MNI: FOMC To Signal Path To 5% Next Year - Ex-Fed Officials

Federal Reserve officials are considering driving the fed funds rate to about 5% in the first half of 2023, as strong demand and healthy consumer balance sheets necessitate more tightening, former Fed officials told MNI.

"The committee is aiming to get to a sufficiently restrictive position to ensure financial conditions overall are adequately tight to produce a clear trend of declining inflation. It's not hard to imagine a terminal rate above 5%," said former Atlanta Fed president Dennis Lockhart. "The committee wants to avoid a 'start and stop' pattern of policy in 2023 that would be credibility and confidence damaging. So, the bias is to push further until they feel very comfortable pausing to take stock and let the policy rate have its effect over time."

William English, former director of the division of monetary affairs at the Fed Board, said the Fed will have to raise rates significantly above the 4.6% anticipated in September’s Summary of Economic Projections and probably stay with higher rates for longer.

"They're not a whole lot more confident than they were at the last meeting or the meeting before that inflation is going to come back down to their target over the next couple of years, so they're still going to want to raise rates," he said. "They still see themselves as away from their endpoint."

HIGHER INFLATION

While the Fed has locked in a stepdown to a 50bp hike this week and could make an adjustment to interest rate guidance, ex-Fed sources expect 2023’s median forecast to be bumped up for the seventh straight SEP, with expectations centered around a fed funds range upper bound of 5.25% due to strong demand and wages.

"My guess is they want to give a little bit of cold water and probably a little bit of a tougher message than maybe what the markets currently expect, but not too far," said Andrew Levin, a former Fed Board economist and special adviser to ex-chair Janet Yellen. "The SEP could show raising rates to about 5%." Levin expects high inflation next year to force the Fed maybe up towards 6% or 7%.

Beth Ann Bovino, U.S. chief economist at S&P Global and former Atlanta Fed analyst, pointed to worrisome wage data. "With still-hot pricing pressure, our forecast of 5.00% to 5.25% peak fed funds rate seems increasingly likely," she said.

But there was more uncertainty about the outlook among sources than in recent months with a few saying the median SEP dot could come in just under 5% and others seeing potential for an even higher fed funds rate range.

"I think they could go to 5.375% on peak, at least five participants could hit that," said Fed adviser and KPMG chief economist Diane Swonk. "The (2022) core inflation will likely rise to 4.9%" from 4.5% in September.

Ex-Fed board economist Jonathan Pingle expects the Fed to again revise up inflation projections, with 4.8% for 2022.

"Facing another round of SEP submissions where they’re revising up their inflation projections I think you'll have a few (officials) in the middle including Chair Powell who will want to signal (a peak rate) a little above five rather than below," he said.

TWO-SIDED CAUTION

Even so, concern is rising that the FOMC could overtighten. "I do worry about overdoing it because of the lags," said English, now at Yale University. "If you keep tightening policy until you see the economy weaken and you see inflation begin to soften then you've gone too far almost for sure."

Inflation may also be at a turning point, some former officials note.

"Once inflation stabilizes, which the most recent report suggests is happening, then the policy calculus changes completely. Rate increases are no longer being diluted by inflation, and each increase is more powerful than the one before, so greater caution is appropriate," said Evan Koenig, former principal policy adviser at the Dallas Fed.

"Given how Fed officials dismissed the initial increases in inflation as transitory, for the Fed to say that we’re going to go ahead and start cutting because we believe inflation will turn down will be a hard sell," Koenig said. (See: MNI INTERVIEW: Real Rate To Climb In 2023 Even As Fed Cuts)