MNI INTERVIEW: Kohn Sees Upside Risks To Fed Funds Rate Peak

Federal Reserve policymakers could be forced to raise interest rates more than their own forecasts and market expectations suggest because of persistent inflation pressures and a strong labor market, former Fed Vice Chair Donald Kohn told MNI.

Fed officials in June said rates were likely to peak around 3.8% and investors now see them topping out at 3.75% in March of 2023. Kohn told MNI’s FedSpeak podcast that “sticky” inflation pressures raised the chances that fed funds might need to go even higher.

“There are upside risks on inflation relative to what the market has and relative to what the Fed had. So there are upside risks to the funds rate relative to what the Fed saw in the June meeting,” Kohn said. (See MNI INTERVIEW: Fed's Bullard-Rates May Be 'Higher For Longer')

His concern about lingering inflation pressures hinges on the strength of the labor market, which saw employment growth surge by another 528,000 jobs in July while the jobless rate fell to 3.5%, matching a 50-year low.

“My concern is inflation will be sticky because labor market tightness will be sticky,” Kohn said. “The labor market remains extremely tight, vacancies are still very high, the unemployment rate is below most estimates of the natural rate. Wages are increasing rapidly, much more rapidly than is consistent with the 2% inflation goal.” (See MNI INTERVIEW: Wages Hotter Than Labor Dept Data-Atlanta Fed)

Kohn said the Fed would be “lucky” to get PCE inflation, which climbed to another 40-year high of 6.8% in June, down to between 4% and 5% by year-end.

“The real issue is whether it’s going to go all the way back to 2% over the next couple of years without a fairly substantial increase in the unemployment rate putting some slack into the economy,” he said.

JACKSON HOLE

Kohn said investors expecting some kind of firm signal on the direction of policy from Fed Chair Jerome Powell’s keynote speech at this week’s Annual Jackson Hole Symposium would be disappointed.

“He will deliberately stay away from anything that looks like a dovish pivot," he said. “He’ll emphasize again their determination to get inflation back to 2% and to do whatever it takes to get there. He doesn’t want any doubt in the minds of consumers, business people, market participants, that the Fed is determined to get inflation down.”

Powell would also not likely tip his hand on whether the Fed will slow the pace of rate hikes in September down to 50 basis points from 75 basis points in its last two meetings.

“At some point they need to step down those increases to a more sustainable pace -- 150 basis points in the last couple of meetings is outside my experience, at least post-1982,” said Kohn, who spent 40 years at the central bank and is now a senior fellow at the Brookings Institution. “But whether that’s going to be September or not I think the incoming data will let them know.”

RECESSION CHANCES

Kohn said that while the unemployment rate clearly needs to rise in order to get inflation down to the Fed’s 2% target, this might still be accomplished without driving the economy into a full-fledged contraction.

“They can make this happen without a recession but it will require slow growth and a rise in unemployment to take pressure off the labor markets,” he said. “That gets to be a very delicate balancing act. Very slow growth can tip into recession because of developments not only in monetary policy in the U.S. but global developments on the supply side.”