By Kavan Choksi
The US Federal Reserve (Fed) increased rates by 0.25%, bringing its total rate increases to 4.5% over the last year. While this move was widely anticipated, market forecasts have diverged from the Fed’s telegraphed policies as far as future rate decisions are concerned. Chairman Powell reaffirmed the Fed’s forecast in which more than one additional rate increase will likely be needed to bring the rate of inflation down to a target rate of 2%.
Additionally, while markets have priced in some likelihood of a rate decrease later in 2023, Chairman Powell reaffirmed a forecast of modest economic growth, a slower period of disinflation and a softening of the labor market – with the US economy avoiding recession – which would preclude the need for rate cuts in 2023.
Signs that inflation is easing without detrimental impacts to the labor markets have been encouraging. Inflation in goods has dropped significantly. But, until disinflation has spread more broadly, the Fed will remain committed to tighter monetary policies. In particular, the Fed mentioned non-housing core services as an area where inflation has not yet cooled.
“Although inflation has moderated recently, it remains too high,” said Chairman Powell, adding that wages remain at an elevated level, and that reaching a sustainable level of inflation is essential for the health of the US economy and labor force over the long term.
Still, Chairman Powell conceded that we’re in a unique, post-pandemic environment, and forecasting the economic direction is difficult.
Market prices indicate an expectation that inflation will cool at a quicker pace than the Fed’s forecast. If inflation comes down much faster than anticipated by the Fed, and economic conditions deteriorate, then the Fed may cut rates later in the year. But the Fed’s projections of continued subdued growth paired with some softening in the labor market will not create conditions that require a rate cut in 2023.
From a policy perspective, undershooting the goal of tamping down inflation comes with more considerable risks than overshooting on rate hikes and hampering economic growth. The Fed views its available tools to reignite growth, such as rate cuts, as more easily enacted and digested by markets than a second tightening cycle, which may damage consumer and business sentiment. Ultimately, the longer that inflation persists, the less confidence that consumers and businesses have in achieving a low-inflation environment, which creates risks of wage spirals and other inflationary problems.
The mechanics of inflation are often self-perpetuating, and expectations that inflation is coming down is part of the process required to bring inflation down. As such, the Fed will most likely sound a more cautious tone than the markets in this early disinflationary process. While indications of disinflation are encouraging, the Fed will likely need to see continued and broad data suggesting inflation is under control before it pauses on rates.
(Author is wealth consultant at KC Consulting)