How much more can the Fed tighten policy?

Every summer, the US Federal Reserve (Fed) holds a coveted economic policy symposium in Jackson Hole, Wyoming. It is one of the oldest central bank conferences in the world, bringing together leading economists, bankers, market participants, academics and policy makers to discuss long-term macroeconomic issues.

While the Jackson Hole Symposium is still high on the financial agenda of investors and policymakers, the importance of the event this year was paramount. For the first time in decades, the Jackson Hole Symposium took place during a historic process of political normalization against a background of well-above-target inflation.

US policy rate and inflation

(Federal funds rate, % per year; consumer price index, y/y, %.)

Sources: Gardens, QNB analysis

Importantly, however, the symposium followed a period of speculation about a possible near-term “policy pivot” by the Fed. After months of aggressive monetary tightening with successive interest rate hikes of 75 basis points (bps) each, investors expected policymakers to be less aggressive after the summer period. The view was that US inflation was likely to peak in June and that this peak in inflation would lead to a peak in tightening. In fact, markets have even considered pricing in significant rate cuts towards the end of 2023.

Despite these hopes for a more moderate Fed, the tone of policymakers in Jackson Hole was decidedly “hawkish,” meaning it was geared toward more aggressive tightening rather than a “dovish” policy pivot supporting more rate hikes and liquidity withdrawals . According to Fed Chairman Jerome Powell, progress on inflation is “well below what the Committee needs to see before it can be confident that inflation is falling” and “restoring price stability will likely require maintaining restrictive policy in some time.” In addition, Powell stressed that future rate hike decisions will be data-driven and that another extraordinary 75bp increase “may be appropriate.”

In our view, the Fed would go hawkish, raising rates by 75 basis points in September and 50 basis points in November and December, before a final hike of 25 basis points in early 2023. then had to pause to reach a final interest rate of 4.25-4.5%. Three main reasons support our view on policy rates.

First, even if US inflation slows significantly, it will still be well above the 2% target. In the past, whenever US inflation exceeded the 5% mark, the problem of price spirals could not be brought under control until policy rates were raised sharply to at least as high as the peak of inflation. We do not see policy rates moving past the likely “peak inflation” of 9.1% in June this year, but the 3.8% final rate currently priced in by the market looks far too optimistic.

Second, despite the recent slowdown, the US economy remains robust, allowing for more aggressive monetary tightening. The US consumer is particularly healthy, with households showing strong balance sheets with high levels of available cash ($15.8 trillion). This supports strong household spending on services, high levels of private domestic investment and a tight labor market. These conditions are likely to make the Fed even more cautious before suspending its rate hikes.

Third, the current balance of institutional incentives encourages the Fed to be more aggressive, even though higher interest rates risk causing a deeper economic slowdown or financial dislocation. The Fed’s credibility is tarnished by its failure to recognize the extent of the inflationary shock that existed early last year. Therefore, the Fed is still trying to catch up with inflation and trying to restore its credibility on price stability. In other words, the bar for a policy pivot is much higher today than it has been in the monetary policy cycles of the past 40 years. The Fed is unlikely to pause until inflation is significantly lower for some time.

Overall, Fed officials used the Jackson Hole conference to reset market expectations for rate hikes. The Fed is likely to continue leaning to the “hawkish” side in the near term as it strives to restore credibility in an environment where inflation is expected to remain well above target for some time, so that the fundamentals of the US economy will remain relatively solid.

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