Tag: federal funds rate

Consumer Price Inflation Comes in Somewhat Higher than Expected

Federal Reserve Chair Jerome Powell (Photo from Bloomberg News via the Wall Street Journal.)

Economists, policymakers, and Wall Street analysts have been waiting for macroeconomic data to confirm that the Federal Reserve has brought the U.S. economy in for a soft landing, with inflation arrving back at the Fed’s target of 2 percent without the economy slipping into a recession. Fed officials have been cautious about declaring that they have yet seen sufficient data to be sure that a soft landing has actually been achieved. Accordingly, they are not yet willing to begin cutting their target for the federal funds rate.

For instance, on March 6, in testifying before the Commitee on Financial Services of the U.S. House of Representatives, Fed Chair Jerome Powell stated that the Fed’s Federal Open Market Committee (FOMC) “does not expect that it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” (Powell’s statement before his testimony can be found here.)

The BLS’s release today (March 12) of its report on the consumer price index (CPI) (found here) for February indicated that inflation was still running higher than the Fed’s target, reinforcing the cautious approach that Powell and other members of the FOMC have been taking. The increase in the CPI that includes the prices of all goods and services in the market basket—often called headline inflation—was 3.2 percent from the same month in 2023, up slightly from 3.1  In January. (We discuss how the BLS constructs the CPI in Macroeconomics, Chapter 9, Section 19.4, Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 3, Section 13.4.) As the following figure shows, core inflation—which excludes the prices of food and energy—was 3.8 percent, down slightly from 3.9 percent in January.

If we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—the values are more concerning, as indicated in the following figure. Headline CPI inflation is 5.4 percent (up from 3.7 percent in January) and core CPI inflation is 4.4 percent (although that is down from 4.8 percent in January). The Fed’s inflation target is measured using the personal consumption expenditures (PCE) price index, not the CPI. But CPI inflation at these levels is not consistent with PCE inflation of only 2 percent.

Even more concerning is the path of inflation in the prices of services. As we’ve noted in earlier posts, Chair Powell has emphasized that as supply chain problems have gradually been resolved, inflation in the prices of goods has been rapidly declining. But inflaion in services hasn’t declined nearly as much. Last summer he stated the point this way:

“Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability.”

The following figure shows the 1-month inflation rate in services prices and in services prices not included including housing rent. Some economists believe that the rent component of the CPI isn’t well measured and can be volatile, so it’s worthwhile to look at inflation in service prices not including rent. The figure shows that inflation in all service prices has been above 4 percent in every month since July 2023. Although inflation in service prices declined from January, it was still a very high 5.8 percent in February. Inflation in service prices not including housing rent was even higher at 7.5 percent. Such large increases in the prices of services, if they were to continue, wouldn’t be consistent with the Fed meeting its 2 percent inflation target.

Finally, some economists and policymakers look at median inflation to gain insight into the underlying trend in the inflation rate. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates. As the following figure shows, although median inflation declined in February, it was still high at 4.6 percent and, although median inflation is volatile, the trend has been generally upward since July 2023.

The data in this month’s BLS report on the CPI reinforces the view that the FOMC will not move to cut its target for the federal funds rate in the meeting next week and makes it somewhat less likely that the committee will cut its target at the following meeting on April 30-May 1.

Economists vs. the Market in Predicting the First Cut in the Federal Funds Rate

The meeting room of the FOMC in the Federal Reserve building in Washington, DC.

As we’ve noted in several recent posts, the inflation rate has fallen significantly from its peak in mid-2022, as U.S. economic growth has been slowing and the labor market appears to be less tight, slowing the growth of wages. Some economists and policymakers now believe that by early 2024, inflation will approach the Fed Reserve’s 2 percent inflation target. At that point, the Fed’s Federal Open Market Committee (FOMC) is likely to turn its attention from inflation to making sure that the U.S. economy doesn’t slip into a recession.

Accordingly, both economists and financial market participants have begun to anticipate the point at which the FOMC will begin to cut its target for the federal funds rate. (One note of caution: Fed Chair Jerome Powell has made clear that the FOMC stands ready to further increase its target for the federal funds rate if the inflation rate shows signs of increasing. He made this point most recently on December 1 in a speech at Spelman College in Atlanta.)  There is currently an interesting disagreement between economists and investors over when the FOMC is likely to cut interest rates and by how much. We can see the views of investors reflected in the futures market for federal funds.

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows values after trading of federal funds futures on December 5, 2023.

The probabilities in the chart reflects investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s meeting on March 20, 2024. This meeting is the first after which investors currently expect that the target is likely to be lowered. The target range is currently 5.25 percent to 5.50 percent. The chart indicates that investors assign a probability of 60.2 percent to the FOMC making at least a 0.25 percentage cut in the target rate at the March meeting. 

