The Fed’s Interest Rate Policy Is Getting Tricky

The Federal Reserve’s June meeting is shaping up to be one of the trickiest in its 15-month campaign to tame inflation: Chair Jerome Powell seems intent on skipping an interest-rate increase, while explaining to the public that officials aren’t done yet.

The strategy is sensible, confusing, and risky all at once, Fed watchers say.

Since March 2022, the U.S. central bank has raised its policy rate at 10 consecutive meetings, to a range of 5 percent to 5.25 percent, with the last two increases following bank runs that led to the collapse of four lenders. Now, Powell and several of his colleagues want to take a break at their meeting next week so that they can assess the outlook, even though their quarterly economic forecasts may show interest rates and inflation moving higher this year than they expected three months ago.

“The reason they want to pause is risk management: There are a lot of uncertainties, and they want to gather more data,” said former Fed Governor Laurence Meyer. “But if you think you are going to do one or two more, and you don’t hike in June, the question is: Why not?”

One possible answer is that the Federal Open Market Committee (FOMC) is trying to fight on two fronts. Policymakers want to bring inflation back down to their 2 percent goal, after more than two years above target. But they also don’t want to push rates so high that they overshoot and crush the economy.

The Fed has raised rates more than five percentage points in little more than a year, one of the fastest rate-hiking campaigns in the Fed’s nearly 110-year history.

“Skipping a rate hike at a coming meeting would allow the committee to see more data before making decisions about the extent of additional policy firming,” Fed Governor Philip Jefferson said on May 31.

So far, the economy has proven more resilient to rapid rate increases than many officials expected. A Labor Department report Friday showed employers added 339,000 jobs last month, though the jobless rate also climbed.

Consumer spending has held up despite persistent price pressures, and the Atlanta Fed’s GDPNow model estimate for the second quarter is running at nearly 2 percent growth.

Progress on inflation, meanwhile, has slowed in recent months, especially in the services sector. The Fed’s preferred measure, minus food and energy, rose 4.7 percent for the 12 months ending April. Trimming away outlier prices, a measure produced by the Dallas Fed showed inflation running at 4.4 percent on a six-month basis—more than double the Fed’s target.

“Their revealed actions over the last two months show that they have recently switched to having a slight bias toward downside growth concerns over inflation concerns,” said Anna Wong, chief U.S. economist at Bloomberg Economics. “The inflation data does not warrant a pause right now.”

With inflation still far from the Fed’s goal, and unemployment near historic lows, policymakers could afford to raise rates at least two more times to lean against price pressures without undercutting growth, Wong added.

Some Fed officials, including Chicago Fed President Austan Goolsbee, have pointed to the lagged effects of rate increases, and the possibility of wide-scale credit tightening by banks, to suggest policymakers should be cautious and monitor incoming data carefully.

While the general thrust of the data has been resilient, there are other indicators that flash caution, such as the Conference Board’s Leading Economic Index, which are signaling a recession sometime in the next 12 months. When the data is confusing, central bankers tend to move gradually or not at all.

“You have leading indicators that suggest a recession is coming and coincident indicators that suggest the economy is chugging along at a good pace,” said Kathy Bostjancic, chief economist at Nationwide Life Insurance Co.

If supply kinks unravel further in coming months, as expected, taking a break makes sense, said Jeff Fuhrer, former research director at the Boston Fed.

“Historically, you can predict tomorrow’s inflation from today’s inflation,” he said—except when supply disruptions are driving prices up. “This episode is a little bit different,” he added. “I don’t think inflation went up because we had outsized demand.”

Pausing rate increases presents some risks. For most of the year, officials have signaled to markets that they planned to bring rates to a restrictive level—their median estimate in March suggested rates would reach 5.1 percent by year-end—and hold them there for some time. Markets have anticipated the Fed would cut rates later in 2023.

Skipping a rate hike in June could make it more difficult for officials to restart if they need to. To avoid that outcome, Powell will need to make clear at his post-meeting press conference that it may take more work to lower inflation.

“The messaging is going to be tough,” said Diane Swonk, chief economist at KPMG LLP in Chicago. “The biggest risk is that markets start front-running them on cuts” later this year.

Easier financial conditions could push growth up more, possibly lifting inflation expectations.

Fed officials are anxious to ensure that inflation expectations stay well-anchored, and some worry—as Powell warned a year ago—that the public could lose faith in the Fed’s ability to bring inflation back to 2 percent the longer it stays above target.

A Cleveland Fed survey of company perceptions of the central bank’s inflation target was at 3.1 percent in the second quarter. Before the pandemic, it stood at 2.2 percent. Other measures of inflation expectations are tilting higher.

“Inflation expectations are volatile right now and vulnerable to un-anchoring,” said Bloomberg’s Wong. “The clock is ticking.”

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