MNI POLICY: Fed Convinced Past Hikes' Full Effect Still To Hit

The Federal Reserve appears increasingly inclined to be done raising interest rates barring a reacceleration of inflation, in part because of something Fed Chair Jerome Powell highlighted Thursday – there is still a significant drag on the economy to come from past tightening.

That’s a key point of agreement among a number of Fed researchers who find that, however long these lags might be, the extent and speed of monetary tightening by the central bank in the last year and a half means past rate increases are likely to continue having a strong dampening effect on growth and inflation.

The Fed has raised interest rates by 525 basis points since March 2022 to a 22-year high of 5.25-5.5%. Officials are widely expected to hold off on additional increases at their November meeting and many have publicly argued the central bank can afford to be done raising rates altogether.

Powell in a speech Thursday emphasized a desire to “proceed carefully” on policy and take into account how much has already been done.

“Given the fast pace of the tightening, there may still be meaningful tightening in the pipeline,” Powell told the Economic Club of New York.

There is a lot of murkiness surrounding the concept of long and variable lags in monetary policy, first identified by Milton Friedman, including whether to start their measurement from the announcement of hikes or from their implementation. There are also doubts about whether the endpoint should be their effect on market rates or their impact on the economy.

VARYING LAGS

Richmond Fed economist Alexander Wolman gets around these uncertainties by measuring the lag time between a spike in market interest rates and the share of consumer deposits in certificates of deposit and retail money market funds.

Based on historical experience, the process of monetary policy transmission is likely only roughly halfway to completion.

“There’s significant further adjustment in bank balance sheets and household portfolios that probably is in the pipeline,” Wolman, vice president for monetary and macroeconomic research at the Richmond Fed, told MNI.

Wolman said lag times vary but “upwards of a year is not unusual from the peak of rates to the peak of these deposit measures or shares.”

The change in official rates this cycle has been the most aggressive since the 1980s and yet Wolman said his measure of total deposits in small CDs plus retail money market funds as a ratio of the level of M2 money supply at the beginning of a tightening episode has still not fully responded.

“I’m expecting that that share is going to go up quite a bit more,” Wolman said, “A doubling would not at all be out of the question.”

RIPPLE EFFECTS

Taking a different approach to measuring lags that focuses more on the importance of forward guidance, Chicago Fed senior economist and economic advisor Thomas King thinks about as much as three-quarters of the effect of past policy tightening has already been felt. (See MNI POLICY: Fed Worried Shorter Lags Require More Tightening)

But as Chair Powell highlighted, given the magnitude and speed of hikes, that means a signification portion of the impact has yet to materialize.

“The tightening was really big so even if the majority has already occurred the piece that’s still left to come is not trivial,” King said in an interview.

Chicago Fed economist Stefania D’Amico and King predict an additional drag from past hikes to the tune of 3 percentage points of GDP and 2.5 percentage points in CPI. The model’s forecast also indicates that policy tightening already enacted is enough to bring inflation near the Fed’s target by the middle of 2024 without a recession.

“CPI inflation will be back in the low twos by next year. We really did a lot of tightening so we shouldn't be surprised that it had and continues to have a significant impact on the economy,” King said.