Looking at the values for federal funds futures after the FOMC’s December 18, 2024 meeting, investors assign a 66.3 percent probability of the committee having reduced its target for the federal funds rate to 4.00 to 4.25 percent of lower. In other words, investors expect that during 2024, the FOMC will have cut its target for the federal funds rate by at least 1.25 percentage points.

Interesingly, according to a survey by the Financial Times, economists disagree with investors’ forecasts of the federal funds rate. According to the survey, which was conducted between December 1 and December 4, nearly two-thirds of economists believe that the FOMC won’t cut its target for the federal funds rate until July 2024 or later. Three-quarters of the economists surveyed believe that the FOMC will cut its target by 0.5 percent point or less during 2024. Fewer than 10 percent of the economists surveyed believe that during 2024 the FOMC will cut its target for the federal funds rate by 1.25 percent or more. (The Financial Times article describing the results of the survey can be found here. A subscription may be requred to read the article.)

So, at least among the economists surveyed by the Financial Times, the consensus is that the FOMC will cut its target for the federal funds rate later and by less than financial markets are indicating. What explains the discrepancy? The main explanation is that economists see inflation being persistently above the Fed’s 2 percent target for longer than do financial market participants. The economists surveyed are also more optimistic that the U.S. economy will avoid a recession in 2024. If a recession occurs, the FOMC is more likely to significantly cut its target than if the economy during 2024 experiences moderate growth in real GDP and the unemployment rate remains low.

One other indication from financial markets that investors expect that the U.S. economy is likely to slow during 2024 is given by movements in the interest rate on the 10-year U.S. Treasury note. As shown in the following figure, from August to October of this year, the interest rate on the 10-year Treasury note rose from less than 4 percent to nearly 5  percent—an unusually large change in such a short period of time. Since then, most of that increase has been reversed with the interest rate on the 10-year Treasury note having fallen below 4.2 percent in early December

The movements in the interest rate on the 10-year Treasury note typically reflect investors’ expectations of future short-term interest rates. (We discuss the relationship between short-term and long-term interests rates—which economists call the term structure of interest rates—in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The increase in the 10-year interest rate between August and October reflected investors’ expectation that short-term interest rates were likely to remain persistently high for a considerable period—perhaps several years or more. The decline in the 10-year rate from late October to early December reflects investors changing their expectations toward future short-term interest rates being lower than they had previously thought. Again, as in the data on federal funds rate futures, investors seem to be expecting either slower economic growth or slower inflation than do economists.

One other complication about the interest rate on the 10-year Treasury note should be mentioned. Some of the increase in the rate from August to October may also have represented concern among investors that large federal budget deficit would cause the Treasury to issue more Treasury notes than investors would be willing to buy without the Treasury increasing the interest rate investors would receive on the newly issued notes. This concern may have been reinforced by data showing that foreign investors, particularly in China and Japan, appeared to have slowed or stopped adding to their holdings of Treasury notes. Part of the recent decline in the interest rate on the Treasury note may reflect investors becoming less concerned about these two factors.

Powell at Jackson Hole: No Change to Fed’s Inflation Target

Federal Reserve Chair Jerome Powell at Jackson Hole, Wyoming, August 2023 (Photo from the Associated Press.)

Congress has given the Federal Reserve a dual mandate to achieve price stability and high employment. To reach its goal of price stability, the Fed has set an inflation target of 2 percent, with inflation being measured by the percentage change in the personal consumption expenditures (PCE) price index.

It’s reasonable to ask whether “price stability” is achieved only when the price level is constant—that is, at a zero inflation rate. In practice, Congress has given the Fed wide latitude in deciding when price stability and high employment has been achieved.  The Fed didn’t announce a formal inflation target of 2 percent until 2012. But the members of the Federal Open Market Committee (FOMC) had agreed to set a 2 percent inflation target much earlier—in 1996—although they didn’t publicly announce it at the time. (The transcript of the FOMC’s July 2-3, 1996 meeting includes a discussion of the FOMC’s decision to adopt an inflation target.) Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.

But why did the Fed decide on an inflation target of 2 percent rather than 0 percent, 1 percent, 3 percent, or some other rate? There are three key reasons:

  1. As we discuss in Macroeconomics, Chapter 9, Section 9.4 (Economics, Chapter 19, Section 29.4 and Essentials of Economics, Chapter 13, Section 13.4), price indexes overstate the actual inflation rate by 0.5 percentage point to 1 percentage point. So, a measured inflation of 2 percent corresponds to an actual inflation rate of 1 to 1.5 percent.
  2. As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), the FOMC has a target for the long-run real federal funds rate. Although the target has been as high as 2 percent, in recent years it has been 0.5 percent.  With an inflation target of 2 percent, the long-run nominal federal funds rate target is 2.5 percent. (The FOMC’s long-run target federall funds target can be found in the Summary of Economic Projections here.) As the Fed notes, with an inflation target of less than 2 percent “there would be less room to cut interest rates to boost employment during an economic downturn.”
  3. An inflation target of less than 2 percent would make it more likely that during recessions, the U.S. economy might experience deflation, or a period during which the price level is falling.  Deflation can be damaging if falling prices cause consumers to postpone purchases in the hope of being able to buy goods and services at lower prices in the future. The resulting decline in aggregate demand can make a recession worse. In addition, deflation increases the real interest rate associated with a given nominal interest rate, imposing costs on borrowers, particularly if the deflation is unexpected.

