Easing inflation in the US has set the stage for the Federal Reserve to reduce the size of future interest rate rises to 0.25 percentage points, even as central bank officials plan to keep throttling the economy for the rest of this year.
Following data on Thursday showing annual US inflation declining to 6.5 per cent, the lowest consumer price index reading in a year, traders added to their wagers that the Fed would downshift from a half-point rate rise in December to a quarter-point at its next meeting in roughly three weeks.
That would represent a return to normal in one sense, after a string of jumbo 0.75 percentage point rate rises last year heralded one of the most aggressive tightening campaigns in the Fed’s history.
Several central bank officials have recently signalled they would be open to a quarter point increase next time while reminding investors there is a sting in the tail: even if the pace of rises does slow down, they still intend to increase the benchmark rate to more than 5 per cent and keep it there throughout this year.
“If they do raise by only 25, they’re going to use their language to make sure that we know that we’re still far away from victory and that there is still more to come,” said Gargi Chaudhuri, a strategist at BlackRock. “Higher for longer is the theme.”
The reason for the Fed’s caution is that “core” inflation, which strips out volatile food and energy costs, is still far too high and in December it rose by 0.3 per cent compared with the prior month. The headline CPI number fell 0.1 per cent over the same period.
A quarter-point rate rise would lift the target range of the federal funds rate to 4.50 per cent to 4.75 per cent, a level that policymakers deem “sufficiently restrictive”. Most officials say the benchmark rate will eventually need to surpass 5 per cent to constrain the economy and bring inflation back under control.
On Thursday, the odds that the Fed will deliver a quarter-point rate rise when its two-day meeting wraps on February 1 swelled to 93 per cent, according to the CME Group, up from 77 per cent the day prior.
The move came after remarks from Patrick Harker, president of the Philadelphia Fed and a voting member on this year’s Federal Open Market Committee, who said he expects the Fed to raise rates a “few more times this year” and that quarter-point increases are “appropriate going forward”.
By adopting a more gradual approach after a string of larger increases, policymakers hope they can take stock of the impact of previous rate rises that will take time to fully feed through to the real economy and reduce the risk of tightening too much.
“Smaller changes give us more flexibility,” Susan Collins, president of the Boston Fed, said this week as she indicated she is leaning towards a quarter-point increase.
Most officials have yet to explicitly endorse a rate decision for the upcoming meeting, but several have said the smaller option is under serious consideration.
Policymakers at the Fed have said they do not want to inflict unnecessary economic pain, but their chief concern is still that price pressures become even more embedded in the economy if the central bank does too little to tame them.
Jason Thomas, head of global research at Carlyle, said there was a “residual anxiety” within the Fed, adding: “Until they deter that next round of price increases and they really change the psychology back to the sense that price increases result in lost sales and market share they will not have actually achieved their objective.”
Despite a welcome retreat in inflation and signs consumer demand is starting to ebb, the economy on the whole still shows signs of strength — especially the labour market, which continues to add jobs at a robust monthly pace. Wage growth has moderated in recent months, but price increases for a number of services have resulted in fears the Fed does not yet have the situation fully under control.
The Fed has sought to alleviate those concerns by pledging to keep interest rates elevated at least through the end of 2023 and refrain from any rate cuts before 2024.
Ethan Harris, head of global economics research at Bank of America, expects the central bank to underscore that message at its upcoming meeting by directly contradicting market indicators suggesting it stop short of what has been signalled.
Traders in fed funds futures markets continue to wager the central bank will stop just short of its 5 per cent target and deliver half-a-percentage point worth of cuts by the end of the year, which Harris said amounts to a “misreading” of the committee’s hawkishness. Financial conditions have also loosened in recent months as US stocks have rallied alongside government and corporate bond markets.
“For policy to be successful, the markets have to co-operate,” said Harris. “And if they are not co-operating, on the margin you do more, not less.”
