Fed struggles to find new leverage as strong economy, inflation refuse to budge much

Facing a stronger-than-expected economy and sticky inflation in core prices, the Federal Reserve signaled Wednesday it’s going to hike interest rates two more times before the year is through despite taking a break in June.

The June pause marks the first interval in one of the fastest quantitative tightening cycles in the history of the U.S. central bank, carried out through 10 consecutive hikes since last year that raised interest rates by 5 percent in 15 months.

But the Fed’s latest projections show the cycle isn’t yet finished, with rates expected to increase to a range of 5.5 to 5.75 percent at some point this year, up from a current range of 5 to 5.25.

In the wake of major failures in the banking sector that spurred depositor bailouts from the government and led to fears of a general financial collapse earlier this year, Fed Chairman Jerome Powell painted a picture Wednesday of an economy that’s fundamentally healthy but still dogged by price levels that are reluctant to subside.

Here are the main takeaways from Powell’s Wednesday press conference.

Sticky core inflation will require two more hikes this year

Inflation is divided into two main categories: headline and core. The headline number includes some of the prices that consumers feel most acutely, like gas and food.

But economists consider the less volatile prices in core manufactured goods and basic services to be a better measure of the underlying inflation in the economy.

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Powell said Wednesday that he’s not seeing the progress he’d like to see in the core, and that’s the reason the Fed will make additional hikes this year to slow economic activity.

“Look at core inflation over the past six months, a year. You’re just not seeing a lot of progress, not the kind of progress we want to see,” Powell said. “We see inflation forecasts are coming in low again, and that tells us we need to do more.”

Core prices in the consumer price index (CPI) have fallen to 5.3 percent annually off a high of 6.6 percent in September, while headline CPI has fallen much further, to 4 percent in May from 9.1 percent last year.

The Fed has implicitly rescinded its recession prediction

The Fed predicted a “mild recession” in March for some time later this year following scores of similar predictions from commercial economists, but its latest forecast for gross domestic product (GDP) walks back this expected downturn.

Fed bankers more than doubled their 2023 annual GDP forecast to 1 percent growth, up from 0.4 percent in March.

This increases the odds that the Fed will achieve its desired “soft landing,” which would entail a resumption of the economy’s normal growth cycle in the wake of the booming recovery from the pandemic shutdowns without a huge jump in unemployment.

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“There is a path to getting inflation back down to 2 percent without having to see the kind of sharp downturn and large losses in employment,” Powell said.

Unemployment is currently near 50-year lows at 3.7 percent, having ticked up slightly in May from 3.4 percent in April.

No mention of profits despite beige book evidence

Powell did not mention on Wednesday the role that profits are playing in the current phase of inflation, despite mentions of “unusually high” profits in the latest anecdotal summary of U.S. economic conditions in the Fed’s beige book.

“Contacts reported far fewer supply chain disruptions – instead noting that many sectors of the economy are enjoying unusually high profit margins,” the Philadelphia Fed reported in May.

Instead, Powell referenced research by former Fed Chairman Ben Bernanke and economist Olivier Blanchard that pointed the finger for inflation going forward at workers and wages over margin expansion and supply chain problems.

“Although tight labor markets have thus far not been the primary driver of inflation, the effects of overheated labor markets on nominal wage growth and inflation are more persistent than the effects of product-market shocks. Controlling inflation will thus ultimately require achieving a better balance between labor demand and labor supply,” the wrote.

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Recent research from the San Francisco Fed suggests a minimal role for labor costs in the current inflation.

“Labor-cost growth is responsible for only about 0.1 percentage point of recent core PCE inflation,” Fed researchers wrote, referring to the personal consumption expenditures (PCE) index.

Housing and rents are now a major driver of inflation

Shelter costs represent nearly half of core inflation measurements, and the housing sector’s interest rate sensitivity means it’s now contributing disproportionately to consumer inflation. 

Shelter inflation is at 8 percent annually, double the headline number in the CPI.

“We do need to see rents bottom out here or at least stay quite low in terms of their increases,” Powell said Wednesday.

“We’re watching that situation carefully,” he said. “I do think we will see rents and housing prices filtering into housing services inflation.”

“Excluding shelter, CPI inflation is now [down] to what we would consider normal levels: 2.2 percent over the past year,” University of Central Arkansas economist Jeremy Horpedahl wrote Tuesday.

Other Fed board members have voiced concern about the housing sector recently.

“We expect lower rents will eventually be reflected in inflation data as new leases make their way into the calculations,” Fed board member Michelle Bowman said at an event last month in Boston.

“The residential real estate market appears to be rebounding with home prices leveling out, which has implications for our fight to lower inflation,” she said.

Fallout from bank failures isn’t over yet

The outsized role that the financial sector plays in the U.S. economy continues to present difficulties for the Fed, especially after a spate of large bank failures earlier this year that threatened “systemic” collapse.

The trouble in that sector inspired bank managers to tighten their credit conditions, which has a similar effect to interest rate increases and essentially did some of the Fed’s work for it.

“It feels like something that will be around for some time,” Powell said.

Powell said central bankers are monitoring credit conditions “very carefully.”

“As we see things unfold, as we see what’s happening with credit conditions and also all the individual banks out there … we can take their macroeconomic implications into account in our rate settings,” he said.