Speed of Fed Tightening Lifted

June 15, 2022

A lack of progress toward lower U.S. inflation and various measures showing upward drift in expected inflation convinced FOMC officials to boost the federal funds rate by 75 basis points today. This follows increases of 25 basis points in March and 50 bps in May, and the decision was taken in spite of a risk of diminishing the credibility of its forward guidance, which in May had fairly explicitly flagged a likely 50-bp move at this meeting. New forward guidance regarding the future path of the federal funds rates moreover paints a much steeper rise of the interest rate than depicted previously to around 3.4% at the end of this year (roughly 1.75 percentage points during the second half of 2022). All of the decisions at the four remaining scheduled policy meetings this year will be ultimately decided in real time and guided by economic and financial market data as well as other information then available. It’s also possible that the inter-meeting rate changes could be done. That was common prior to the 1990s.

The FOMC statement upgrades its characterization of recent economic growth and calls unemployment low. The sentence describing inflation is the same as in the May statement, but an added sentence speaks to policy priority: The Committee is highly attentive to inflation risks. Revised macroeconomic forecasts project real GDP growth 1.7% this year, down from forecasts of 2.8% made in March and 4.0% made last December, and PCE inflation in 2022 has been raised to 5.2% from 4.3% predicted in March and 2.6% projected six months ago. Unemployment goes slightly higher but only to 4.1% by 2024.

These numbers paint a soft landing that avoids a recession, but when pressed during the press conference, Chairman Powell used more minced wording that  seemed to concede that a recession by 2024 was at least a 50-50 risk. To restore price stability around 2.0% in both actual PCE deflator and in inflation expectations is likely to require a recession. At least that’s the sense one gets from the 1960-1990 history. One problems is that with much of inflation hinging on factors the Fed doesn’t control directly and supply-side drivers of inflation like the war in Ukraine and supply chain disruptions showing no sign of going away, aggregate demand growth has to slow very sharply. Another hurdle is that when inflation gets as high as now, it doesn’t slow sustainably unless monetary policy remains restrictive until the economy is well into a recession.

The U.S. economy experienced five recessions between 1965 and 1992. From 1.6% in November 1965, U.S. CPI inflation rose to 6.2% by January 1970, slid back to 2.7% in June 1972, rose to 12.3% in December 1974, retreated to 4.9% by December 1976, climbed to 14.6% in March 1980, fell to 9.6% in mid-1981, climbed to 11.0% in September 1981, dropped to 2.5% by July 1988, rose to 4.8% in March 1984, retreated to 1.1% in December 1986 but was back at 6.3% in November 1990 and even 2.6% in January 1992. Quantitative tightening under Paul Volcker didn’t mean aligning restrictive interest rate levels with periods when inflation was too high. It meant subordinating interest rate settings to market forces and focusing instead on slowing monetary growth, a process that officials knew would put the economy through a severe recession. But no officials back in that time outright predicted a recession nor spelled out in advance that such was probably going to be long and painful.

Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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