(Bloomberg) — The Federal Reserve this week will begin a months-long campaign to fight inflation, which could lead to even more aggressive action by Chairman Jerome Powell after Russia’s war with Ukraine further inflated prices.
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Having already moved to tighten monetary policy amid the fastest rise in consumer prices in four decades, Powell and his colleagues now must deal with the economic fallout from a war that threatens to deliver a double whammy of weaker growth and even faster inflation.
On Wednesday, after Powell took the rare step of publicly backing such a shift, a 25 basis point gain is almost certain, futures markets are showing a tightening of about 165 basis points this year, the equivalent of at least six quarter-point advances.
There is certainly reason to be concerned about inflation, as Russia’s incursion exacerbates the pressures caused by the pandemic. The cost of food, fuel and metals has skyrocketed since the war began, with gasoline alone setting record highs while prices for many services were already higher.
Watching the first rate hike since 2018, Powell has been licensed to be hawkish by President Joe Biden, lawmakers across the political spectrum and many fellow Fed officials as businesses and households increasingly seek to avoid the harm of 1970s-style price shocks. that limit their purchasing power.
“Powell can’t afford to be dovish at the moment, that would be inconsistent with what sound policy is and where it should be headed,” said Derek Tang, an economist at Monetary Policy Analytics in Washington.
While he argued that the Fed would be nimble, Powell’s post-decision press conference on Wednesday will be analyzed for clues as to how high rates could end up coming down from zero today and how quickly officials can move towards that. Goldman Sachs Group Inc. predicts that officials will eventually stop raising rates by 3% sometime next year.
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Key insights will come from the scatter chart of the Fed’s rate projections through 2024 and how supportive Powell is of it.
Last week’s European Central Bank meeting showed the potential for hawkish surprises when President Christine Lagarde announced an accelerated end to monetary stimulus. The Bank of England also intends to raise rates this week for the third meeting in a row.
US central banks are starting their tightening campaign with real interest rates—nominal rates adjusted for inflation—at their deepest negative level since the 1970s. If longer-term inflation expectations rise, it means there may be more ways to bring policy to a more neutral environment that neither speeds up nor slows growth, even though the conflict makes it harder to find a path.
“It’s a real mess,” said Tim Dye, chief US economist at SGH Macro Advisors, who believes the risks from higher inflation outweigh the dangers of slower growth. “Powell would like to thread the needle so that we maintain strong growth, but also bring inflation back to something more reasonable,” Dai said. “If he can do it, he’s a legend.”
In doing so, the focus is on whether Powell is signaling that a more hawkish or lighter path of tightening should be taken, or whether he is leaving his options open, speaking of the need for flexibility in the face of uncertainty.
This is not a simple call. Forecasters expect the economy to slow down this year due to spending cuts, and a University of Michigan poll on Friday showed that consumer sentiment fell to its lowest level since 2011 after a surge in fuel prices and inflation, which does not bode well for spending.
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“The Fed’s gradualism comes at a cost: future inflation is best predicted by past inflation lags, and a more gradual Fed now is likely to mean a more aggressive Fed later.”
— Anna Wong, Chief US Economist
Fed officials will also want to see how their plans to cut the balance sheet will affect financial conditions, which have tightened further since the war. They are expected to announce the pace at which they plan to cut the balance sheet at this meeting, although they have not yet set a start date for the process.
A sharp slowdown in hiring rates could lead to a slowdown in the pace of tightening.
Powell “signified that they were going to move steadily towards a neutral position,” said Julia Coronado, founder of MacroPolicy Perspectives. “Sustainability of demand will be the main indicator” of how fast they will develop.
At the same time, the Fed has a mission to maintain price stability, and patience is running out both inside and outside the central bank.
Earlier this month, Powell heard from lawmakers on both sides of the aisle that their constituents want to take action on inflation. And his own committee took a more hawkish stance.
St. Louis Fed President James Bullard, who is voting for policy this year, called for a “quick policy exit” while Gov. Christopher Waller said he wants at least 100 basis points of tightening by mid-year, with a half point like an option. Gov. Michelle Bowman said she was ready to take “drastic action” to get inflation back on target.
Not a single Fed official is talking about provoking a recession in the economy to control inflation. But their ability to be patient is only limited by the public’s confidence in their ability to bring inflation back to around 2% a year.
“Given the rise in commodity prices, inflation expectations are now at a dangerous level,” said Sarah House, senior economist at Wells Fargo & Co. “They are not exceeding the Fed’s targets, but dangerously close to them. This will help implement the Fed’s plan.”
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