A united front among Federal Reserve officials is in danger of splintering as sharper divisions emerge among policymakers over how forcefully to squeeze the economy to tackle inflation, economists have warned.
As the US central bank prepares to slow the pace of interest rate rises next month after one of the most aggressive tightening campaigns of recent times, it is grappling with disagreements over how much more restraint will be needed and the extent to which the economy must suffer.
“It’s a group that likes consensus if they can reach it, but they may not be able to,” said Bill English, former director of the Fed’s division of monetary affairs. “The fundamental issue is that it’s going to be much less clear what they need and want to do with policy.”
On Wednesday Fed watchers will look for more guidance from chair Jay Powell in remarks to be delivered at the Brookings Institution against the backdrop of whipsawing financial markets that have struggled to interpret policy signals from the central bank.
Minutes from the Fed’s last policy meeting in November suggest some officials have taken comfort in data pointing to a slight easing of inflation, while another cohort still appears wary of further upward price pressure — especially stemming from the historically tight labour market.
Andrew Hollenhorst, chief US economist at Citi, said the minutes showed officials no longer unanimously agreed that the risk of doing too little outweighed the risk of doing too much, with some saying the cumulative effect of the Fed’s tightening could “exceed what was required” to bring inflation under control.
“It’s going to be a really different experience analysing the Fed and listening to their public pronouncements because you will have this division”, he said.
Earlier this year, decisions around policymaking were more clear-cut. As it became obvious that inflation was becoming more embedded in the economy, the Fed nearly unanimously decided to jettison its more cautious approach to raising interest rates and ploughed ahead with four consecutive 0.75 percentage point rate rises.
The most recent of these hikes, implemented in November, lifted the federal funds rate to a new target range of 3.75 per cent to 4 per cent — a level officials believe is high enough to begin restraining consumer demand.
However, the Fed has now reached a tricky inflection point where it must decide the degree to which it should begin taking its foot off the brake, amid signs that businesses and consumers are starting to wobble under the weight of rapidly rising borrowing costs.
While officials broadly back a half-point rate rise in December, Mary Daly of the San Francisco Fed has conceded that the coming months would involve a “much more difficult” phase of policymaking.
“The spread of opinion gets wider at turning points. Some people are more eager to jump on [them] as evidence of something sustainable than others,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.
“At the moment, I think it’s no more than fraying at the edges, but I would expect over the next few months that disagreements probably will become more widespread,” he added.
At the root of these divisions is a simmering debate about the trajectory of inflation. Commodity prices and housing costs have already plummeted from their peaks, while goods prices have started to ease, but those tied to services sectors remain stubbornly high.
Retail margins have also declined as companies mark down products to clear excess inventory, a process vice-chair Lael Brainard has said could “meaningfully” help reduce inflationary pressures. Meanwhile, wage growth, although far exceeding the Fed’s 2 per cent target, has begun to ease, according to some metrics.
Among the most vocal officials warning against wishful thinking over inflation have been Loretta Mester of the Cleveland Fed and governor Christopher Waller, who have argued the central bank needs to see much stronger evidence that price pressures are easing to be sure it has inflation under control.
They, along with James Bullard of St Louis and Neel Kashkari of Minneapolis, have said the Fed is not yet close to pausing its rate rises.
While Brainard has also said the Fed has more work ahead, she was an early advocate for slowing the pace of rate rises and has consistently warned about international spillovers from the central bank’s tightening campaign.
Susan Collins, president of the Boston Fed, echoed this sentiment earlier this month, saying: “As rates get higher, the concerns that we might go too high do increase.”
Complicating officials’ assessment of the economy is the fact that rate rises impact different sectors by different magnitudes at different times. Disruptions from the coronavirus pandemic and the war in Ukraine have damaged “faith” in their own inflation forecasts, said Ray Farris, a chief economist at Credit Suisse.
That has led to a reliance on backwards-looking data as officials try to decide how restrictive they need to be and how long they should maintain rates at a given level, he added.
Most economists believe the funds rate will need to surpass 5 per cent next year for the US central bank to sufficiently cool down the economy, with many also forecasting a mild recession. Despite protestations from officials, including John Williams at the New York Fed this week, traders in fed funds futures markets still say the central bank will slash rates in the latter half of next year.
With data likely to become even more mixed over the coming months, English, who is now at Yale University, expects at least a “dissent or two” over future rate decisions as the faultlines between Fed officials deepen.
“There’s always a risk when there’s a lot of communication from a lot of different committee participants, that you have a cacophony problem,” he said. “On the other hand, if there’s genuine uncertainty and genuine disagreement across the participants, it’s probably helpful to have that be known by the public.”
