US central bankers face a tricky balancing act as they prepare to deliver another interest rate increase next month, weighing evidence that inflation is still too high against a pullback in lending following the recent banking turmoil.
Ahead of the quiet period before their next policy meeting in early May, officials at the Federal Reserve have tacitly endorsed another rate rise, in a move that would lift the federal funds rate above 5 per cent for the first time since mid-2007.
Beyond that point, however, policymakers have been non-committal about how much more they will need to do to get inflation under control. This reflects a desire to keep all options on the table, but also uncertainty over how much a credit crunch will slow an economy that remains robust.
John Williams, president of the New York Fed and a close ally of chair Jay Powell, articulated this dilemma just days before the so-called communications “blackout”.
“There are a lot of factors that are telling me the economy is doing better and could even surprise further on the upside, but then obviously there are concerns around the risks around the tightening of credit conditions,” he told reporters on Wednesday. “It’s just a question of getting the right view on the balance of that and the right monetary policy.”
He added: “The uncertainty can go both ways.”
The economy is still showing signs of rude health. Most Fed officials characterise the labour market as “tight” even as monthly jobs growth has ebbed. Wage growth, while slower, remains far above a level consistent with inflation trending back to the Fed’s 2 per cent target. While the annual pace of inflation has declined significantly, monthly measures of underlying price pressures remain worryingly elevated.
Speaking on the final day before the quiet period, Lisa Cook, a Fed governor, emphasised the Fed’s focus on incoming data in guiding their future policy decisions.
“If tighter financing conditions are a significant headwind on the economy, the appropriate path of the federal funds rate may be lower than it would be in their absence,” she said, adding that “if data show continued strength in the economy and slower disinflation, we may have more work to do.”
In justifying his stance for at least one more rate rise, Christopher Waller, an influential Fed governor, went so far as to say that the recent data indicate “we haven’t made much progress on our inflation goal”.
Opinions have diverged, however, about how significantly regional banks have pulled back from lending in the wake of Silicon Valley Bank’s failure last month and the extent to which credit availability around the economy is now hamstrung. Powell and other officials acknowledge the credit crunch will act as a substitute for additional rate rises from the Fed itself. But given that the full impact is not yet known, “it is about risk management at the moment”, said Matthew Luzzetti, chief US economist at Deutsche Bank.
According to the Fed’s latest Beige Book, which compiles anecdotal evidence from businesses across the country, there has already been a broad-based tightening in lending standards and a sharp drop in loan volumes for consumers and businesses across a number of districts. The question now is how much worse it could get, fomenting fears that the central bank is on the precipice of pushing its monetary tightening campaign too far.
“Even in the best of times, monetary policy is a mistake-prone undertaking,” said David Wilcox, who led the research and statistics division at the Fed and is now affiliated with the Peterson Institute for International Economics and Bloomberg Economics. “That banking contraction probably makes the calculus a bit trickier at the moment.”
Since the SVB debacle, staffers at the central bank have altered their call about a recession, concluding that a “mild” one was now their base case this year, according to minutes from the March meeting. Officials continue to play down the likelihood of an economic contraction but several have adopted a more circumspect approach about the path for policy.
“At this point, I don’t see why we would just continue to go up, up, up and then go, ‘oops’” and rapidly cut rates, Patrick Harker, president of the Philadelphia Fed and a voting member on the Federal Open Market Committee, recently said. Austan Goolsbee, the new president of the Chicago Fed as well as a voting FOMC member, has also called for “prudence and patience” following what has been the most aggressive campaign to tighten monetary policy in decades.
Tim Duy, chief US economist at SGH Macro Advisors, said: “As interest rates get higher, you’re getting that conflict between people who are really still focused on the data and then others who are being more cautious because of the potential for policy lags, which has been exacerbated by the banking situation.”
Duy expects the Fed to signal at its policy meeting that it could well raise rates again in June in order to carve out as much flexibility as possible. That could be done by maintaining the language in the last policy statement, which was adapted to a more non-committal stance that “some additional policy firming may be appropriate”.
As of March, most officials forecast fed funds to peak between 5 per cent and 5.25 per cent and for that level to be maintained until 2024.
Duy said: “It’s very hard for an inflation-targeting central bank to walk away from rate hikes when underlying inflation has not shown persistent progress towards its target.”