The following figure shows that for most of the period from late 2008 until the spring of 2021, the inflation rate as measured by the PCE was below the Fed’s 2 percent target. Beginning in the spring of 2021, inflation soared, reaching a peak of 7.0 percent in June 2022. Inflation declined over the following year, falling to 3.0 in June 2023. 

On August 25, at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming, Fed Chair Jerome Powell made clear that the Fed intended to continue a restrictive monetary policy until the inflation rate had returned to 2 percent: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.” (The text of Powell’s speech can be found here.) Some economists have been arguing that once the Fed had succeeded in pushing the inflation rate back to 2 percent it should, in the future, consider raising its inflation target to 3 percent. At Jackson Hole, Powell appeared to rule out this possibility: “Two percent is and will remain our inflation target.”

Why might a 3 percent inflation target be preferrable to a 2 percent inflation target? Proponents of the change point to two key advantages:

  1. Reducing the likelihood of monetary policy being constrained by the zero lower bound. Because the federal funds rate can’t be negative, zero provides a lower bound on how much the FOMC can cut its federal funds rate target in a recession. Monetary policy was constrained by the zero lower bound during both the Great Recession of 2007–2009 and the Covid recession of 2020. Because an inflation target of 3 percent could likely be achieved with a federal funds rate that is higher than the FOMC’s current long-run target of 2.5 percent, the FOMC should have more room to cut its target during a recession.
  2. During a recession, firms attempting to reduce costs can do so by cutting workers’ nominal wages. But, as we discuss in Macroeconomics, Chapter 13, Section 13.2 (Economics, Chapter 23, Section 23.2 and Essentials of Economics, Chapter 15, Section 15.2), most workers dislike wage cuts. Some workers will quit rather than accept a wage cut and the productivity of workers who remain may decline. As a result, firms often use a policy of freezing wages rather than cutting them. Freezing nominal wages when inflation is occurring results in cuts to real wages.  The higher the inflation rate, the greater the decline in real wages and the more firms can reduce their labor costs without laying off workers.

Why would Powell rule out increasing the Fed’s target for the inflation rate? Although he didn’t spell out the reasons in his Jackson Hole speech, these are two main points usually raised by those who favor keeping the target at 2 percent:

  1. A target rate above 2 percent would be inconsistent with the price stability component of the Fed’s dual mandate. During the years between 2008 and 2021 when the inflation rate was usually at or below 2 percent, most consumers, workers, and firms found the inflation rate to be low enough that it could be safely ignored. A rate of 3 percent, though, causes money to lose its purchasing power more quickly and makes it less likely that people will ignore it. To reduce the effects of inflation people are likely to spend resources in ways such as firms reprinting menus or price lists more frequently or labor unions negotiating for higher wages in multiyear wage contracts. The resources devoted to avoiding the negative effects of inflation represent an efficiency loss to the economy.
  2. Raising the target for the inflation rate might undermine the Fed’s credibility in fighting inflation. One of the reasons that the Fed was able to bring down the inflation rate without causing a recession—at least through August 2023—was that the expectations of workers, firms, and investors remained firmly anchored. That is, there was a general expectation that the Fed would ultimately succeed in bringing the inflation back down to 2 percent. If expectations of inflation become unanchored, fighting inflation becomes harder because workers, firms, and investors are more likely to take actions that contribute to inflation. For instance, lenders won’t assume that inflation will be 2 percent in the future and so will require higher nominal interest rates on loans. Workers will press for higher nominal wages to protect themselves from the effects of higher inflation, thereby raising firms’ costs. Raising its inflation target to 3 percent may also cause workers, firms, and investors to question whether during a future period of high inflation the Fed will raise its target to an even higher rate. If that happens, inflation may be more persistent than it was during 2022 and 2023.

It seems unlikely that the Fed will raise its target for the inflation rate in the near future. But the Fed is scheduled to review its current monetary policy strategy in 2025. It’s possible that as part of that review, the Fed may revisit the issue of its inflation target.  

Is the U.S. Economy Coming in for a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from Bloomberg News via the Wall Street Journal.)

