MNI: Fed's Reticence To Hike Rates Raises Risk of Hard Landing

The Federal Reserve’s slow march toward eventually raising interest rates in the face of surging inflation puts them further behind in the fight to combat price pressures, and may well force officials to overcorrect later by tightening policy too quickly, former Fed staffers told MNI after last week’s FOMC meeting.

“I am disappointed that the Fed did not get more aggressive,” said Dean Cruoshore, a former Philadelphia Fed economist now at the University of Richmond.

“With a long lag between monetary policy actions and its impact, they are very far behind where they should be. As inflation continues to grow in 2022, they will be forced to raise rates faster and by more than would have been the case if they had acted more quickly.

Cruoshore said he expects PCE inflation to average 5% in the fourth quarter compared with the same period in 2021, “with wide error bands, especially on the high side.”

U.S. inflation jumped 7% in the year to December according to CPI, and 5.8% in the same period for the Fed’s preferred PCE measure – nearly three times the central bank’s official 2% goal.

LUCKY BREAK?

Record-high inflation has been driven by a combination of a bungled supply chain and strong demand, particularly for goods as services remain crimped due to Covid.

“If luck turns against them, in the form of inflation staying stubbornly high, then perhaps they will need to undertake some hawkish surprises,” said John Weinberg, former economist and research director of the Richmond Fed.

The Fed’s forecast for how high the official federal funds rate will ultimately go, around 2.5%, also presumes a benign inflation backdrop that looks increasingly out of reach.

“The longer run median from the SEP is a reasonable focal point for how far they’ll go,” said Weinberg. “But this, too, assumes that they continue not to see evidence that trend inflation has risen above 2% — otherwise, acting to bring inflation down could require an overshoot.”

Weinberg said the FOMC is placing a lot of weight on market indicators of inflation expectations, which show long-run inflation expectations still fairly contained as measured by the five-year five-year forward.

“The risk remains that, given our indicators of expectations are imperfect, we may not know whether there has already been some slippage until we see how inflation is trending over the next several quarters,” he said.

‘NO CONCRETE ACTION’

High and persistent inflation has forced a fairly dramatic pivot from Fed officials, who until recently had been insisting the spike was “likely transitory.” Policymakers penciled in three rate hikes in December but those quickly looked stale as inflation remained high and the jobless rate fell further, pointing to conditions the Fed could claim as approaching full employment.

"If you had asked me a year ago that inflation would rise to 7% and the Fed would have taken no concrete action to raise interest rates, I would have said that that scenario was extremely unlikely,” said John Leahy, who has consulted at the Federal Reserve Banks of New York, Philadelphia and Kansas City and is currently co-editor of the American Economic Review.

“The Fed is already behind the curve. Standard economic models suggest interest rates should be higher than even the three to five rate hikes being priced into the market. The Fed appears to be clinging to the hope that the spike in inflation is temporary and that talking about the possibility of future action will be enough to rein it in."