MNI STATE OF PLAY: Fed To Debate More Aggressive Rate Moves

Federal Reserve officials are set to debate even more aggressive interest rate increases at their meeting this week after inflation and inflation expectations data came in worse than expected Friday and Monday.

Futures markets all but fully priced in a 75-basis-point rate increase this week after a Wall Street Journal report late Monday suggested the FOMC could surprise markets with such a move, which would be the first rate increase of such a magnitude since a rare 3/4-point hike in 1994.

Officials had laid out a plan for 50-basis-point hikes in June and July before reassessing in September, but CPI jumped 1.0% in May from a month earlier, rising 8.6% over a 12-month period, a fresh 40-year high.

Inflation expectations in two consumer surveys also rose as sentiment plunged due to worries over surging inflation. Fed officials do not comment on policy for 10 days prior to their meetings.

BROAD, PERSISTENT INFLATION

Even before the most recent inflation reports, the FOMC was expected to raise their rates forecasts sharply over the next two years as inflation proved more persistent and widespread than officials believed, former Fed policymakers told MNI.

Officials said they need to see clear and convincing evidence that inflation was slowing before a decelerating in the pace of tightening. But current and former Fed economists told MNI supply shocks and strong domestic demand are likely to keep prices rising more than expected for months longer.

The full impact of the war in Ukraine and China's zero-Covid policy is only starting to be felt, while continued reopening could light a fire under demand for services, a sector already experiencing acute staffing shortages. Housing costs also continue to rise, with the shelter component of CPI in May rising the most since 2004.

RATES PEAK

Ultimately, interest rates may be headed much higher than markets expect, former Fed officials told MNI.

Ex-Richmond Fed President Jeffrey Lacker reckons rates will be above 5% before policy becomes restrictive enough to tamp down demand. A back-of-the-envelope Taylor Rule calculation using 4% as the rate of underlying inflation would suggest a 4.5% neutral rate, Evan Koenig, former principal policy adviser at the Dallas Fed told MNI.

Still, officials are likely to turn more cautious as rates rise past 2.5%, the FOMC's estimate for the longer run fed funds rate predicated on stable long-run inflation expectations, for fear of pushing the economy into a deeper recession than necessary, former staffers said.