The key macroeconomic question of the past two years is whether the Federal Reserve could bring down the high inflation rate without triggering a recession. In this blog post from back in February, we described the three likely macroeconomic outcomes as:

  1. A soft landing—inflation returns to the Fed’s 2 percent target without a recession occurring.
  2. A hard landing—inflation returns to the Fed’s 2 percent target with a recession occurring.
  3. No landing—inflation remains above the Fed’s 2 percent target but no recession occurs.

The following figure shows inflation measured as the percentage change in the personal consumption expenditures (PCE) price index and in the core PCE, which excludes food and energy prices. Recall that the Fed uses inflation as measured by the PCE to determine whether it is hitting its inflation target of 2 percent. Because food and energy prices tend to be volatile, many economists inside and outside of the Fed use the core PCE to better judge the underlying rate of inflation—in other words, the inflation rate likely to persist in at least the near future.

The figure shows that inflation first began to rise above the Fed’s target in March 2021. Most members of the Federal Open Market Committee (FOMC) believed that the inflation was caused by temporary disruptions to supply chains caused by the effects of the Covid–19 pandemic. Accordingly, the FOMC didn’t raise its target for the federal funds from 0 to 0.25 percent until March 2022. Since March 2022, the FOMC has raised its target for the federal funds rate in a series of steps until the target range reached 5.25 to 5.50 percent following the FOMC’s July 26, 2023 meeting.

PCE inflation peaked at 7.0 percent in June 2022 and had fallen to 2.9 percent in June 2023. Core PCE had a lower and earlier peak of 5.4 percent in February 2023, but had experienced a smaller decline—to 4.1 percent in June 2023. Inflation as measured by the consumer price index (CPI) followed a similar pattern, as shown in the following figure. Inflation measured by core CPI reached a lower peak than did inflation measured by the CPI and declined by less through June 2023.

As inflation has been falling since mid-2022, , the unemployment rate has remained low and the employment-population ratio for prime-age workers (workers aged 25 to 54) has risen above its 2019 pre-pandemic peak, as the following two figures show.

So, the Fed seems to be well on its way to achieving a soft landing. But in the press conference following the July 26 FOMC meeting Chair Jerome Powell was cautious in summarizing the inflation situation:

“Inflation has moderated somewhat since the middle of last year. Nonetheless, the process of getting inflation back down to 2 percent has a long way to go. Despite elevated inflation, longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.”

By “longer-term expectations appear to remain well anchored,” Powell was referring to the fact that households, firms, and investors appear to be expecting that the inflation rate will decline over the following year to the Fed’s 2 percent target.

Those economists who still believe that there is a good chance of a recession occuring during the next year have tended to focus on the following three points:

1. As shown in the following two figures, the labor market remains tight, with wage increases remaining high—although slowing in recent months—and the ratio of job openings to the number of unemployed workers remaining at historic levels—although that ratio has also been declining in recent months. If the labor market remains very tight, wages may continue to rise at a rate that isn’t consistent with 2 percent inflation. In that case, the FOMC may have to persist in raising its target for the federal funds rate, increasing the chances for a recession.

2. The lagged effect of the Fed’s contractionary monetary policy over the past year—increases in the target for the federal funds rate and quantitative tightening (allowing the Fed’s holdings of Treasury securites and mortgage-backed securities to decline; a process of quantitative tightening (QT))—may have a significant negative effect on the growth of aggegate demand in the coming months. Economists disagree on the extent to which monetary policy has lagged effects on the economy. Some economists believe that lags in policy have been significantly reduced in recent years, while other economists believe the lags are still substantial. The lagged effects of monetary policy, if sufficiently large, may be enough to push the economy into a recession.

3. The economies of key trading partners, including the European Union, the United Kingdom, China, and Japan are either growing more slowly than in the previous year or are in recession. The result could be a decline in net exports, which have been contributing to the growth of aggregate demand since early 2021.

In summary, we can say that in early August 2023, the probability of the Fed bringing off a soft landing has increased compared with the situation in mid-2022 or even at the beginning of 2023. But problems can still arise before the plane is safely on the ground.

The Fed Continues to Walk a Tightrope

Photo from the Associated Press of Fed Chair Jerome Powell at a news conference

At its Wednesday, May 3, 2023 meeting, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate by 0.25 percentage point to a range of 5.00 to 5.25.  The decision by the committee’s 11 voting members was unanimous. After each meeting, the FOMC releases a statement (the statement for this meeting can be found here) explaining its reasons for its actions at the meeting. 

The statement for this meeting had a key change from the statement the committee issued after its last meeting on March 22. The previous statement (found here) included this sentence:

“The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”

In the statement for this meeting, the committee rewrote that sentence to read:

“In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

This change indicates that the FOMC has stopped—or at least suspended—use of forward guidance.  As we explain in Money, Banking, and the Financial System, Chapter 15, Section 5.2, forward guidance refers to statements by the FOMC about how it will conduct monetary policy in the future.

