Why the Fed should pause, and why it won't
The Federal Open Market Committee meets next week. Financial markets overwhelmingly expect a quarter point hike in the federal funds rate, and that this will be the last hike of the current tightening cycle.
The Federal Reserve is the country's main inflation fighter. It does this primarily by raising interest rates to discourage borrowing and spending. The Fed's challenge is to slow spending just enough to reduce demand pressures that push up prices, but not so much that it causes a recession—a period of broad contraction of economic activity. The Fed began raising rates last March, and its upper bound for the federal funds rate now stands at 5%.
There are plenty of reasons that the Fed should stop hiking now:
Some bellwether sectors are already in recession: Real estate sales have tumbled as interest rates soared over the past year, and home prices have moved lower, with sharp drops in some markets. (February Case-Schiller data show home prices may be starting to stabilize). Manufacturing is also in recession. Measured by the Institute for Supply Management’s manufacturing index, the sector has been contracting by widening margins since last November.
There are emerging indications of slowing in the broader economy. Increments to the non-farm payroll job base, while still healthy, have been trending lower, and job openings, which have been exceptionally high, have receded somewhat. While the unemployment rate remains near multi-decade lows, it has begun to turn up for the most vulnerable groups, in particular for hispanics. Small firms are shedding workers and having difficulty meeting fixed costs like rents. Consumer spending, which has been strong, may also be starting to crack: Retail sales have been slowing since last summer, and have been contracting for more than a year when adjusted for inflation. Overall consumer spending is still expanding year-on-year, but has declined recently.
Forward-looking indicators are signaling a coming recession. The Conference Board’s Leading Economic Indicators index has moved into the deep negative territory usually associated with recessions in the past. New orders for durable goods have softened. And the forecasts of FOMC members themselves imply a mild recession later this year and early 2024.
The recent Silicon Valley Bank event has worsened credit conditions that were already becoming more restrictive. The extent of credit tightening that has now occurred is consistent with that seen prior to past recessions. Fed Chairman Powell has acknowledged that recent liquidity problems are equivalent to one or more Fed interest rate hikes.
Progress fighting inflation suggests that the interest rate hikes to date have probably been sufficient to get us to 2% inflation over the next few years. Pick your measure of inflation, and it has receded steadily since the middle of 2022. Consumer price index (CPI) inflation has receded from about 9% in June to 5% in March, and the Fed's preferred personal consumption expenditure (PCE) inflation has receded from 7% to just over 4%. Disinflation has proceeded further than suggested by annual statistics. We can see this by comparing average prices to those that prevailed six months earlier (expressed at an annual rate). CPI inflation by this measure was running at 3.6% in March.
Inflation remains above the Fed's 2% target, but it is clearly headed in the right direction. And one substantial driver of current inflation, housing and utility costs, has turned the corner and will decline further as falling rents feed through to lower measured shelter inflation.
So why won't the Fed pause interest rate hikes now? Inflation for services other than housing and utilities continue to run hot, rising at an annual rate of 4.7% over the past six months, accounting for more half of all inflation. So far, there is no sign of this tailing off. These are labor intensive sectors, and with average hourly earnings still running above 4%, the Fed will be concerned that labor costs could keep this category of inflation high for some time. This could mean that the overall inflation picture is not yet consistent with convergence to its 2% target.
But the Fed is likely putting too much weight on service inflation, considering the weakening we are seeing in the broader economy. In particular, the strength in consumer spending is waning. Today's personal consumption expenditure report shows that inflation-adjusted consumer spending declined in both February and March. As consumer spending slows further in coming months, weaker demand will cause wage growth and service inflation to slow, moving us closer to the Fed's long-run 2% inflation target. If inflation proves more durable than expected, the Fed would still have time to act. Because expectations of future inflation remain muted, the risk that high inflation will become entrenched in the economy is limited.
The Fed may argue that it is being conservative by continuing to raise interest rates until there are convincing signs of receding service inflation. But this downplays the heavy costs that households will have to bear if high rates tip us into an unnecessarily deep recession. In that case unemployment could rise more sharply than needed, with all the attendant personal and social burdens that that imposes. Better for the Fed to keep its powder dry for a few months to see if its past rate hikes bring about sufficient slowing to push us toward long-run price stability without extreme economic fallout.