Did the Fed get it right?
At the recently concluded FOMC meeting the Federal Reserve approved an interest-rate increase of 0.5% and signaled plans to continue to lift rates through the spring of 2023. It is expected that the next hike, at the Jan 31-Feb 1 meeting, will be the more traditional 0.25% hike followed by one or two additional similar hikes later in 2023. This increase in the benchmark rate by 0.50% brings the target range to 4.25% to 4.5%, the highest level since 2007. The recent hike of 0.50%, after four straight larger hikes of 0.75% each, comes amid signs that consumer prices are finally starting to slow after inflation hit a 40-year high of 9.1% in June. Most economists now see a terminal rate over 5.0% when the Fed pauses in 2023 – this is a higher level than the 4.6% end-target rate projected as recently as September. Along with the higher end-target rate, projections now point to a higher unemployment rate (moving from 3.7% to 4.8% in 2023) and flat to negative economic growth. It is this combination of higher unemployment and declining economic growth that suggests the US economy will enter a recession at some time in 2023. As 2022 closes, recessionary pressures are building as our economy faces the combined impacts of a higher dollar, quickly rising interest rates, a slumping stock market and declining business and consumer confidence. At his December 14th press conference Fed Chair Jerome Powell said this, “Worse pain would come from a failure to raise rates high enough and for allowing inflation to become entrenched in the economy. I wish there were a completely painless way to restore price stability. There isn’t.”
With the December rate hike the Fed is entering a new phase of policy tightening in its ongoing fight against historically high inflation. The November read on inflation showed a decline to 7.1% - this good news was lost in the somewhat hawkish comments of Chair Powell this week. As he noted in his news conference, the speed and pace of large consecutive rate hikes, like that seen throughout 2022, were necessary to set the foundation for smaller hikes in future months. Now the focus must be more on what is the ultimate level (or end-target rate) needed and how long must Fed monetary policy be restrictive. It may surprise some investors to learn that most Fed officials anticipate cutting rates by 1% in 2024.
So, did the Fed get it right? That remains to be seen. Since the spring of 2021 (when inflation first started to spike) the Fed has been overly optimistic in its inflation projections – remember for most of the spring and summer of last year that Chair Powell assured us that higher inflation was merely “transitory.” In 2022, as inflation reached historic levels the Fed charted a very aggressive rate hike path to slow the economy and rein in inflation. The problem here is that rate hikes work with long and variable lag times, which means that the Fed may not really know for a year or more if they have tightened too much or too little. Thus, the potential for a rate cut in 2024. We must remember that the current above trend inflation was not caused by easy Fed policy in response to the pandemic, rather it has many other causes including soaring consumer demand, supply chain bottlenecks, historic government stimulus (CARES), a war in eastern Europe, computer chip shortages and a revolution within the American workplace. As we move further away from the pandemic, supply chain problems will lessen, and labor shortages should moderate suggesting that some of the imbalances that led to rapid inflation may very well begin to dissipate on their own without further aggressive policy intervention and pain.