After the March meeting, the committee was providing investors, firms, and households with the forward guidance that it intended to continue raising its target for the federal funds rate—which is what the reference to “additional policy firming” means. The statement after the May meeting indicated that the committee was no longer giving guidance about future changes in its target for the federal funds rate other than to state that it would depend on the future state of the economy.  In other words, the committee was indicating that it might not raise its target for the federal funds rate after its next meeting on June 14. The committee didn’t indicate directly that it was pausing further increases in the federal funds rate but indicated that pausing further increases was a possible outcome.

Following the end of the meeting, Fed Chair Jerome Powell conducted a press conference. Although not yet available when this post was written, a transcript will be posted to the Fed’s website here. Powell made the following points in response to questions:

  1.  He was not willing to move beyond the formal statement to indicate that the committee would pause further rate increases. 
  2. He believed that the bank runs that had led to the closure and sale of Silicon Valley Bank, Signature Bank, and First Republic Bank were likely to be over.  He didn’t believe that other regional banks were likely to experience runs. He indicated that the Fed needed to adjust its regulatory and supervisory actions to help ensure that similar runs didn’t happen in the future.
  3. He repeated that he believed that the Fed could achieve its target inflation rate of 2 percent without the U.S. economy experiencing a recession. In other words, he believed that a soft landing was still possible. He acknowledged that some other members of the committee and the committee’s staff economist disagreed with him and expected a mild recession to occur later this year.
  4. He stated that as banks have attempted to become more liquid following the failure of the three regional banks, they have reduced the volume of loans they are making. This credit contraction has an effect on the economy similar to that of an increase in the federal funds rate in that increases in the target for the federal funds rate are also intended to reduce demand for goods, such as housing and business fixed investment, that depend on borrowing. He noted that both those sectors had been contracting in recent months, slowing the economy and potentially reducing the inflation rate.
  5. He indicated that although inflation had declined somewhat during the past year, it was still well above the Fed’s target. He mentioned that wage increases were still higher than is consistent with an inflation rate of 2 percent. In response to a question, he indicated that if the inflation rate were to fall from current rates above 4 percent to 3 percent, the FOMC would not be satisfied to accept that rate. In other words, the FOMC still had a firm target rate of 2 percent.

In summary, the FOMC finds itself in the same situation it has been in since it began raising its target for the federal funds rate in March 2022: Trying to bring high inflation rates back down to its 2 percent target without causing the U.S. economy to experience a significant recession. 

Is a Soft Landing More Likely Now?

Photo from the Wall Street Journal.

The Federal Reserve’s goal has been to end the current period of high inflation by bringing the economy in for a soft landing—reducing the inflation rate to closer to the Fed’s 2 percent target while avoiding a recession. Although Fed Chair Jerome Powell has said repeatedly during the last year that he expected the Fed would achieve a soft landing, many economists have been much more doubtful.

It’s possible to read recent economic data as indicating that it’s more likely that the economy is approaching a soft landing, but there is clearly still a great deal of uncertainty. On April 12, the Bureau of Labor Statistics released the latest CPI data. The figure below shows the inflation rate as measured by the CPI (blue line) and by core CPI—which excludes the prices of food and fuel (red line). In both cases the inflation rate is the percentage change from the same month in the previous year. 

The inflation rate as measured by the CPI has been trending down since it hit a peak of 8.9 percent in June 2022. The inflation rate as measured by core CPI has been trending down more gradually since it reached a peak of 6.6 percent in September 2022. In March, it was up slightly to 5.6 percent from 5.5 percent in February.

As the following figure shows, payroll employment while still increasing, has been increasing more slowly during the past three months—bearing in mind that the payroll employment data are often subject to substantial revisions. The slowing growth in payroll employment is what we would expect with a slowing economy. The goal of the Fed in slowing the economy is, of course, to bring down the inflation rate. That payroll employment is still growing indicates that the economy is likely not yet in a recession.

The slowing in employment growth has been matched by slowing wage growth, as measured by the percentage change in average hourly earnings. As the following figure shows, the rate of increase in average hourly earnings has declined from 5.9 percent in March 2022 to 4.2 percent in March 2023. This decline indicates that businesses are experiencing somewhat lower increases in their labor costs, which may pass through to lower increases in prices.

Credit conditions also indicate a slowing economy As the following figure shows, bank lending to businesses and consumers has declined sharply, partly because banks have experienced an outflow of deposits following the failure of Silicon Valley and Signature Banks and partly because some banks have raised their requirements for households and firms to qualify for loans in anticipation of the economy slowing. In a slowing economy, households and firms are more likely to default on loans. To the extent that consumers and businesses also anticipate the possibility of a recession, they may have reduced their demand for loans.

