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A jogger runs past the Federal Reserve building in Washington, on Aug. 22, 2018.CHRIS WATTIE/Reuters

U.S. Federal Reserve officials have aligned around plans to accelerate the pace of interest rate hikes this year but remain split over what could be the make-or-break decision of where to stop to avoid dragging the economy into recession.

That debate is only beginning but will become more critical this summer as policy makers gauge how quickly their initial rate increases cause households and firms to slow spending and whether that, in turn, slows the pace of inflation running at levels not seen since the 1980s.

A recent rise in long-term interest rates has done little yet to improve the inflation outlook and left the Fed at a risky juncture – torn between an even more aggressive pace of rate hikes that may push the economy backward, or moving too slowly and allowing an inflationary psychology to take hold.

“Ultimately it’s making a decision … ’this is a path that seems consistent [with controlling inflation]’ … Or judging that it’s not the case,” Chicago Fed President Charles Evans said last week, outlining the struggles Fed officials anticipate in determining how high rates may need to rise to bring inflation back in line with the central bank’s 2-per-cent target.

“It’s a devilishly hard question,” Mr. Evans said.

The current economic expansion depends on Fed policy makers getting the answer right, and not everyone thinks they will.

Former Treasury Secretary Lawrence Summers, who has argued forcefully the Fed waited too long to respond to price increases, recently wrote that inflation this high – last at 6.4 per cent by the Fed’s preferred measure – coupled with low unemployment makes a recession likely within two years.

The Fed will take the next step in its policy shift during a meeting May 3-4 when officials are expected to increase the target policy rate by half a percentage point.

Even the most dovish policy makers, including Mr. Evans, now agree that rate hikes in increments beyond the familiar quarter-point-per-meeting are needed, given the strength of inflation. They also have coalesced around an overall increase of the federal funds rate to at least 2.5 per cent by year end from the near-zero level set to fight the steep but brief recession caused by the coronavirus pandemic.

Consumers, businesses and financial markets have largely taken that much tightening in stride.

But it may not prove enough. Analysts note that periods of high inflation can generate their own momentum, lifting the effective level of rates needed to blunt price increases.

The rate where interest rate increases meaningfully influence the economy “could be higher than it otherwise would be because of what’s going on with inflation, and that’s partly what’s driving them to be more comfortable with going higher, faster,” Nomura Research economist Robert Dent said. “It’s an extremely important debate that will get more attention at the Fed in the next six months.”

At their last meeting in March, the range of rates policy makers projected as appropriate by the end of 2023 ran from 2.1 per cent to 3.6 per cent, a cavernous gap reflecting risks around the pandemic, the Ukraine war and other largely uncontrollable forces, but also pointing to uncertainty over how businesses and consumers might react to higher borrowing costs.

Equity markets have been rocked by volatility in recent days in part, Bank of America economists argued in an analysis, because the berth around possible Fed policy paths is currently so wide, with options contracts indicating the central bank’s policy rate could top out anywhere between 2 per cent and 4.5 per cent over the next two years.

In debating monetary policy Fed officials use a concept known as the “neutral” or “natural” rate of interest to judge whether the rate they set for overnight loans between banks, a key figure that influences borrowing costs more broadly, is encouraging or discouraging economic activity.

Over the long-term it is the rate considered to balance the economy across a number of fronts while maintaining full employment, inflation at the Fed’s target, and output growing at a rate consistent with underlying productivity, demographic and other trends.

Fed officials currently estimate the neutral rate to be around 2.4 per cent and have committed as a group to reach that level “expeditiously” in one of the fastest monetary policy shifts ever undertaken by the U.S. central bank.

But if the next few weeks or months veer from the Fed’s baseline outlook – if consumers alter their spending or businesses begin setting wages and prices differently than anticipated because their own expectations or preferences have shifted – policy makers may have to get more aggressive.

Markets are already betting they will. On Thursday, futures contracts tied to the Fed’s policy rate reflected overwhelming bets on the speediest monetary policy tightening in decades, with traders pricing in a path that would put short-term rates in that watershed 2.25 per cent-2.5 per cent range by September.

As a short-term concept, “neutral” may have moved higher because of the very inflation dynamics the Fed is trying to fight, potentially forcing the central bank to play catch-up. Some, like St. Louis Fed President James Bullard, argue they are in fact already “behind the curve” and may need to move rates faster and higher than planned.

Fed officials want to keep the recovery on track and avoid in particular any large jump in unemployment from the current 3.6 per cent, arguably the strongest job market since the 1950s.

But that means they need to take the edge off some of the current economy’s extremes, be it the 35-per-cent jump in median home prices during the pandemic, or wage increases that Fed Chair Jerome Powell has dubbed “unsustainably hot.”

Inflation data this week will show whether any progress is being made, and the April employment report released next week will provide an update on wage growth.

There is some initial evidence the housing market is beginning to cool as home mortgage rates exceed 5 per cent, compared with around 3 per cent last year.

But the issues around the Fed’s policy path are still far from resolved. Many economists recently raised their estimates of how much the Fed will need to do and look to next week’s meeting for guidance.

The job market and related wage growth remain strong, and unemployment could dip below 3 per cent this year, Jefferies economists projected recently. Consumers so far have been impervious to “Omicron, Ukraine invasion, a spike in gas prices and sharply higher interest rates,” economists Aneta Markowska and Thomas Simons wrote.

For the Fed that could mean pushing rates to more than 4 per cent, a level not seen since before the 2007-to-2009 financial crisis and one that would likely raise recession risks.

“The U.S. economy is climbing the wall of worry,” they wrote, with inflation broadening and the economy’s underlying strength meaning that “the Fed will have to be even more aggressive.”

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