Trying not to fall.
Photo: Manuel Balce Ceneta/AP/Shutterstock
Right now, Jerome Powell is walking a tightrope. He’s trying to stick to a narrow path, and disaster looms if he (well, the $23 trillion American economy that he, to a rather meaningful extent, manages) strays from it. Like the best and bravest circus performers, he is doing it blindfolded. The next step he takes — watched by a nervous global audience — will be at the February 1 Federal Open Market Committee meeting.
To one side of his tightrope is the catastrophe of high inflation. History teaches that it can wreck economies once it becomes entrenched. That’s why the Fed can’t avoid hiking interest rates in this situation — consumer spending would stay relatively cheap, demand would stay high, and prices would keep spiraling.
To the other side is the abyss of a hard recession. Everyone knows what that means. The danger there is raising rates too high — carrying debt becomes expensive, everyone pulls back on their spending, and all of a sudden the economy is shrinking.
Powell and his fellow members of the Fed’s Open Market Committee are deciding right now, in the quiet period preceding the meeting, what the correct next step should be for interest rates. Which level of the fed funds rate — the rate banks charge one another for overnight lending, which in turn affects all the various interest rates consumers pay on mortgages and credit-card debt — keeps the Federal Reserve on their tightrope?
The market is guessing, almost unanimously, that it will be a quarter-point increase, the smallest possible increment. That would be erring more on the side of avoiding recession than avoiding inflation. But for almost a year, the market has underestimated how aggressive Powell would be about raising rates, and it’s not impossible (though it’s unlikely) that the Fed chair is still more worried about inflation than recession and may opt for half a point.
Assuming it is a quarter point, that would be the smallest move in nearly a year, following a string of six half-point and three-quarter-point hikes. The reason for a relatively dovish approach here is that a slew of data has recently suggested that inflation really has cooled off quite a bit. With slower prints in manufacturing, negative anecdotes from the Beige Book (the Federal Reserve Board’s regularly published report on the state of the economy), soft numbers in retail sales, and the inflation metrics of the Consumer Price Index and Producer Price Index both falling, it seems as though all those rate hikes Powell & Co. made in 2022 are working.
At the same time, things are bifurcated. Consumers are still spending money but are taking out credit-card debt to finance it. Tech is going through layoffs, but other industries can’t find enough workers. Manufacturing is in a slowdown, but supply chains are recovering. To some extent, it’s a question of which story Powell & Co. find more persuasive.
No one ever said running the world’s most important economy would be easy, and the closer you look at the Fed’s actions, the more you realize it is actually trying to achieve various other goals, too, subtler ones, many of them very difficult. Here are six key things, besides the question of how much to raise rates, that the Fed is trying to figure out how to do right now:
(1) Convince markets that it is serious — in other words, maintain “Fed cred.” The Fed faces a tough balance with Fed credibility, a core component of its tool kit. It wants to keep hiking rates so that consumers, investors, and businesses take it seriously. Boosting rates shows it is committed to stopping inflation — and if everyone is convinced that the Fed is serious about stopping inflation, that can actually help stop inflation. (Welcome to the weird world of macroeconomics.) By contrast, if everyone stops believing in the Fed’s seriousness on inflation, that will make the job much harder. Stock-market investors in particular are a key audience. If stocks start going up and up again — remember 2021? — because Wall Street thinks the Fed is going to tap on the monetary-policy brakes (generally a bullish setup for equities), that could create new problems in an economy vulnerable to inflation.
(2) Bring us out of our zero-interest-rate world. Rates have been really low for a long time — essentially going back to the Great Financial Crisis. But now, Powell seems to be serious about moving out of that era and into one where rates are higher. There are many reasons for that, but a core one is that it’s much easier to save the economy when the Fed has a tool kit to save it with. During times of crisis, the Fed’s go-to measure is to cut rates to encourage consumer and business spending. If rates are at zero, that doesn’t give it a whole lot of leverage. Ideally, the Fed would like to boost rates to a higher range while still avoiding a Recession (and maintaining the Fed Cred).
(3) Understand where a renewed outbreak of inflation may come from. A big focus of the Fed has been “core services ex shelter” inflation (money we spend on haircuts, health care, legal services, pet services, and transportation), which is about 50 percent of Core PCE, the inflation metric the Fed loves to look at. It’s worried that this will become an inflationary pocket as people choose to get more haircuts, more health-care procedures, and so on. Inflation is no longer concentrated in supply chains; now it’s more about making sure it doesn’t spread to other parts of the economy. (Fortunately, the recent Consumer Price Index print showed these pressures easing.)
(4) Determine the impact of what it has done already: One of the trickiest challenges for Powell is to decipher how much of this cooling of price pressures is a result of the rate hikes and how much is the economy slowing down on its own. According to economic orthodoxy, the Fed’s hikes really haven’t worked through the economy yet — a process that ought to take at least six months. But this being economics, there is another view: Some recent papers argue that monetary-policy lags have shortened, and there’s also a case being made that inflation responds to the Fed’s rhetorical cues, not just its rate hikes.
(5) Shrink its balance sheet without causing a crisis this time: It’s no secret to bond traders, but a lot of Americans may not know that the Fed is a major player in the debt markets. This was especially true during the COVID crisis when it bought trillions of dollars’ worth of treasury bonds and other debt. These show up on the central bank’s balance sheet, which now stands at around $9 trillion. Slowly and carefully — when Powell tried this in late 2018, there was a crisis and he famously had to pivot — the Fed is trying to reduce this position without disrupting or spooking the financial markets.
(6) Eventually get inflation back down to where it started: The Fed’s goal of all goals is to get us back to a long-term target of 2 percent inflation as part of its dual mandate of price stability and maximum employment. The number is somewhat arbitrary, but it is the Fed’s goal. While we are quite far from it, nothing is impossible, right?
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