MNI INTERVIEW: Resilience Calls For More Fed Tightening -Tracy

Elevated trend inflation and a more resilient economy likely warrant slightly higher real interest rates, though weakness in Europe and China and the recent rise in 10-year Treasury yields allow the Fed some breathing room to decide on its next move, former Federal Reserve Bank of Dallas special adviser Joseph Tracy told MNI.

U.S. central bankers are weighing the trade-offs between holding rates at their current level for a bit longer -- and risk getting stuck with higher inflation and inflation expectations -- versus potentially overtightening and needing to reverse course quickly if the economy sinks into recession and inflation falls faster than expected, Tracy said.

"In risk-management thinking, the cost of the holding rates constant is we will have to tighten more going into 2024. On the other hand if I tighten too much now, I increase the chance of a recession next fall at an awkward time around the election," he said.

"Whether they wait a meeting or two to hike won't matter that much. It's down to what they learn in the interim that might inform the decision so they don't make an inadvertent error."

75BP REAL RATE

The mixed data are fueling a widening range of views on where the U.S. economy is headed and increasing uncertainty over the path of Fed policy. Third-quarter growth is well above the FOMC's estimates of the economy's speed limit, while trend inflation has come down and the labor market has stayed in surprisingly good shape. (See: MNI FED WATCH: On Hold, But Open To One More)

The difference between the nominal effective fed funds rate and the Dallas Fed trimmed mean PCE inflation rate is around 75 basis points above an assumed neutral short-run real rate of 50 bps, a "fairly modest degree of tightening," Tracy said.

"My sense is that's going to be insufficient to bring inflation down over the near term to the committee’s target. Most likely the current stance of policy is not tight enough, and we’ll need a bit more tightening just to make sure that inflation is trending back to 2% over the next couple years."

Once the FOMC is convinced that inflation is on a steady path to 2%, it can start cutting rates to maintain a constant real interest rate, he said. When inflation is close to 2%, the Fed will likely reduce rates faster than inflation is falling to get to a neutral stance.

MORE POWERFUL

As the spread between the fed funds rate and the 10-year Treasury yield has narrowed, "the last couple rate hikes likely had more impact than the ones before them," Tracy said. "If I were trying to convince myself to wait, this is one reason," he said.

A number of factors are also in place to pull down inflation, Tracy said. Downward trending rents are showing up in shelter inflation measures with a lag, while consumers are depleting their pandemic-era savings and starting to retrench, reflecting the decline in real household incomes.

Weaker demand stemming from slowdowns in Europe and China should also lead to less pressure on commodity prices, helping the Fed, Tracy said.

Though the White House has consciously constrained U.S. energy production, reenabling OPEC's control over the price of oil, "I don't think we'll see a big breakout in oil prices," Tracy said.