The decision on the scenario in action will have a broad impact on consumers, markets and the economy, writes the WSJ
Much of the work to slow U.S. inflation is done: Amid the most aggressive string of interest rate hikes in four decades, consumer price growth slowed to 3.2 percent from 9.1 percent.
This news puts the Federal Reserve in front of a new difficult decision: how aggressively to act in the final, writes WSJ.
The Fed’s decision could have serious consequences for consumers, markets and the economy. It depends on whether Fed Chairman Jerome Powell achieves a so-called “soft landing” — beating inflation without causing a recession.
The US Federal Reserve’s official inflation target is 2%. With inflation still above that level, central bankers are currently considering whether to raise rates once more this year.
The answer to the question of how long to keep interest rates higher is more complicated.
Federal Reserve officials could try to get to the 2 percent inflation target quickly — by the end of next year, for example — by raising rates further and then cutting them slowly amid a weakening economy. With such an action, they risk a sharp decline, which will probably destroy the chances of a “soft landing”.
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On the other hand, if they are satisfied that inflation is slowing down permanently, they could keep rates at their current level and consider a cut later next year. So the Fed’s inflation target will take longer to reach – perhaps around 3 years.
And what if reaching the 2% goal isn’t worth the trouble? According to some analysts, the Federal Reserve should adopt a new inflation target of around 3%. Powell and other Fed officials say raising the inflation target is not an option.
The challenge of ending the fight against inflation is likely to be a big topic of debate for central bankers when they gather at their regular annual meeting in Jackson Hole. Jerome Powell’s speech is scheduled for Friday.
Many economists still see the risk of a recession next year under the weight of rapid interest rate hikes, which have weighed heavily on the property sector and, by extension, regional banks. The central bank raised its key interest rate last month to a range between 5.25% and 5.5%, a 22-year high. This rate affects other borrowing costs throughout the economy, including mortgages, car loans and credit cards.
Others worry that the slowdown in inflation will stall and consumer and business spending will pick up again in the coming months, forcing the Fed to raise rates again.
A debate is already raging among economists and policymakers about how the Fed should manage the coming phase. The do-quick camp argues that the Federal Reserve needs to keep a tight rein to push inflation down quickly to the 2% level, even if that leads to a recession. They say it is taking too long to reach the price growth target and that this could undermine confidence in the Fed, especially if the economy is hit by further inflation-boosting shocks.
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If that happens, it will probably take an even more painful rise in interest rates to slow inflation, as happened in the early 1980s.
The other camp suggests that the central bank could take a lesson from former Federal Reserve Chairman Alan Greenspan and reach its 2% target more slowly. Greenspan in the early 1990s outlined an approach later called “opportunistic.” This approach envisages a gradual approach to the 2% target, keeping interest rates at a level that may seem a bit higher than necessary.
Some former Fed officials say the approach makes sense if inflation falls below 3% and then stops falling.
Richmond Federal Reserve President Tom Barkin commented that the 1990s was not a useful parallel because then the Fed was slowing inflation after a longer period when it was much higher. The Fed could act more slowly then because the public expected inflation to remain high. Now, unlike then, inflationary expectations are different and people are more worried about high inflation that may persist.
Fed officials are unlikely to be patient if inflation stabilizes above 3%. That would be a problem because, without more obvious signs of an economic slowdown, pressure would come from prices. Expectations are that core inflation, the Fed’s preferred measure, will head towards 3.5% early next year.
Inflation that continues to exceed 3% may require the Fed to continue raising rates. Once inflation slows below that level, the case for the Fed to consider cutting rates will heat up.
Some economists support raising the inflation target, as the cost of bringing inflation down to 2% over the next two years is likely to be significantly higher unemployment. With a higher target of 3%, interest rates would be higher in good times, giving the Fed more room to counter potential economic shocks by cutting interest rates.
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The higher target is also popular among Democrats, who are concerned that rising unemployment or a possible recession would threaten President Joe Biden’s re-election prospects.
Current and former Fed officials believe that changing the target now would be a big mistake. Central banks use clear inflation targets to reassure the public that inflation will remain low and stable, as banks signal in advance how they will react in periods of higher inflation.
Powell made it clear that he would not consider raising the inflation target when consumer price growth is stronger than even the new potential target, because it risks undermining the entire strategy.
According to analysts, the 2% target has proven to be reasonable in recent decades and is not a “chimera” that no one can achieve.
Relatively low yields on long-dated Treasuries suggest investors believe Powell will achieve 2% inflation within a few years. Raising the target to 3% now will almost certainly lead to a serious sell-off in US bonds.
Some central bankers say they need to see clearer signs of a slowdown in economic activity to be convinced that inflation will continue to slow. They could push for a rate hike this year.
A key consideration is “whether the economy really accelerates in the second half of 2023,” which could pressure central bankers to raise rates above 6 percent next year, said James Bullard, who stepped down last month as chairman of the Federal Reserve in St. Louis to become dean of the business school at Purdue University.
According to some central bankers, including Powell, interest rates are now constraining economic activity by slowing hiring, spending and investment. They see much more balanced risks now. This brings the Fed closer to the last of the three stages of monetary tightening.
In the first stage, in 2022, central bankers raised interest rates quickly. Earlier this year, they went through the second stage, starting to raise borrowing costs more slowly to avoid causing unnecessary economic weakness.
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In the third stage, the focus shifts to inflation-adjusted interest rates. This means that even if the Federal Reserve keeps its benchmark interest rate steady as inflation weakens, the effect will be the same as a rate hike.
As inflation slows, “if we don’t cut interest rates, at some point the real interest rate will continue to rise,” New York Federal Reserve President John Williams said in an interview earlier this year. He commented that he expects a rate cut next year not because of a sharp slowdown, but simply to prevent real rates from becoming unnecessarily restrictive.
The Federal Reserve under Greenspan had no publicly announced inflation target. Congress charged the Fed with achieving “price stability,” but Greenspan never defined the term, which made it easier for him to cut rates when the economy weakened. Under Greenspan’s successor, Ben Bernanke, the Fed adopted its official 2% inflation target in 2012.
Most analysts expect interest rates to be cut by about 1 percentage point next year, although core inflation is forecast to fall to 2.6% by the end of the year. Most analysts and economists agree that inflation will reach its 2% target by the end of 2025.
Those forecasts may be too optimistic, according to Riccardo Tresi, a former Fed economist. However, most believe that the path to a “soft landing” looks wider and flatter in recent months.
2023-08-22 18:11:00
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