The Fed talks like a hawk, acts like a dove

The US Federal Reserve Board has, as widely expected, paused what has been the most aggressive rate-hiking cycle in the US since the 1980s, but foreshadowed two more rate rises to come this year. It’s now acting like a dove, but talking like a hawk.

After this week’s two-day meeting of the Fed’s Open Market Committee (FOMC), which sets the federal funds rate (the US equivalent of the Reserve Bank’s cash rate), the Fed has left its target for the rate at 5 to 5.25 per cent, its highest level in 16 years. The decision ends, at least momentarily, a run of 10 consecutive rate rises in 15 months.

“We have covered a lot of ground and the full effects of our tightening have yet to be felt,” Fed chair Jerome Powell said.Credit: Bloomberg

The Fed’s famous “dot plot” – a chart that plots the individual projections of the 18 members of the FOMC – shows, however, that a clear majority expect there to be at least two more 25 basis point hikes before the end of the year. Nine members expect 50 basis points more, two members expect 75 basis points, and one expects 100 basis points.

Fed chair Jerome Powell explained the pause – or, as some have described it, the “skip” in the cycle of rate rises – in terms of two variables: the speed at which the Fed has raised rates versus the level at which they will eventually peak.

“We have covered a lot of ground, and the full effects of our tightening have yet to be felt,” Powell said. “In light of how far we have come in tightening policy, the uncertain lags with which monetary policy affects the economy, and potential headwinds from credit tightening, today we decided to leave our policy interest rate unchanged.”

The RBA and the Bank of Canada similarly paused their rate rises earlier this year, before both resuming rate hikes this month after data showed continuing high rates of inflation.

End in sight

US markets have priced in an expectation that the Fed will do the same at its July meeting, raising the federal funds rate by another 25 basis points, but haven’t yet subscribed to the view of the FOMC majority that there will be more to come beyond July.

Regardless, it is apparent that the Fed is within sight, at least, of the end point in this cycle.

While the median FOMC projection for the federal funds rate at the end of this year is 5.6 per cent (50 basis points higher than projected in March), 15 of the 18 members expect rates to be falling next year, with a median projection for the federal funds rate of 4.6 per cent at the end of next year.

The Fed targets an inflation rate of 2 per cent “over time”. That’s half the headline rate of 4 per cent the US printed in May, which was the lowest in more than two years.

Most of the major central banks have very similar targets, with the RBA targeting a range of 2 to 3 per cent, on average, over time. By saying they target a number or range over time, the banks give themselves some wriggle room.

There’s nothing scientific about the targets. There were no explicit targets until former New Zealand Reserve Bank governor Don Brash was asked on television about the NZ government’s new approach to monetary policy, which targeted inflation specifically after a period of double-digit price growth.

Brash made an off-the-cuff comment that he’d ideally want an inflation rate between zero and 1 per cent, although the RBNZ subsequently raised its explicit target to 2 per cent. The central banks in Canada and Australia followed New Zealand’s lead.

The Fed adopted its 2 per cent target in the late 1990s during Alan Greenspan’s chairmanship but didn’t tell anyone until, with Ben Bernanke as chair, it formally announced it would target the 2 per cent rate.

Arbitrary targets

The targets are, therefore, quite arbitrary and have been consistently questioned.

A higher target would give a central bank more scope to respond to economic downturns with significant rate cuts without necessarily resorting to the unconventional monetary policies that the Americans and Europeans deployed in response to the 2008 financial crisis, and which most advanced economies put in place in response to the pandemic. It might also enable higher economic growth rates.

None of the central banks are going to deviate from their targets publicly for fear of losing credibility, but there is an interesting question as to whether they should.

In this post-2008 and post-pandemic world of record levels of public and private debt, some level of inflation is probably not such a bad thing, whereas if the central banks are too fixated on driving inflation rates down to their targeted levels, they risk creating otherwise avoidable recessions and acute household and business distress. Jobs, investment and economic output would be lost unnecessarily.

The crudeness of the tools the central banks have – essentially interest rates and liquidity – and the 12 to 18-month lags between a policy action and its full effect mean there is a very real risk that there will be policy overkill and unintended and quite unpleasant consequences.

‘Neutral rate’

Inflation targeting is predicated on setting a real interest rate – the so-called “neutral rate” – that balances savings and investment at a level that delivers full employment, within an economy operating at close to its maximum potential, with stable inflation rates.

When real interest rates are below the neutral level they stimulate demand and inflation, and when they are above that level they choke demand, lower growth rates and reduce inflation.

The challenge is that there is no way to precisely calculate a neutral rate.

In the pre-pandemic years there was considerable academic discussion about the long period of minimal inflation, low growth rates and ultra-low interest rates that had set in after the 2008 financial crisis, where policymakers were far more concerned about the threat of deflation than of inflation. With a real interest rate at or below zero, there should have been more growth.

The pandemic threw all the variables up into the air, as central banks and governments threw everything they had at their economies and financial systems. Supply chains were broken, ultimately igniting inflation at levels not seen since the 1980s. A misconceived view by the Fed and its peers that this was a “transitory” phenomenon allowed an inflation breakout.

“Deglobalisation”, the decoupling to some extent of the Western economies from China; re-shoring; “friend-shoring”; trade sanctions; and the war in Ukraine mean that there will be no return to a pre-pandemic “normal”.

There will be a structural element to provide a floor under inflation, at least in the medium term, as activity within the global economy is rearranged.

If inflation at higher than pre-pandemic levels is going to be resilient, should central banks maintain their targets and try to offset those structural pressures by choking all other sources of demand and growth?

Or, perhaps, should they use the wriggle room in their mandates – the “average, over time” escape clause in the RBA’s mandate, for instance, to tolerate inflation moderately above their targets until the transition to the new world order has been completed?

The answer matters for Americans, Australians and others for whom the targets set by their central banks will have significant economic consequences.

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