Tag: Monetary Policy

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. 

NEW! 4/29/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss a hard vs. soft landing, the debt ceiling, and an economics view of the CHIPS act passed in 2022.

Join authors Glenn Hubbard & Tony O’Brien as they discuss the state of the landing the economy will achieve – hard vs. soft – or “no landing”. Also, they address the debt ceiling and the barriers it might present to a recovery. We also delve into the Chips Act and what economics has to say about the subsidy of a particular industry. Gain insights into today’s economy through our final podcast of the 2022-2023 academic year! Our discussion covers these points but you can also check for updates on our blog post that can be found HERE .

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.

NEW! 4/8/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the role of small banks in the US financial system in the wake of the recent bank failures.

Join authors Glenn Hubbard and Tony O’Brien as they discuss the future of small banks in the US financial system in the wake of recent bank failures. With a government that is guaranteeing just about all deposits, what is the role of deposit insurance. Small banks serve a real purpose in our economy and will further government regularly only complicate their mission. Other small business rely on small banks for their intimate knowledge of their market and of their business. However, many may now rely on larger banks that may seem a safer place over the next few years. Our discussion covers these points but you can also check for updates on our blog post that can be found HERE .

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.

NEW! 3/13/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the collapse of SVB in the context of a classic bank run. Is it? Listen & find out.

Join authors Glenn Hubbard and Tony O’Brien as they review the collapse of Silicon Valley Bank (SVB) in the context of a classic bank run. What lessons can be learned to avoid other bank collapses in this unchartered economic territory? Will this become a contagion? Or, is it simply an example of a bank searching for additional return in an uncertain economic world? Our discussion covers these points but you can also check for updates on our blog post that can be found HERE.

An Old-Fashioned Bank Run: The Collapse of Silicon Valley Bank [This post will be updated as new information becomes available. Updated Sunday 7:15 pm.]

NEW! 2/19/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the Fed’s response to economic conditions and their ability to execute a soft-landing.

Join author Glenn Hubbard & Tony O’Brien in their first Sprint 2023 podcast where they revisit inflation as the major topic facing our country, our economy, and our classrooms. Glenn & Tony discuss the Federal Reserve response and the outlook for the economy. While rates have continued to move up, is a soft-landing still possible?

NEW! 11/17/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, FTX collapse, and also share thoughts on economics themes in holiday movies!

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.