MNI FED WATCH: May Hike Brings Tightening Cycle Closer To End

The Federal Reserve is widely expected to lift its benchmark interest rate by another 25 basis points this week to a range of 5%-5.25% and debate whether further increases are needed to curb inflation as the economy slows.

Former U.S. central bank officials told MNI the FOMC could well retain a tightening bias even if the May hike is the committee's last, in a signal that officials are committed to holding borrowing costs high for some time barring a major financial crisis. Officials won't hesitate to restart them later in the year either if needed.

Where futures traders are pricing in 50 bps in cuts by December, the FOMC is unlikely to pivot even if a recession takes hold this year because inflation remains persistently high, the former officials said.

Policymakers are gauging the possible drag on credit from the recent bank sector stress, but the full extent of the fallout won't be known for months. The economy does appear to be slowing. First-quarter GDP cooled to 1.1%, below Wall Street expectations, and manufacturing surveys and consumer spending have been soft in April.

INFLATION TOO HIGH

However, measures of underlying inflation are still coming in around 4.5%, a concern for the Fed. Core PCE inflation slowed to 4.6% in March, after peaking at 5.4% last year, while the Dallas Fed trimmed mean rate is running at a 4.4% six-month annualized rate.

The employment cost index, the Fed's preferred measure of wage growth, slowed three-tenths to 4.8% in the first quarter but remains above levels the Fed would like to see.

Whether there is a June hike will depend heavily on the inflation trend, and the risks may still tilt to the upside, former Atlanta Fed President Dennis Lockhart told MNI. With short-run price expectations of consumers and firms staying elevated, inflation could end the year above 5%, according to a St. Louis Fed researcher.

PAUSE DEBATE

Some former policymakers argue monetary policy is not yet truly restrictive, despite the Fed's assurances it would like to raise rates to a "sufficiently restrictive" level to re-attain price stability. Last month, seven out of 18 policymakers projected rates higher than 5.25% this year.

But the policy calculus has become trickier, without lasting solutions to the regional bank crisis and a debt ceiling fight gaining momentum heading into summer.

A prolonged impasse on the latter will add to risks and volatility in money markets, though the Fed is unlikely to revise its balance sheet reduction program despite fears that the Treasury market could seize up. As of Wednesday, the Fed had USD8.6 trillion in assets, including USD3.1 trillion in bank reserves, quite a bit above their projected USD2.4 trillion level after QT ends.