Fed officials in danger of splitting on future rate rises, warn economists

Economists have warned that the united front among Fed officials is at risk of splintering, with sharper divisions emerging among policymakers over how aggressively the pressure should be on the economy to tackle inflation.

As the US central bank prepares to slow the pace of interest rate hikes next month after one of the most aggressive tightening campaigns in recent times, it is grappling with disagreements over how much more restraint will be needed and how much the economy will suffer. .

“It’s a group that would love consensus if they can reach it, but they may not be able to,” said Bill English, former director of monetary affairs at the Federal Reserve. “The main issue is that it will be much less clear what they need and want to do with the policy.”

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On Wednesday, Fed watchers will be looking for further guidance from Chair Jay Powell in remarks to be delivered at the Brookings Institution against the backdrop of faltering financial markets that have struggled to interpret policy signals from the central bank.

Minutes of the Fed’s last policy meeting in November suggest that some officials took comfort in data pointing to a slight drop in inflation, while another group remains wary of further upward price pressures – particularly stemming from the historically tight labor market.

Andrew Hollenhorst, chief US economist at Citi, said the minutes showed officials no longer agreed unanimously that the risk of doing too much outweighed the risk of doing too much, with some saying the cumulative effect of Fed tightening could “beyond what is needed” to control inflation.

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“It would be a really different experience analyzing the Fed and listening to their public statements because you would have that segmentation,” he said.

Earlier this year, policy decisions were much clearer. When it became clear that inflation was becoming more entrenched in the economy, the Fed almost unanimously decided to abandon its more cautious approach to raising interest rates and proceed with four consecutive rate hikes of 0.75 percentage point.

The most recent of those hikes, implemented in November, raised the federal funds rate to a new target range of 3.75 percent to 4 percent — a level officials believe is high enough to start constraining consumer demand.

However, the Fed has now reached a difficult inflection point where it must determine the degree to which it should begin to take its foot off the brake, amid signs that businesses and consumers are starting to wiggle under rapidly rising borrowing costs.

And while officials broadly support a half-point rate hike in December, San Francisco Fed Mary Daley acknowledged that the coming months will include a “much more difficult” phase of policy making.

“The spread of opinion widens at tipping points. Some people are more eager to jump in [them] Evidence of something more sustainable than otherwise,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.

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“Right now, I think it’s just tension on the edges, but over the next few months I expect the disagreements to become more widespread,” he added.

At the root of these divisions is a heated debate about the path of inflation. Commodity prices and housing costs have already receded from their peaks, while commodity prices have begun to decline, but those associated with the service sectors remain stubbornly high.

Retail margins have also slumped as companies cut back on products to get rid of excess inventory, which could “helpfully” help reduce inflationary pressures, vice president of operation Lyle Brainard said. Meanwhile, wage growth, though well above the Fed’s 2 percent target, has begun to moderate, according to some measures.

Among the most outspoken officials cautioning against wishful thinking about inflation were Cleveland Fed’s Loretta Mester and Governor Christopher Waller, who argued that the central bank needs to see much stronger evidence that price pressures are easing to make sure inflation is under control.

They, along with James Bullard of St. Louis and Neil Kashkari of Minneapolis, have said that the Fed is nowhere near stopping interest rate hikes.

While Brainard also said the Fed has more work ahead, she has been an early advocate for slowing the pace of rate hikes and has consistently warned of the spillover international repercussions of the central bank’s tightening campaign.

Susan Collins, President of the Boston Federal Reserve, echoed that sentiment earlier this month, saying, “As interest rates rise, so do concerns that we may rise too much.”

Complicating officials’ assessment of the economy is the fact that rising prices affect different sectors by different amounts at different times. Ray Fares, chief economist at Credit Suisse, said the disruptions from the coronavirus pandemic and the war in Ukraine had destroyed “confidence” in their inflation outlook.

This has led to reliance on backward-looking data as officials try to determine how much restraint they need and for how long they should keep prices at a certain level.

Most economists believe the money rate will need to exceed 5 percent next year for the US central bank to sufficiently cool the economy, with many also predicting a mild recession. Despite protests from officials, including John Williams at the Federal Reserve Bank of New York this week, traders in the federal funds futures markets continue to say the central bank will cut interest rates in the latter half of next year.

With the data likely to become more mixed over the coming months, English, who is currently at Yale University, expects at least “a disagreement or two” over future interest rate decisions as fault lines deepen among Fed officials.

“There’s always a risk when there’s a lot of contact from so many different participants on the panel, that you have a cacophony problem,” he said. “On the other hand, if there is real uncertainty and disagreement among the participants, it would probably be helpful for the audience to know.”