But such a sharp decline in bank lending may also be an indication that the economy is not just slowing, on its way to a making a soft landing, but is on the verge of a recession. The minutes of the March meeting of the Federal Open Market Committee (FOMC) included the information that the FOMC’s staff economists forceast “at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.” (The minutes can be found here.) The increased chance of a recession was attributed largely to “banking and financial conditions.”

At its next meeting in May, the FOMC will have to decide whether to once more increase its target range for the federal funds rate. The target range is currently 4.75 percent to 5.00 percent. The FOMC will have to decide whether inflation is on a course to fall back to the Fed’s 2 percent target or whether the FOMC needs to further slow the economy by increasing its target range for the federal funds rate. One factor likely to be considered by the FOMC is, as the following figure shows, the sharp difference between the inflation rate in prices of goods (blue line) and the inflation rate in prices of services (red line).

During the period from January 2021 to November 2022, inflation in goods was higher—often much higher—than inflation in services. The high rates of inflation in goods were partly the result of disruptions to supply chains resulting from the Covid-19 pandemic and partly due to a surge in demand for goods as a result of very expansionary fiscal and monetary policies. Since November 2022, inflation in the prices of services has remained high, while inflation in the prices of goods has continued to decline. In March, goods inflation was only 1.6 percent, while services inflation was 7.2 percent. In his press conference following the last FOMC meeting, Fed Chair Jerome Powell stated that as long as services inflation remains high “it would be very premature to declare victory [over inflation] or to think that we’ve really got this.” (The transcript of Powell’s news conference can be found here.) This statement coupled with the latest data on service inflation would seem to indicate that Powell will be in favor of another 0.25 percentage point increase in the federal funds rate target range.

The Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The Bureau of Economic Analysis will release the March PCE on April 28, before the next FOMC meeting. If the Fed is as closely divided as it appears to be over whether additional increases in the federal funds rate target range are necessary, the latest PCE data may prove to have a significan effect on their decision.

So—as usual!—the macroeconomic picture is murky. The economy appears to be slowing and inflation seems to be declining but it’s still difficult to determine whether the Fed will be able to bring inflation back to its 2 percent target without causing a recession.

Why Don’t Financial Markets Believe the Fed?

Fed Chair Jerome Powell holding a news conference following the March 22 meeting of the FOMC. Photo from Reuters via the Wall Street Journal.

On March 22, the Federal Open Market Committee (FOMC) unanimously voted to raise its target for the federal funds rate by 0.25 percentage point to a range of 4.75 percent to 5.00 percent.  The members of the FOMC also made economic projections of the values of certain key economic variables. (We show a table summarizing these projections at the end of this post.) The summary of economic projections includes the following “dot plot” showing each member of the committee’s forecast of the value of the federal funds rate at the end of each of the following years. Each dot represents one member of the committee.

If you focus on the dots above “2023” on the vertical axis, you can see that 17 of the 18 members of the FOMC expect that the federal funds rate will end the year above 5 percent.

In a press conference after the committee meeting, a reporter asked Fed Chair Jerome Powell was asked this question: “Following today’s decision, the [financial] markets have now priced in one more increase in May and then every meeting the rest of this year, they’re pricing in rate cuts.” Powell responded, in part, by saying: “So we published an SEP [Summary of Economic Projections] today, as you will have seen, it shows that basically participants expect relatively slow growth, a gradual rebalancing of supply and demand, and labor market, with inflation moving down gradually. In that most likely case, if that happens, participants don’t see rate cuts this year. They just don’t.” (Emphasis added. The whole transcript of Powell’s press conference can be found here.)

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk–such as a sudden increase in oil prices or in interest rates–and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banks, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart shows values after trading of federal funds futures on March 24, 2023.

The chart shows six possible ranges for the federal funds rate after the FOMC’s last meeting in December 2023. Note that the ranges are given in basis points (bps). Each basis point is one hundredth of a percentage point. So, for instance, the range of 375-400 equals a range of 3.75 percent to 4.00 percent. The numbers at the top of the blue rectangles represent the probability that investors place on that range occurring after the FOMC’s December meeting. So, for instance, the probability of the federal funds rate target being 4.00 percent to 4.25 percent is 28.7 percent. The sum of the probabilities equals 1.

Note that the highest target range given on the chart is 4.50 percent to 4.75 percent. In other words, investors in financial markets are assigning a probability of zero to an outcome that the dot plot shows 17 of 18 FOMC members believe will occur: A federal funds rate greater than 5 percent. This is a striking discrepancy between what the FOMC is announcing it will do and what financial markets think the FOMC will actually do.

