MNI: Fed’s Peak Rate Looking Perkier As Jobs Boom-Ex-Officials

Federal Reserve officials could raise interest rates more than the FOMC's December forecasts, pushing the peak above what investors expect toward 6% as the decline in inflation proves bumpy and the labor market remains ultra-tight, former Fed policymakers and staffers told MNI.

That could evolve through ongoing quarter-point increases, they said, or, less optimally for the central bank, with a pause followed later by a resumption of rate hikes.

“If they pause they're prepared to resume again if conditions call for it -- they have to put that disclaimer in some form of communications. That is understood, really, all the time, but they need to make it explicit,” said Dennis Lockhart, former president of the Atlanta Fed, in an interview with MNI’s FedSpeak podcast. “Having said that, I think the ideal policy does not involve a restart after a pause.”

The Fed this month reduced the pace of hikes to a more traditional quarter-point clip, down from more drastic increases last year as it sought to catch up with inflation at 40-year highs.

The decision to slow tightening could prolong the rate hike cycle well above policymakers’ median December forecast for rates to top out at 5.1%.

SLOWER FOR LONGER

“The slower they are, the more persistent inflation will be, and they will end up going up to 6% by the time it is all over,” said Dean Cruoshore, a former Philadelphia Fed economist.

Inflation has eased markedly in recent months, with the Fed’s preferred PCE measure falling from a summer peak above 7% to 5% in December.

Still, Andrew Levin, a former Fed board economist who was special adviser to ex-Chair Janet Yellen, said consumer surveys from the Cleveland and New York Fed banks pointing to one-year inflation expectations north of 5% suggest the Fed will have to be more aggressive than is currently priced in order for real interest rates to be significantly positive.

That, he said, is what it takes for monetary conditions to be sufficiently restrictive, the parameter set by officials as the threshold for a pause.

“Consumers could be mistaken, but if their projections turn out to be correct and inflation stays stubbornly high this year, then the Fed will need to raise the federal funds rate substantially further -- not just an extra quarter notch in May, but more likely a whole percentage point or more,” he said.

Peter Ireland, a former Richmond Fed economist, sees the risk of a plateauing of inflation that would create headaches for officials. (See INTERVIEW: Fed Could Need To Hike Again After Pause-Ireland)

“What happens if we get into the fall and into next winter and, stubbornly, core measures of inflation remain elevated, say, around 4%,” Ireland said. “That’s the scenario where the Fed is going to have to continue to raise interest rates. The probability of sending the economy into recession goes up even more.”

OFFICIAL HINTS

Lorie Logan, the Dallas Fed’s new president, made perhaps the clearest argument yet from a sitting FOMC member as to why the December SEP view of rates might be too sanguine.

"Even after we have enough evidence to pause rate increases, we’ll need to remain flexible and raise rates further if changes in the economic outlook or financial conditions call for it," she said last month.

"A slower pace could reduce near-term interest rate uncertainty, which would mechanically ease financial conditions. But if that happens, we can offset the effect by gradually raising rates to a higher level than previously expected."

Fed Chair Powell himself this week for the first time acknowledged the possible need for going beyond the just-over 5% rate peak that markets expect and the FOMC projects.

"If the data were to continue to come in stronger than we expect, and we were to conclude that we needed to raise rates more than is priced into the markets, or than we wrote down at our last group of forecasts in December, then we would certainly do that. We would certainly raise rates more."