MNI: Shallow Fed Hiking Path Seen Likely, Could Turn Higher

The Federal Reserve is likely to begin its rate hiking cycle next year with the assumption that only a couple of increases are needed to break inflation momentum, but there are risks it may need to tighten further in order to cement price credibility with markets and consumers, former Fed economists told MNI.

"The Fed faces very asymmetrical risks at this point and in that sense there's not a huge trade-off, because slowing the economy slightly is not going to be harmful for employment, but could help on the inflation side," said Stephen Cecchetti, former research director at the New York Fed and ex-head of the monetary and economic department at the Bank for International Settlements, suggesting 25 or 50 bps of hikes could be enough to slow down prices.

Given changes to the Fed's framework and questions about deeper structural changes to the economy, some have said rates may need to reach over 4%. But former Fed economists told MNI the Fed could be expected to take a cautious step-by-step stance.

CREDIBILITY

"The difference between those that think one or two rate hikes and several hundred basis points worth of hikes to break inflation momentum is really about the role of expectations," said Carl Walsh, a former San Francisco Fed economist. "You only need a small rise in interest rates for the Fed to really signal that they're taking inflation seriously."

Others though said there may be less slack in the economy than thought and a few hikes may not be enough. Some economists think full employment could be achieved in the second half of next year. (See MNI: Fed May Reach Job Goal Sooner As Participation Lags)

"If 25 bps isn't going to do too much to demand pressures in the economy, extending that argument, then it wouldn't do too much to suppress inflationary pressures," said Kenneth Kuttner, a former assistant vice president at the New York Fed. "It's not like you get something for nothing."

"Unless you think that 25 bps signals that it will reinforce the Fed's credibility and keeps expected inflation in check, little tweaks around 25 or 50 bps isn't going to make a huge amount of difference," he said.

Ethan Harris, who spent nine years at the New York Fed, sees rates starting next year on a hike-per-quarter path to 2.25%, which is above current market pricing.

"The way the Fed presents this and goes about tightening will be perhaps more important than when they hike," said Harris, "It does matter a lot about what's priced in and the way the Fed presents what it is trying to do. Are we just normalizing? Are we trying to hurt the economy? Those messages are much more powerful than just saying taper could end earlier and we could hike."

Credibility will also be key to the Fed in reducing inflation. As Governor Christopher Waller said at an event last week, the steep hikes of the Volcker era came because markets had lost belief in the Fed's determination to constrain inflation.

FINANCIAL FRAGILITY

The FOMC is expected to consider at its December meeting whether it should speed up its USD15 billion per month reduction of its bond purchases, a process currently on track to end in June. Waller is eyeing an end to the taper in April, giving space for a hike as early as the second quarter. Markets are pricing in about a one-third chance of four rate hikes by the end of 2022, according to the CME's FedWatch tool.

Michael Dooley, a former long-time Fed Board economist and ex-IMF researcher, said the Fed will be guided by concerns over financial fragility. "They're going to go slow," he said. "But if you do that, you risk inflation getting out of control."