In other words, financial markets are indicating that actual Fed policy for the remainder of 2023 will be different from the policy that the Fed is indicating it intends to carry out. Why don’t financial markets believe the Fed? It’s impossible to say with certainty but here are two possibilities:

  1. Markets may believe that the Fed is underestimating the likelihood of an economic recession later this year. If an economic recession occurs, markets assume that the FOMC will have to pivot from increasing its target for the federal funds rate to cutting its target. Markets may be expecting that the banks will cut back more on the credit they offer households and firms as the banks prepare to deal with the possibility that substantial deposit outflows will occur. The resulting credit crunch would likely be enough to push the economy into a recession.
  2. Markets may believe that members of the FOMC are reluctant to publicly indicate that they are prepared to cut rates later this year. The reluctance may come from a fear that if households, investors, and firms believe that the FOMC will soon cut rates, despite continuing high inflation rates, they may cease to believe that the Fed intends to eventually bring the inflation back to its 2 percent target. In Fed jargon, expectations of inflation would cease to be “anchored” at 2 percent. Once expectations become unanchored, higher inflation rates may become embedded in the economy, making the Fed’s job of bringing inflation back to the 2 percent target much harder.

In late December, we can look back and determine whose forecast of the federal funds rate was more accurate–the market’s or the FOMC’s.

The FOMC Splits the Difference with a 0.25 Percentage Point Rate Increase

Photo from the Wall Street Journal.

At the conclusion of its meeting today (March 22, 2023), the Federal Reserve’s Federal Open Market Committee (FOMC) announced that it was raising its target for the federal funds rate from a range of 4.50 percent to 4.75 percent to a range of 4.75 percent to 5.00 percent. As we discussed in this recent blog post, the FOMC was faced with a dilemma. Because the inflation rate had remained stubbornly high at the beginning of this year and consumer spending and employment had been strongly increasing, until a couple of weeks ago, financial markets and many economists had been expecting a 0.50 percentage point (or 50 basis point) increase in the federal funds rate target at this meeting. As the FOMC noted in the statement released at the end of the meeting: “Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low. Inflation remains elevated.”

But increases in the federal funds rate lead to increases in other interest rates, including the interest rates on the Treasury securities and mortgage-backed securities that most banks own. On Friday, March 10, the Federal Deposit Insurance Corporation (FDIC) was forced to close the Silicon Valley Bank (SVB) because the bank had experienced a deposit run that it was unable to meet. The run on SVB was triggered in part by the bank taking a loss on the Treasury securities it sold to raise the funds needed to cover earlier deposit withdrawals. The FDIC also closed New York-based Signature Bank. San Francisco-based First Republic Bank experienced substantial deposit withdrawals, as we discussed in this blog post. In Europe, the Swiss bank Credit Suisse was only saved from failure when Swiss bank regulators arranged for it to be purchased by UBS, another Swiss bank. These problems in the banking system led some economists to urge that the FOMC keep its target for the federal funds rate unchanged at today’s meeting.

Instead, the FOMC took an intermediate course by raising its target for the federal funds rate by 0.25 percentage point rather than by 0.50 percentage point. In a press conference following the announcement, Fed Chair Jerome Powell reinforced the observation from the FOMC statement that: “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” As banks, particularly medium and small banks, have lost deposits, they’ve reduced their lending. This reduced lending can be a particular problem for small-to medium-sized businesses that depend heavily on bank loans to meet their credit needs. Powell noted that the effect of this decline in bank lending on the economy is the equivalent of an increase in the federal funds rate.

The FOMC also released its Summary of Economic Projections (SEP). As Table 1 shows, committee members’ median forecast for the federal funds rate at the end of 2023 is 5.1 percent, indicating that the members do not anticipate more than a single additional 0.25 percentage point increase in the target for the federal funds rate. The members expect a significant increase in the unemployment rate from the current 3.6 percent to 4.5 percent at the end of 2023 as increases in interest rates slow down the growth of aggregate demand. They expect the unemployment rate to remain in that range through the end of 2025 before declining to the long-run rate of 4.0 percent in later years. The members expect the inflation rate as measured by the personal consumption (PCE) price index to decline from 5.4 percent in January to 3.3 percent in December. They expect the inflation rate to be back close to their 2 percent target by the end of 2025.

The Fed’s Latest Dilemma: The Link between Monetary Policy and Financial Stability

AP photo from the Wall Street Journal

Congress has given the Federal Reserve a dual mandate of high employment and price stability. In addition, though, as we discuss in Macroeconomics, Chapter 15, Section 15.1 (Economics, Chapter 25, Section 25.1) and at greater length in Money, Banking, and the Financial System, Chapter 15, Section 15.1, the Fed has other goals, including the stability of financial markets and institutions. 

