By Howard Schneider
(Reuters) -The Federal Reserve’s latest financial stability report was good news for anyone worried that a record run of interest rate hikes might overstress the banking system or trigger a recession with companies and households pushed into default through a broad credit crackdown.
None of that is happening.
Instead, the Fed is wrestling with an economy that has sloughed off tight monetary policy to such a degree that U.S. central bank officials are without a clear view of what to expect and divided over issues like productivity, the economy’s underlying potential, and even whether the current policy interest rate is as restrictive as imagined when they called off further hikes.
New gross domestic product figures released on Thursday highlighted the dilemma, with the economy growing just 1.6% over the first three months of the year, below expectations and a marked slowdown from the 3.4% registered in the fourth quarter of 2023. It was the first reading below the Fed’s 1.8% estimate of the economy’s potential since the second quarter of 2022.
Yet inflation, as measured by the personal consumption expenditures (PCE) price index, came in at 3.4% in the first quarter, well above the Fed’s 2% target and a level that could further undermine the case for rate cuts that had been expected to begin early this year but now seem on hold until at least September and perhaps later.
“The Fed is now finding itself caught between a rock and a hard place. The growth numbers suggest monetary policy has worked its magic and the Fed’s foot on the monetary brake can be eased somewhat. But the inflation figures suggest otherwise,” said Stuart Cole, chief macro economist for Equiti Capital in London.
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Across the economy a wave of tight credit seems to have come and gone – bank lending is growing, corporate credit spreads are narrow, and household balance sheets are largely healthy. A recently updated Fed index of overall financial conditions showed there was virtually no impact on economic growth right now from the central bank’s monetary policy or the broader credit conditions it is intended to influence.
Contrary to Fed officials assessment that policy is restrictive, current credit conditions in the economy are “consistent with above-trend growth. That tells me that the transmission of monetary policy to the real economy in the U.S. has been much less effective” than elsewhere, said Joe Kalish, chief global macro strategist at Ned Davis Research.
Fed officials themselves are unsettled on whether they still need the economy to slow for inflation to fall, or whether the “immaculate” influence of productivity and other factors will do the job, an important issue since one view leans towards tighter policy and the other towards easing. The release of key inflation data on Friday is expected to show the Fed’s preferred measure of price pressures remained well above the central bank’s 2% target, a possible sign that progress has stalled.
It is a situation that may have left the Fed professing data-dependence but running largely on intuition in deciding whether the U.S. has found a new equilibrium of higher growth and lower unemployment, or needs more pressure from the central bank to be sure inflation eases.
With doubt about the role of wages in driving inflation, whether more demand needs to be squeezed from the economy, and controversy over the level of interest rates that might do the job, “there is no clear inflation framework and no clear set of parameters to assess the stance of policy,” said Ed Al-Hussainy, a senior analyst with the global rates and currency team at Columbia Threadneedle Investments. “The ‘policy-is-restrictive’ judgment has to come from somewhere … They’ve really struggled to articulate it.”
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NOT AS TIGHT AS THOUGHT
The intellectual shocks have been deep in recent years, from a surprise boost in immigration that bolstered U.S. labor supply to the partial unwinding of globalization and a reallocation of consumer spending towards services. Unlike past tight policy eras the housing market won’t buckle and has been driving inflation of late. There is rekindled concern about the influence of massive federal deficits on financial markets, and open questions about productivity and the “neutral” rate of interest used to guide whether policy is tight or not.
The puzzle: Whether economic potential is higher than thought, with ongoing strong growth possible without high inflation, or whether growth in recent years has been buoyed by a series of “temporary” jolts – from tax cuts during the Trump administration, for example, or federal transfers and infrastructure spending under President Joe Biden – that could mean faster price increases and higher rates of interest.
Joseph H. Davis, global chief economist at Vanguard, said in a recent study that federal debt and an aging population had driven the neutral rate of interest higher by perhaps a percentage point, meaning Fed policy isn’t as tight as thought. That would help explain the ongoing growth, but also make it harder to lower inflation.
“When you zoom out, the evidence is building that the Federal Reserve is not as restrictive as they think,” said Davis, who at this point expects the central bank won’t cut rates at all this year. “You can infer by financial conditions, the labor market, inflation – you look at all three and the neutral rate is higher … If someone had been asleep for 10 years, you’d wonder why there was strong conviction in an easing cycle” given how the economy is performing.
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Fed officials at this point say they are content to wait and see whether the 5.25%-5.50% range set in July coaxes inflation back to the 2% target, and are not contemplating further hikes in the policy rate. With the rate again likely to be held steady at the Fed’s policy meeting next week, observers will look for some clue in either the last Fed statement or in Fed Chair Jerome Powell’s press conference about where things are heading.
Powell may be the first to admit he isn’t sure.
“At some point they sort of threw up their hands and they sort of abandoned the idea that they were going to be able to predict” the path of inflation and the economy given how much is in flux, said Luke Tilley, chief economist at Wilmington Trust.
“They said there would have to be pain … Then they said jobs are good and growth is good, we just want good inflation numbers,” Tilley said. “They are having a very hard time understanding it.”
