A united front among Federal Reserve officials is likely to crumble as sharper divisions emerge among policymakers over how hard to squeeze the economy to fight inflation, economists have warned.
As the U.S. central bank prepares to slow the pace of interest rate hikes next month after one of the most aggressive tightening campaigns in recent times, it is grappling with disagreements over the degree of necessary restraint and the extent to which the economy must suffer. .
“This is a group that likes consensus if it can get it, but it may not get there,” said Bill English, former director of the Fed’s monetary affairs division. “The fundamental problem is that it will be much less clear what they need and want to do with politics.”
On Wednesday, Fed watchers will seek more guidance from Chairman Jay Powell in remarks to be delivered at the Brookings Institution amid financial markets struggling to interpret central bank policy signals.
Minutes from the Fed’s last policy meeting in November suggest some officials were reassured by data pointing to a modest slowdown in inflation, while another cohort still appears wary of renewed upward pressure on stocks. prices, in particular due to a historically tight labor market.
Andrew Hollenhorst, chief US economist at Citi, said the minutes showed officials were no longer unanimous that the risk of doing too little outweighed the risk of doing too much, with some saying that the cumulative effect of Fed tightening could “exceed what was necessary”. to control inflation.
“It’s going to be a really different experience analyzing the Fed and listening to their public statements because you’ll have this division,” he said.
Earlier this year, decisions about policymaking were clearer. As it became clear that inflation was becoming more entrenched in the economy, the Fed decided almost unanimously to abandon its more cautious approach to raising interest rates and followed up with four hikes. consecutive 0.75 percentage points.
The most recent of those hikes, implemented in November, took the federal funds rate to a new target range of 3.75% to 4% – a level officials believe is high enough to start restraining consumer demand. .
However, the Fed has now reached a tricky inflection point where it must decide how much it should start to ease off, amid signs that businesses and consumers are beginning to reel under the weight of rapidly rising costs. of borrowing.
While officials largely support a half-point rate hike in December, the San Francisco Fed’s Mary Daly conceded that the coming months will involve a “much tougher” phase of policy-making.
“The spread of opinion widens at the corners. Some people are more eager to jump on it [them] as evidence of something enduring than others,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.
“At the moment I think it’s nothing more than a fraying around the edges, but I expect that over the next few months the disagreements will probably become more widespread,” he said. added.
At the root of these divisions is a latent debate over the path of inflation. Commodity prices and housing costs have already fallen from their highs, while goods prices have started to decline, but those related to service sectors remain stubbornly high.
Retail margins have also shrunk as companies markdown products to eliminate excess inventory, said a vice president of the process, Lael Brainard, which could “significantly” help reduce inflationary pressures. Meanwhile, wage growth, though far exceeding the Fed’s 2% target, has begun to slow, by some measures.
Cleveland Fed’s Loretta Mester and Gov. Christopher Waller are among the most vocal officials warning against inflation pious hopes, who have argued that the central bank needs to see much stronger evidence than pressures on prices were easing to ensure that inflation was under control.
They, along with James Bullard of St Louis and Neel Kashkari of Minneapolis, said the Fed was not yet ready to suspend rate hikes.
Although Brainard also said the Fed still had work to do, it was an early defender of the pace of rate hikes and consistently warned of the international fallout from the bank’s tightening campaign. central.
Boston Fed President Susan Collins echoed that sentiment earlier this month, saying, “As rates rise, fears that we may go too high are growing.”
Officials’ assessment of the economy is complicated by the fact that rate hikes impact different sectors to different magnitudes at different times. Disruptions caused by the coronavirus pandemic and the war in Ukraine have undermined “confidence” in their own inflation forecasts, said Ray Farris, chief economist at Credit Suisse.
This has led to a reliance on historical data as officials try to decide how restrictive they should be and how long they should keep rates at a given level, he added.
Most economists believe the funds rate will need to rise above 5% next year for the US central bank to cool the economy sufficiently, and many also predict a mild recession. Despite protests from officials including John Williams at the New York Fed this week, traders in the fed funds futures markets continue to say the central bank will cut rates in the second half of next year.
With data likely to become even more mixed over the coming months, English, who is now at Yale University, expects at least a “dissent or two” on future rate decisions as the fault lines between Fed officials are deepening.
“There’s always a risk when there’s a lot of communication from a lot of different participants on the committee, that you have a problem with cacophony,” he said. “On the other hand, if there is genuine uncertainty and genuine disagreement among the participants, it is probably useful for that to be known to the public.”
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