Since March 2022, the Fed has been rapidly increasing its target for the federal funds rate in order to slow the growth in aggregate demand and bring down the inflation rate, which has been well above the Fed’s target of 2 percent. (We discuss monetary policy in a number of earlier blog posts, including here and here, and in podcasts, the most recent of which (from February) can be found here.) The target federal funds rate has increased from a range of 0 percent to 0.25 percent in March 2022 to a range of 4.5 percent to 4.75 percent. The following figure shows the upper range of the target for the federal funds rate from January 2015 through March 14, 2023.

This morning (Tuesday, March 14, 2023), the Bureau of Labor Statistics (BLS) released its data on the consumer price index for February. The following figure show inflation as measured by the percentage change in the CPI from the same month in the previous year (which is the inflation measurement we use most places in the text) and as the percentage change in core CPI, which excludes prices of food and energy. (The inflation rate computed by the percentage change in the CPI is sometimes referred to as headline inflation.) The figure shows that although inflation has slowed somewhat it is still well above the Fed’s 2 percent target. (Note that, formally, the Fed assesses whether it has achieved its inflation target using changes in the personal consumption expenditures (PCE) price index rather than using changes in the CPI. We discuss issues in measuring inflation in several blog posts, including here and here.)

One drawback to using the percentage change in the CPI from the same month in the previous year is that it reduces the weight of the most recent observations. In the figure below, we show the inflation rate measured by the compounded annual rate of change, which is the value we would get for the inflation rate if that month’s percentage change continued for the following 12 months. Calculated this way, we get a somewhat different picture of inflation. Although headline inflation declines from January to February, core inflation is actually increasing each month from November 2022 when, it equaled 3.8 percent, through February 2023, when it equaled 5.6 percent. Core inflation is generally seen as a better indicator of future inflation than is headline inflation.

The February CPI data are consistent with recent data on PCE inflation, employment growth, and growth in consumer spending in that they show that the Fed’s increases in the target for the federal funds rate haven’t yet caused a slowing of the growth in aggregate demand sufficient to bring the inflation back to the Fed’s target of 2 percent. Until last week, many economists and Wall Street analysts had been expecting that at the next meeting of the Fed’s Federal Open Market Committee (FOMC) on March 21 and 22, the FOMC would raise its target for the federal funds rate by 0.5 percentage points to a range of 5.0 percent to 5.25 percent.

Then on Friday, the Federal Deposit Insurance Corporation (FDIC) was forced to close the Silicon Valley Bank (SVB). As the headline on a column in the Wall Street Journal put it “Fed’s Tightening Plans Collide With SVB Fallout.” That is, the Fed’s focus on price stability would lead it to continue its increases in the target for the federal funds rate. But, as we discuss in this post from Sunday, increases in the federal funds rate lead to increases in other interest rates, including the interests rates on the Treasury securities, mortgage-backed securities, and other securities that most banks own. As interest rates rise, the prices of long-term securities decline. The run on SVB was triggered in part by the bank taking a loss on the Treasury securities it sold to raise the funds needed to cover deposit withdrawals.

Further increases in the target for the federal funds rate could lead to further declines in the prices of long-term securities that banks own, which might make it difficult for banks to meet deposit withdrawals without taking losses on the securities–losses that have the potential to make the banks insolvent, which would cause the FDIC to seize them as it did SVB. The FOMC’s dilemma is whether to keep the target for the federal funds rate unchanged at its next meeting on March 21 and 22, thereby keeping banks from suffering further losses on their bond holdings, or to continue raising the target in pursuit of its mandate to restore price stability.

Some economists were urging the FOMC to pause its increases in the target federal funds rate, others suggested that the FOMC increase the target by only 0.25 percent points rather than by 0.50 percentage points, while others argued that the FOMC should implement a 0.50 increase in order to make further progress toward its mandate of price stability.

Forecasting monetary policy is a risky business, but as of Tuesday afternoon, the likeliest outcome was that the FOMC would opt for a 0.25 percentage point increase. Although on Monday the prices of the stocks of many regional banks had fallen, during Tuesday the prices had rebounded as investors appeared to be concluding that those banks were not likely to experience runs like the one that led to SVB’s closure. Most of these regional banks have many more retail deposits–deposits made be households and small local businesses–than did SVB. Retail depositors are less likely to withdraw funds if they become worried about the solvency of a bank because the depositors have much less than $250,000 in their accounts, which is the maximum covered by the FDIC’s deposit insurance. In addition, on Sunday, the Fed established the Bank Term Funding Program (BTFP), which allows banks to borrow against the holdings of Treasury and mortgage-back securities. The program allows banks to meet deposit withdrawals by borrowing against these securities rather than by having to sell them–as SVB did–and experience losses.

On March 22, we’ll find out how the Fed reacts to the latest dilemma facing monetary policy.

Podcasts Back for Fall 2022! – 9/9/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, cryptocurrency, and also briefly touch on labor markets.