Powell underscored this point during a press conference following the Fed's decision to maintain its benchmark interest rate at the highest level seen in 22 years.
Is the Fed Picturing a Rosy Outlook?
The question now arises: Is the Fed crafting an optimistic outlook? Jerome Powell has indicated that he has not yet determined whether there will be further interest rate hikes following a series of remarkably swift rate increases over the past 18 months. The Fed is awaiting concrete evidence that the recent deceleration in inflation is a sustained trend.
During the Jackson Hole conference of central banks in August, Powell concluded his address with the statement, "We are navigating by the stars under a cloudy sky." Perhaps because of the persistently uncertain economic climate, he has, on Wednesday, stressed the need for caution on six separate occasions.
Despite maintaining a tight monetary policy, the Fed anticipates that economic growth will continue to be robust, and the unemployment rate is not expected to experience significant increases. Forecasts suggest that the Fed is leaning toward a "higher for longer" approach to interest rates. In fact, the Fed appears more confident now than it did in June that it can curb inflation to reach its 2% target without triggering a sharp economic downturn—a scenario often referred to as a "soft landing."
Mr. Powell remarked, "Overall, stronger economic activity means we need to exercise more discretion with regard to interest rates," when questioned about the outlook for fewer interest rate cuts in the coming year, despite the trajectory of inflation. Expected growth is improving compared to what was projected in June.
Forecasts indicate that core inflation, which excludes food and energy prices, will decline to 3.7% by the end of this year, followed by further reductions to 2.6% and 2.3% in 2024 and 2025, respectively. Concurrently, the labor market has shown signs of modest softening. In July, the worker quit rate—often seen as an indicator of employees' bargaining power when they leave for better-paying positions—decreased and is returning to levels seen before the pandemic.
The Four Key Challenges Confronting the Fed
The Federal Reserve (Fed) faces a set of four significant challenges as it navigates the complex terrain of monetary policy. While an ideal scenario for central banks would involve a smooth and controlled economic transition, historical data suggests that achieving this outcome is an exceptional feat, often requiring a good deal of luck. Since World War II, the United States has experienced only one instance of a sustained soft landing, which occurred in 1995. This unique success story was confronted with four key hurdles that provide valuable insights into the challenges facing the Fed today.
Firstly, the issue of interest rates being too high for an extended period must be addressed. In the 1995 soft landing, the Fed doubled interest rates to 6% within a span of 12 months. However, recognizing the potential repercussions of their aggressive approach, they subsequently reduced interest rates three times consecutively.
Secondly, the specter of economic acceleration looms as consumer spending and business activity show signs of resurgence following a period of slowdown last year. If this trend persists, the Fed may perceive a risk of terminating disinflation, potentially necessitating higher interest rates and thereby increasing the likelihood of a recession.
Thirdly, the challenge of rising energy prices is on the horizon. Historically, the Fed has not had to contend with an energy price shock during its interest rate hikes. However, in the current environment, the Fed may require a stroke of luck as elevated gas prices threaten to disrupt the previously stable inflation expectations. As of late, benchmark U.S. crude oil futures have surged by nearly 30% since June, closing at around USD 91 per barrel.
Lastly, the Fed must remain vigilant regarding incidents in the financial markets. The U.S. economy could be susceptible to market fissures or geopolitical crises. Jamie Dimon, CEO of JPMorgan Chase, has cautioned that a further 0.5% interest rate increase could place added strain on the banking and real estate sectors. He also sounded alarms about the growing U.S. budget deficit, even as it garners investor funding. Simultaneously, the Fed is reducing its asset portfolio, which comprises approximately USD 8.1 trillion in government bonds. This move continues to drive up government bond yields, heightening the risk of a banking crisis, akin to the occurrence of three U.S. bank bankruptcies in March earlier this year. The yield on 2-year Treasury bonds has climbed to 5.118%, marking its highest level since 2006.
Extending the cycle of rate hikes by maintaining higher interest rates for an extended duration becomes a logical approach when policymakers are grappling with the underlying reasons behind falling inflation. One of the critical factors that the Fed needs to consider in this context is the notion of neutral interest rates. However, the challenge lies in the fact that the neutral interest rate cannot be directly observed but rather inferred from the economy's response to specific interest rate levels.
If current interest rates fail to dampen demand or inflation, the Fed deduces that the neutral interest rate is presently higher than in the past, leading to the conclusion that monetary policy is not in a tightening phase. Powell acknowledged this uncertainty by stating that the economy and labor market have remained resilient despite interest rates ranging between 5.25% and 5.5%, citing an increase in the neutral rate, albeit with the caveat, "We do not know that."
Banks' Pursuit of the Fed Ends in Frustration
Banks are in a frenzied pursuit of the Federal Reserve, and the outlook appears increasingly grim when we cast our gaze worldwide. Central banks across the globe seem to be approaching the culmination of their interest rate hike campaigns, yet the economic toll of the battle against inflation is only beginning to reveal itself. There are ominous indications that Europe could be among the regions hardest hit by these consequences.
The recent surge in interest rates in Europe stands as an unprecedented exercise in terms of both scale and speed. Borrowing costs have soared to levels unseen during previous periods of similar duration. Many forecasts suggest that the prospect of interest rate cuts remains distant, possibly not until 2024 or even later. Dario Perkins, an economist at TS Lombard, astutely noted, "Maybe the Fed has taken things too far, but Europe has chased the Fed to a point where the economy struggles to coexist with high interest rates."
In the global context, the economy cooled off in the three months leading to June, and there are scant signs of recovery beyond the borders of the United States. While China's economic woes have triggered concerns of a worldwide recession, Europe faces the ominous prospect of a substantial and abrupt contraction. Despite some progress in overcoming the energy crisis stemming from the Russia-Ukraine conflict, the headwinds created by elevated interest rates prove to be an insurmountable challenge. Surveys conducted in September among European purchasing managers for manufacturing and service providers revealed a clear trend of slowing economic activity. These reports suggest that, as of September, the European economy has been in a recession for three consecutive months.
Research by economists at the International Monetary Fund, published in early September, underscores the need for a sustained period of tight monetary policy to effectively address past inflation shocks—averaging around three years. In over a hundred instances of inflation shocks observed worldwide, central banks have often been criticized for "celebrating too soon" by prematurely easing policy when inflation initially receded.
Despite advocating for a balanced approach, the IMF ultimately concludes that maintaining interest rates at relatively high levels is the appropriate course of action following an inflation shock. Even within their forecasts and statements, certain economists at the Federal Reserve have hinted at the possibility of not only higher interest rates for an extended duration but potentially indefinitely. This perspective is rooted in the observation that the neutral interest rate, which aids in preserving long-term stability in inflation and unemployment, has increased by approximately 1% compared to the period of the global financial crisis. If this holds true, U.S. interest rates are poised to remain elevated for an extended period, potentially exacerbating currency volatility in emerging economies.
It appears that, much like the Federal Reserve, a majority of central banks worldwide are navigating their policies by the guidance of celestial bodies in a sky clouded with uncertainty.
