Following a 50-basis-point rate hike in May, the Federal Reserve (Fed) is now widely expected to announce two more 50-basis-point rate hikes — one after the June Federal Open Market Committee meeting and the other after the July meeting. While the Fed may decide to pause in September, a further 50 basis-point rate hike by December appears inevitable. Even dovish Fed officials, such as Mary C. Daly, are now pushing for an “an expeditious march to neutral by the end of the year.” It is generally assumed that “neutral” in Fed speak refers to a 2.25-2.5 percent federal funds rate target range.
Recent stock market conniptions have, at least so far, not generated much concern among Fed officials. Going forward, it will be interesting to see whether Federal Reserve Chair Jerome Powell and his colleagues can hold their nerve and avoid capitulating in the face of market tantrums. To reestablish its inflation-fighting bonafides, the central bank needs to clarify to the financial markets that the so-called “Fed Put” is no longer in play.
As I have previously noted, the “central bank’s penchant for turning a blind eye to surging asset prices and financial distortions while staying ever ready to step in and cleanup the damages caused by the collapse of asset bubbles has led many market participants to believe in the existence of a ‘Fed Put.’” It is high time that the Fed prioritized main street over Wall Street.
Looking ahead, even if the Fed does not buckle in to pressure from investors, there are still two specific areas of uncertainty that cloud any forecasts regarding the interest rate outlook for 2023. First, there is some debate regarding what exactly constitutes the neutral rate in the current environment. The so-called neutral monetary stance is a theoretical concept that is inherently vague and somewhat imprecise.
In a 2018 speech, then-Dallas Fed President Robert Kaplan noted that the “neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. … The neutral rate is an ‘inferred’ rate — that is, it is estimated based on various analyses and observations. This rate is not static. It is a dynamic rate that varies based on a range of economic and financial market factors.”
The Fed’s consensus estimate for the neutral rate (of around 2.5 percent) may turn out to be incorrect if de-globalization, demographic and labor supply shifts and other structural changes fundamentally alter the U.S. economy. The long-run neutral rate is determined by the supply and demand for savings, and they in turn are dependent on factors such as productivity growth, international capital flows and demographics.
Another source of uncertainty is whether the Fed has to raise its policy rate above the neutral rate to bring inflation under control. Former New York Fed President Bill Dudley recently noted that “the Fed might need to go significantly beyond neutral to get inflation under control. Powell has so far refused to comment on the possibility, arguing that the central bank must first reach neutral before deciding whether to press on. This coyness is a mistake. It reinforces the jarring disconnect between Fed officials’ commitment to curb inflation and their unwillingness to explain what that commitment will entail.”
Will the Fed actually push the fed funds rate target to 3.5 percent or even higher in 2023? If inflation rates remain elevated at the end of 2022, and if upward wage pressures remain persistent, can the Fed really afford to take its foot off the accelerator and ease up on the pace of rate hikes? The fear and uncertainty roiling financial markets in recent weeks are largely tied to these very questions.
So far, U.S. consumers have exhibited considerable resiliency and the labor market has remained very tight. The housing market has yet to show signs of significant cooling down. Fresh supply chain disruptions, though less severe than those observed in 2021, pose an ongoing challenge for the U.S. and global economy. Energy and food prices are expected to remain elevated in the near term. Ongoing geopolitical shocks pose an additional inflationary threat to both the U.S. and global economy.
Given the above noted factors, it appears that the Fed will have to raise its policy rate well above 2.5 percent if it plans to bring inflation back down to the 2 percent target level. A steady diet of easy money from the G-4 central banks (the Fed, European Central Bank, Bank of Japan and Bank of England) has generated significant asset bubbles in recent years. Now, as the Fed and its counterparts deal with a 1970s-style stagflationary environment, the potential for a serious financial disruption over the coming year is quite high.
Having stuck with an ultra-loose monetary policy stance for far too long, the Fed now faces a difficult choice — it must either tighten interest rates far more than it originally anticipated and risk serious economic and financial disruptions or accept above-target inflation rates as the new normal.
The odds of a recession in 2023 are quite high. But the real challenge for monetary authorities is no longer limited to the question of whether or not the Fed can avoid an economic downturn and achieve the elusive soft-landing. In fact, market participants are increasingly fretting about the potential risk of a major financial shock if the Fed is forced to ratchet up interest rates to levels not seen since early 2008.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.