Chairman Pledges to Raise Rates “More” as Needed

Federal Reserve Chairman Jerome Powell headed to Washington this week for his renomination hearing. During the testimony, Powell appeared to be playing to both sides of the aisle, assuring some legislators the Fed was focused on controlling inflation, while reassuring others the Committee was dedicated to achieving maximum employment. However, with consumer prices rising to a four-decade high, prices took center stage, leaving members on both sides somewhat dissatisfied with such a broad-based commitment that left many questions unanswered – What exactly will the Fed do to control inflation? Is the Fed willing to force the economy into recession in order to rein in prices? Why did the Fed wait so long if policy makers are committed to keeping inflation in check? And of course, who’s to blame for this rapid rise in price pressures?

Heading to the Hill

On Tuesday, Chairman Powell appeared for his confirmation hearing on Capitol Hill before the Senate Banking Committee. Powell was originally nominated to head the central bank by President Trump with a four-year term ending in February 2022. In November, President Biden nominated Powell to serve a second term – with Lael Brainard nominated for the Vice Chair position.

Political theater aside, the focus of this week’s hearing was the surge in inflation and the Fed’s plan to control rising costs. In his prepared remarks, Chairman Powell insisted that the Fed will use all tools necessary to?“support the economy and a strong labor market and to prevent higher inflation from becoming entrenched."?More specifically, however, when asked about the persistent nature of inflation, the Fed Chairman acknowledged that cost increases have been somewhat unexpected both in level and duration and would potentially need a firmer-handed approach. "These problems have been larger and longer lasting than anticipated, exacerbated by waves of the virus. As a result,” Powell said, “overall inflation is running well above our 2 percent longer-run goal and will likely continue to do so well into next year.”

Despite the apparent mea culpa from the leader of the Fed, Powell’s concession – or more accurately the Committee’s concession – does nothing to arrest the current inflationary situation or the toll rising costs are taking on American families. The latest read on inflation showed consumer prices rose 0.5% at year-end and 7% over the past 12 months. Excluding food and energy costs, the core CPI rose 0.6% in December and 5.5% year-over-year. In both instances, this is the fastest pace of annual price gains in more than thirty years. In fact, while the Fed insisted for nine months that price pressures would prove transitory, rising prices have since spread across nearly every aspect of the marketplace with no indications of cooling just yet. Costs of everything from gas and housing, to groceries and appliances are up double digits.?

If We Have To, We’ll Hike More

In response to concerns regarding inflation, Powell was clear in his messaging this week: the central bank may have been wrong about the more permanent nature of rising prices, but the Fed will contain inflation. “If we have to raise interest rates more over time, we will,"?he said,?“the economy no longer needs or wants the very accommodative policies we have had in place.”

Convinced inflation would prove temporary as a result of the virus and distortions caused in the global supply chain, the more persistent nature of cost increases has now arguably left the Fed behind the curve with officials forced to play catch-up. The Chairman says the Committee will do “more,” but how much more is more? And how much “more” can the economy withstand?

The market is convinced the Fed will raise rates three times with the possibility of a fourth by the end of the year. Committee members themselves, however, are much less certain “more” will translate into 100bps of tightening. While the latest guidance from Fed officials suggests a growing number of policy members may be taking a more hawkish position at least as far as the timetable for initiating liftoff, many more policy makers have indicated a preference for an increased reliance on balance sheet reduction as opposed to interest rate hikes alone. According to the Fed’s latest dot plot, there remains a sizable divide among policy members regarding the appropriate pathway for fed funds – only two Committee members expect the Fed to raise rates four times, while five anticipate only two hikes in 2022. A majority of 10 members anticipate three rates hikes within the next 12 months.

High Inflation Now?

Much of the divide regarding the pathway to higher rates rests on the expected trajectory of inflation, and the underlying momentum of the recovery. While the Fed has acknowledged inflation has moved higher than expected with Fed officials revising up their forecasts for prices in 2022 and 2023, many participants also anticipate prices to peak early in 2022 and moderate quickly. Thus, while inflation is expected to remain well above the Fed’s 2% target for some time, a second derivative decline – or a slower pace of positive price growth – in the coming months would alleviate the sense of urgency for the Fed to act, or at least remove some of the pressure on the Fed to act “aggressively.” But will inflation peak near term and begin to abate?

Looking out to 2022, many – ourselves included – would have answered yes. However, much of the ongoing pressure on prices stems from international supply chain disruptions that could actually intensify, at least in the near term, as much of the developing world implements additional safety protocols to stem the spread of the latest variant, including China’s zero Covid policy. With just 33 positive cases, for example in Tianjin alone, China has implemented new lockdown measures in the eastern port of Tianjin, as well as in places like Xi’an in central China, and the southern technology hub of Shenzhen. As a result, some are bracing for?“the mother of all shocks”?in the next few months.

Without near-term relief in inflation, the Fed is likely to raise rates more and faster than anticipated, if – and this is a monster sized if – the economy is strong enough to withstand a rise in rates and market forces “allow” for a more aggressive Fed. After all, if much of the rise in prices is a result of cost-push inflation, would raising rates return inflation to the Fed’s 2% target or simply curtail growth, forcing Americans to contend with both higher costs and a weaker economy??Furthermore, while short-term rates are likely to follow along with the Fed, the long end could remain somewhat restrained by the prospect of returning to pre-pandemic levels of activity or circa 2% GDP. In this case, even if the Committee wanted to raise rates 100bps or more this year, a limited backup on the long end of the yield curve would leave the Fed with very limited wiggle room to elevate the federal funds rate without the risk of severely flattening the yield curve, or worse, forcing an inversion.?

-Lindsey Piegza, Ph.D., Chief Economist