Federal Reserve signals not done yet as it raises interest rates again

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The Federal Reserve is poised to leave the door open for another interest rate hike after resuming its monetary tightening campaign this week, as officials debate how much more to strangle economic activity to bring inflation under control.

The Federal Open Market Committee is widely expected to raise its benchmark rate another quarter of a percentage point on Wednesday after a reprieve in June. This will raise the federal funds rate to a target range of between 5.25% and 5.5%.

Traders in the fed funds futures market believe this will be the last interest rate hike in what has become a historic campaign to stifle stubbornly high inflation. But economists say the Fed is unlikely to signal as much, as it wants to retain the flexibility to tighten monetary policy further if prices do not ease as much as expected in the coming months.

“The committee is unlikely to be willing to communicate that it expects an extended suspension,” said Kris Dawsey, head of economic research at the DE Shaw Group, who previously worked at the New York Fed. “There are a lot of possibilities that they end up hiking more after the July meeting, if prompted by the data.”

Speculation that the Fed may be about to end its rate hike streak follows a recent batch of economic data that showed a decisive slowdown in the most worrisome lingering parts of inflation, as well as a continued cooling in the labor market.

Monthly job growth, while still robust, has moderated from last year’s average pace and other signs of demand, including job vacancies, continue to decline. Consumers continue to spend but with less intensity and the monthly pace of “core” inflation, which excludes the volatility of food and energy prices, has slowed.

Christopher Waller, a Fed governor who is one of the FOMC’s most hawkish officials, recently signaled the possibility of another rate hike as early as the September rally, but conceded that two other consumer price index reports that show significant progress “might suggest stopping.”

“It will be difficult to argue in the coming months that the backdrop calls for additional policy restraint,” said Tom Porcelli, chief US economist at PGIM Fixed Income. “Against the backdrop of a slowing economy, prudence would require the Fed to exercise caution here.”

Moreover, officials are still grappling with uncertainty about the effect not only of past increases in interest rates, but also the side effects of the banking turmoil that hit the financial system earlier this year. Mid-size lenders pulled out – albeit to a lesser extent than expected – making access to credit more expensive.

To reflect this, Julia Coronado, a former Fed economist who now leads MacroPolicy Outlook, predicts that policymakers will revise their individual core inflation forecasts downward when new projections are released in September.

In June, when they were last released, officials predicted a slower descent this year towards the Fed’s 2% inflation target, with the core personal consumption expenditure price index registering an annual pace of 3.9%. That was up from 3.6%, according to March estimates. Combined with a more optimistic growth outlook, most officials projected an additional half percentage point of monetary tightening this year to eventually push the fed funds rate to a high of between 5.5% and 5.75%.

Coronado expects core inflation forecasts to drop big enough to force policymakers to eventually scrap the latest quarter-point rate hike incorporated into their projections after a July increase, but warns it’s too early to tell.

“Part of that strategy is to keep the market from going crazy with ‘Fed is done’ euphoria,” she said. “By holding the threat of rate hikes in the market for most of the year, they can control rate expectations.”

The Fed has managed to convince market participants that it is not about to cut its key rate anytime soon, after struggling to do so for most of the tightening cycle. Traders’ forecasts for the cuts are now in line with officials’ forecasts for the earliest start in 2024, indicating less fear of an impending recession that would require a sharp about-face.

Having been caught off guard in the past by persistent price pressures, officials would be even more cautious not to take any policy possibilities off the table, said Karen Dynan, a former top Fed executive now at Harvard University.

One point of concern is the recent low in house prices after a precipitous drop last year – a resilience that New York Fed Chairman John Williams admitted was “a bit of a surprise”. The Dallas Fed’s Lorie Logan warned that it could even pose an “upside risk to inflation going forward.”

Dynan said officials also needed to prepare for additional shocks, including rising food and energy prices.

“There’s a long way to go to get back on target and it’s something that weighs heavily on them,” she said.

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