For Federal Reserve officials who want to get inflation under control, the outlook has certainly improved in recent weeks.
First, inflation has peaked. In particular, goods price inflation is falling as supply chain disruptions ease and demand shifts toward services and away from goods. And even though the labor market remains unusually tight, wage inflation has stabilized rather than continued to climb.
Second, inflation expectations remain remarkably well-anchored. While near-term inflation expectations of households are elevated, longer-term expectations have fallen. Similarly, market-based measures based on the differential between nominal 10-year Treasuries notes and 10-year Treasury-Inflation Protected Securities have also declined.
Third, the Fed’s efforts to guide market expectations about the future path of monetary policy have been, for the most part, effective. Market participants expect that monetary policy makers will move “expeditiously” toward neutral, with 50-basis-point interest rate hikes expected at each of the next two Federal Open Market Committee meetings and the federal funds rate reaching a peak of around 3% next spring, from the current range of 0.75% to 1%. As part of this, Chair Jerome Powell has become more forceful in making it clear that raising rates to “a more normal level” is “not a stopping point. It’s not a looking around point.” The Fed will keep going until there “is really clear and convincing evidence that inflation is coming down,” he added.
Fourth, financial conditions have tightened materially. Prices for U.S. equities have fallen about 15% from their peak in the first week of January, 10-year Treasury note yields have climbed about 1 percentage point in the past three months, credit spreads have widened and the dollar has appreciated. Because tighter financial conditions are the means by which higher short-term rates work to slow economic growth, Fed officials must be pleased that market participants are taking the Fed’s monetary policy tightening campaign more seriously.
Nevertheless, the Fed’s job is far from complete. First, the FOMC needs to be more realistic in its own forecasts about what will be required. In the FOMC’s last Summary of Economic Projections in March, the expected rate of inflation for the end of 2024 magically fell back close to the Fed’s 2% objective even though monetary policy that was not tight enough to push the unemployment rate up to a level that Fed officials judge consistent with stable inflation over time. The forecast posed an open question: If the unemployment rate doesn’t rise materially, then how does inflation fall back to the Fed’s 2% objective?
It will be noteworthy when the SEP projections are updated at the next FOMC meeting in two weeks to see whether participants expect to make monetary policy sufficiently tight, which would mean a median federal funds rate above 3% in order to push the unemployment rate above the 4% level judged consistent with keeping inflation stable at the Fed’s 2% target.
Second, Fed officials and market participants continue to underestimate the level of short-term rates that will be necessary to tighten financial conditions sufficiently to push inflation back down to 2% from the most recent year-over-year reading of 6.3%. If, in the long run, a neutral short-term rate is 2.4% (the FOMC’s median estimate) when inflation is 2%, then the neutral rate should be higher to compensate for the fact that inflation is higher. In addition, given that the Fed’s enlarged $8.9 trillion balance sheet is still providing stimulus—the balance sheet won’t become “neutral” until it shrinks to its desired level in about three years—the neutral short-term rate needs to be higher in the meantime.
Third, the risks of a hard landing continue to be understated. According to Fed officials, monetary policy tightening can slow the economy and eliminate the imbalance between the current supply and demand for labor without precipitating an economic downturn. This assertion flies in the face of economic history. Every time the unemployment rate has climbed by half a percentage point or more, the outcome has been a full-blown recession and a much larger rise in unemployment. Given that the labor market is tighter than it ever has been, the need for the unemployment rate to rise is greater, making the odds of a hard landing higher, not lower.
Finally, as near-term uncertainty about the U.S. monetary policy course has fallen significantly in recent weeks, financial conditions have eased a bit, with stock prices rebounding and bond yields falling. If this easing of financial conditions were to continue, Fed officials would have to respond by pushing short-term rates higher than currently anticipated.
Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.