The Federal Open Market Committee’s perceptions are moving closer to reality, but members still believe they can achieve a miracle: stamping out high inflation without pushing the economy into a recession.
Before its latest policy announcement on June 15, the policy-setting FOMC projected the federal funds rate would rise to 2% by yearend; now it has moved that up to 3.35% (based on the median central tendency of Fed member expectations).
The Federal Reserve, in other words, has just shifted the “median” yearend federal funds rate expectation up by more than 1 percentage point from its March estimate. That is a substantial move.
The movement in federal funds rates in the central bank’s outlook profile through 2024 have also been substantial. The central tendency range for yearend 2023 when it hits its maximum is 3.6% to 4.1%. Previously, the projected high yearend federal funds rate range was 2.4% to 3.4%. The Fed clearly has lifted the path for rates and moved the rate increases forward.
There will always be arguments over whether interest rates are high enough or rise quickly enough to reduce inflation. For now, the Fed expects rates to increase to a range that seems more realistic given the challenge at hand.
That doesn’t mean the Fed won’t have to do more. The global situation is evolving, and the Russia-Ukraine war keeps open the possibility that inflation conditions could worsen and require more Fed action. Also, China’s adherence to a “zero-Covid” policy could hurt global supply chains longer than expected.
The Fed expects to see the personal-consumption expenditures (PCE) inflation number decline to 2.25% by the end of 2024, close to its long-term target of 2%. Whether inflation acts like this and slows this sharply will depend more on how the economy performs in the face of this policy move.
This is where the Fed’s assessments seem fantastic: The unemployment rate, which didn’t move at the Fed’s previous Summary of Economic Projections in March, is now expected to rise to a midpoint high of 4%, with the highest of the central tendency rates at only 4.1%. This seems unlikely. The risk of rising unemployment surely is greater than that, especially if it slows inflation.
Before this meeting, Federal Reserve Gov. Christopher Waller had said he would consider it a “masterful performance” if the central bank could hold the rise in the unemployment rate to 4.25%.
Is the Fed playing three-card monte with the outlook for recession? A well-known economic metric is that a rise in the unemployment rate of more than 0.5 percentage point is a very reliable signal for recession. The Fed has avoided signaling a recession by holding the level of its projected unemployment rate below 4.2%. It keeps the view that it can raise rates sharply and bring inflation down significantly without causing a recession.
How a policy can affect prices and lower inflation without hitting demand hard (GDP and employment) remains a bit of a mystery/miracle. It isn’t the same “loaves and fishes” miracle from March when the unemployment rate didn’t rise at all. But it is a large drop for inflation that clearly isn’t caused by a rise in the unemployment rate.
The Fed must have a view that rising interest rates can, and do, cut demand faster than they affect unemployment. This is the weak part of the Fed’s outlook. The real federal funds rate is still negative at yearend 2022 and it only gets to a peak of 1.1% at the end of 2023. How does it manage to do all that work?
As long as the Fed fails to look the problem in the eye by putting politics and political pressure aside, we will have a hard time taking the whole of the Fed’s presentation as truthful.
The problem isn’t just that the projected rise in the unemployment rate is so low; it is that no one in the central tendency has an unemployment rate at any yearend higher than 4.1%. FOMC members clearly don’t want to trigger recession signals. There are also the looming midyear elections: No one wants to think of starting a recession before that.
‘Masterful’ policy in the making?
The rate forecasts in the Summary of Economic Projections are at odds with the clear, plain-spoken comment by Waller a week or so ago that keeping the unemployment rate from going above 4.2% would be a masterful performance.
Every FOMC member expects to make masterful policy despite the committee’s stumbling since it began raising interest rates in 2015. That year, the Fed decided to make policy based on its own models and expectations. The Fed called it a “bygones” policy in which it was so sure of its own abilities that it didn’t look back at past errors.
When the Fed raised rates at every meeting in 2017 and 2018, the core and headline PCEs reached 2% or more only about one-quarter of the time, falling short of the target 75% of the time.
Then in 2020 the Fed adopted its new employment-centric approach, and that fostered this inflation. Why do any Fed members have any confidence in their ability to make adequate — let alone excellent — policy?
The Fed still has a lot to prove to us. Still, it is making progress. But you will still hear from a lot of detractors in the wake of this decision. The FOMC continues to think it can draw to an inside straight and win.
Robert Brusca is chief economist of FAO Economics.