MNI INTERVIEW-Fed’s Anti-Inflation Drive Risks Overtightening

The Federal Reserve’s aggressive effort to raise interest rates to fight inflation near 40-year highs raises the risk that policymakers will overdo it and push the economy into recession, driving a steep global downturn, ex-Fed board economist Julia Coronado told MNI.

Coronado does not believe a recession is inevitable, but says the window for avoiding one is narrowing after the August CPI report showed worrisome and broad-based inflation pressures still percolating.

“If the risk management lean is toward preventing inflation from taking hold then, yes the risk is tilted toward overtightening,” she told MNI’s FedSpeak podcast. “I don’t think they’re trying to overtighten but that’s where the predominant risk lies right now.”

Now president of MacroPolicy perspectives, Coronado said it’s hard to pinpoint where the fed funds rate will peak in this cycle given the unpredictability of inflation. But she added the September Summary of Economic Projections will offer clues into how policymakers are currently foreseeing the policy path.

“We’re expecting a 75-basis-point rate hike that will take us to 3.25% for the top of the range,” she said. That would be the third such move in as many meetings, an extremely rapid clip by historical standards.

“Most officials willing to say what their baseline is are talking about getting to around 4% by the end of the year. That’s quite doable – either another 75 in November and decide what to do in December or you could go 50 in November and 50 in December.”

Deciding when to slow the pace of hikes from a historic run of ¾-point moves will be difficult because the Fed will only get one more month's worth of data between the September and November meetings.

RESTRAINING PASS-THROUGH

Whether the economy can avoid recession will depend in part on how quickly demand begins to wane in response to the Fed’s tightening, Coronado said.

“It does seem like a close call at this stage,” she said. “We may need to tighten the screws more to shake out that inflationary passthrough behavior.” (See MNI: Fed's Mester: Wages May Be Stabilizing, Need More Hikes)

Coronado said firms have taken advantage of the unusual pricing power they achieved during the pandemic, a combination of product scarcity and strong consumer balance sheets, to widen their margins.

“It’s quite possible that we actually do need to see a break in the current conditions, a really weak environment where consumers are more cautious, more price sensitive, because the job picture has weakened, because incomes are getting squeezed,” she said.

A U.S. recession would be especially troubling for the global economy because the country’s growth has been a driver of strength. “If the U.S. goes into recession we really are looking at a pretty significant global downturn,” she said.

The giant U.S. mortgage market, which has already taken a huge hit from the Fed’s tightening campaign amid a surge in rates above 6%, bears close watching.

“The mortgage market is going through not just a cyclical tightening but structural changes, you are now in a world where neither the GSEs nor the Fed are buyers of mortgages and that’s something we haven’t seen in a very long time,” she said.

“More than doubling mortgage borrowing costs is radical. So the market is functioning, but bid-ask spreads are wide, the liquidity is poor. Do you get some kind of a seizing up on some kind of event? it’s possible. It feels like that’s a vulnerable market.”