MNI: Fed To Keep Tightening Bias As Cycle Nears End- Ex-Offls
The FOMC needs to manage medium-term expectations at a time of diverging market views on rate cuts.
Federal Reserve officials will likely retain a tightening bias in their forward guidance even if next week's rate increase is their last, in a signal they're committed to holding interest rates high for some time barring a major financial crisis, former Fed officials told MNI.
A 25-basis-point rate increase at the May 2-3 FOMC meeting is widely expected and will take the fed funds rate target above 5% for the first time since 2007. But where futures traders are pricing in 50bp in cuts by December, the FOMC is unlikely to pivot even if a recession takes hold this year, the former officials said.
The FOMC will either keep its language that "some additional policy firming may be appropriate" or revise the rate guidance to be open-ended but hawkish, former Dallas Fed President Robert Kaplan said in an interview. "It's going to be very challenging to get inflation below 4%, due to structural factors not highly susceptible to monetary policy. As a result the Fed needs to be prepared to leave the fed funds rate at current levels for a much more extended period of time than currently reflected in the financial markets."
Marc Giannoni, former Dallas Fed research director and now at Barclays, expects May to provide the final hike but a hawkish statement that conveys inflation risks to the upside. For a cut this year, "It takes inflation coming down more rapidly. I don't think a conventional slowdown or mild contraction in economy activity will be nearly sufficient."
JUNE DECISION
Former Atlanta Fed President Dennis Lockhart looks for Chair Jerome Powell to "send a message that they remain vigilant" in the face of both higher inflation and financial system fragility, he said in an interview. "The wise approach is for Powell to keep options open and be suggestive rather than definitive. It’s easy enough to say they’re moving toward a stopping point without being explicit."
Whether the FOMC lifts borrowing costs again in June will depend heavily on the inflation trend, he added. Seven out of 18 policymakers last month projected rates higher than 5.25% this year, and there have been few data surprises to shift views. The Dallas Fed trimmed mean PCE inflation rate is currently pointing to underlying inflation around 4.5%.
Keeping a tightening bias in the statement would speak to a scenario in which inflation runs persistently high, said Peter Ireland, ex-Richmond Fed economist now a professor at Boston College.
"Everybody's sort of hoping that inflation will keep moving back toward 2% in the fall and winter, but say core inflation continues to run at 3.5% or 4% or even higher in the fall. Then it is going to be clear that more rate increases will be needed, and I think the committee will be anxious to guard against a situation where it appears to promise too much."
TRICKY CALCULUS
As the FOMC nears the end of its hiking cycle, policy calculus becomes ever trickier, former officials said. Add to that the unique circumstances of a debt ceiling fight and recent banking chaos, and the risk of a policy mistake rises again.
Having fallen behind the curve last year, "a prolonged period of mildly restrictive policy is the best you can do at this point, but the historical record isn’t very encouraging," former Dallas Fed principal policy adviser Evan Koenig told MNI. "It's not unusual for the neutral real rate to fall sharply if recession dynamics kick in. Cuts tend to be steeper when they come, but I haven’t seen anything yet to suggest fed funds rate declines are imminent or warranted."
For now, nominal demand growth has not slowed to a level consistent with 2% inflation. It is too early to tell how much a credit crunch following banking turmoil will slow the economy, though lending and deposit data thus far reflect a gradual tightening of lending conditions and not an abrupt pullback.
Kaplan said his preference would be to execute a "hawkish pause" on rate hikes until policymakers more fully understand the impact on small and midsize banks and their small and midsize borrowers. Kaplan is concerned that a higher fed funds rate will have little effect on large firms but may be very impactful for smaller enterprises which are highly dependent on bank funding.
"I don't remember a time where I felt like my decision on the fed funds rate would disproportionately hurt one group and advantage another group, and I think that's where we are right now."