end of 2024, the decline is less than the
expected drop in inflation, which means the inflation-adjusted
interest rate is really still rising.
The risk of continued restrictive policy is that the economy not
only slows, but buckles, something previous Fed officials know can
come quick. In December of 2000, Fed staff and policymakers wrestled
with weakening data and concluded the economy was going to slow but
not contract, according to transcripts of Federal Open Market
Committee meetings. A month later the central bank was cutting
rates, and it was eventually determined that a recession started in
March of 2001.
"I think the economy is kind of at the 'last-gasp' phase," said
Thomas Simons, senior U.S. economist at Jefferies, with slowed bank
lending, rising credit costs, and rising loan delinquencies
"consistent with the beginning of every recession we've seen since
1980."
"Given that inflation is still sticky, they're going to end up with
rates either too high or as high as they are for too long. They're
going to be relatively slow to cut because they need that weakness
to develop."
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)
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