MNI INTERVIEW: Fed Defacto Hiked Via SEP, Maybe Too Much-Sahm

Federal Reserve officials are using the forward guidance embedded in their interest rate and economic forecasts as a way to effectively raise borrowing costs, making an already imprecise process more prone to possible overshooting, former Fed board economist Claudia Sahm told MNI.

The U.S. central bank held interest rates steady last week but officials on median penciled in one more rate increase for 2023 and, importantly, cut in half the number of rate cuts expected next year to two from four in the June projections. Bond markets sold off, with 10-year note yields extending their recent spike to hit new 16-year highs around 4.5%.

“The FOMC did not raise interest rates but their Summary of Economic Projections raised rates,” said Sahm, who is also a former White House staffer. “Forward guidance is a very powerful tool. Time and again it’s clear that it’s too powerful. They are going to overdo it.”

The problem with using the SEP as a tool for guiding market expectations is that it is a much more disjointed way of delivering the committee’s message than something on which policymakers deliberate to decide together, she said. (See MNI POLICY: Softer Trend Inflation Boosts Case For Fed Pause)

“The rate increase is a consensus vote. With the Summary of Economic Projections it is each of them sitting down largely independently, there’s no one that enforces that their forecasts have any kind of internal consistency,” said Sahm.

“I don’t think they know how to use it. Sometimes it’s not a big deal but this one is like – you want to potentially stop raising rates and you write down a forecast that just raised rates. It is so frustrating that they’re doing monetary policy with a tool that is not coordinated.”

Fed officials now see interest rates topping out in a 5.5-5.75% range before staying there for most of next year. They also predict rates will stay above 5% through the end of 2024.

PESSIMISTIC ON SOFT LANDING

Sahm said the Fed’s insistence that high inflation remains the central issue facing the economy even as price pressures have abated consistently through this year raise the chances that they will make a policy error by tightening too much.

“They’re getting close to 6%. They put the soft landing more at risk,” she said.

It’s not just the peak of the rate cycle that matters but also the Fed’s willingness to reverse course if the economy takes a sharp turn for the worse. Yet policymakers have signaled a “higher for longer” policy with a very high bar for interest rate reductions, said Sahm.

“Real rates rise next year in the SEP they have written down. They have inflation stepping down even with the lower fed funds rate,” she said. “They set a very high bar of being convinced that core inflation is coming down towards 2%. It’s coming down. What exactly are you waiting for?”

Sahm, author of the Sahm rule, which helps forecast recessions by focusing on the magnitude of rises in the jobless rate, said she has trouble buying the view embedded in the Fed’s SEP that policy can remain this tight without a major hit to the labor market.

“The labor market has this aspect of momentum, once it gets going it tends to keep going,” she said. “The trend of job growth has been cut in half. That’s a pretty fast clip.”