MNI INTERVIEW: Fed Close To Done As Credit Tightens–Kroszner

The Federal Reserve is nearly done raising interest rates because credit conditions are tightening after the recent bank turmoil, but officials will hold policy steady through the end of the year despite market expectations for cuts, former Fed Board Governor Randall Kroszner told MNI.

“Powell has talked about this – he said in some sense the tightening of credit conditions is likely to help them not have to raise interest rates quite as much because it’s likely to lead to less credit creation, less investment, less employment growth,” Kroszner said in the latest episode of MNI's FedSpeak Podcast.

“They’re pretty close to where they want to be (on rates). I think they want to get anything with a five handle, so it’ll be 5% to 5.25%. Then I think they’ll hold on for a while. But the markets don’t seem to believe that.”

Kroszner said investors’ lack of faith in the Fed’s resolve to keep rates at cycle peaks stems from an entire generation of traders that has never actually seen policy so restrictive.

“The standard metaphor about the Fed is that you take away the punchbowl when the party gets going,” said Kroszner, a Booth School Professor who was recently appointed to the Bank of England’s Financial Policy Committee. “For the last 20 years no one has seen that, so people don’t realize that the Fed may be willing to actually hold tight even as conditions slow and even if a recession comes if they really feel they have to bring inflation down."

Holding in the low fives over the year as inflation continues to go down will effectively tighten policy even further, he said, as the real rate of interest rises.

“That just makes it more likely we’ll have a slowdown,” said Kroszner, adding a soft landing is unlikely.

NO RELIEF IN SERVICES

Kroszner said Fed officials won’t be excessively encouraged by the latest CPI reading despite a decline in the headline annual figure to 5.0%, especially given that core prices posted a fourth straight monthly gain of 0.4%.

“Core is really where there’s more information about where inflation is going rather than where inflation has been. And the core numbers are still reasonably elevated, especially if you look at core services,” he said.

“That’s where the Fed is most worried, because until the labor market starts to cool the Fed is going to be worried that inflation pressures will be there because wage pressures will be there and such a large part of the U.S. economy is services.”

COMMERCIAL REAL ESTATE

Kroszner said financial markets may be too sanguine about the worst of the banking crisis being behind us. (See MNI INTERVIEW: Financial Stress Could Be In Early Stage-Hoenig)

“There may be some other shoes to drop and commercial real estate is one that I would look at,” he said.

“We’ve certainly seen a lot of downward pressures there, people not going back to the office completely, people downsizing in cities – not just the biggest cities but also medium-sized towns. And there’s a lot of small and medium-sized banks with a lot of local commercial real estate exposure.”

As rents on those properties fall or plateau, “a number of those firms will have trouble refinancing themselves. That’s going to be the next key thing to manage.”