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The Fed may choose to wait in the first half of 2023 rather than raise rates further, writes Sonia Meskin.
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About the author: Sonya Myskin is Head of US Macro at BNY Mellon Investment Management in the New York office. She previously worked at the International Monetary Fund, Standard Chartered Bank and the Federal Reserve Bank of New York.
The Federal Reserve may soon find itself at a crossroads. The two parts of their mandate, full employment and price stability, are likely to come into conflict. The Fed would then have two options: cut a significant number of jobs to bring inflation down on a sustained basis, or accept a higher inflation target than it formally committed to in January 2012. Either option would pose significant policy and institutional challenges for the Fed and could also challenge its credibility.
Was this fork in the road inevitable? No, but the uncertainty of the pandemic probably made it hard to predict. While economists agree that the pandemic has disrupted many economic relationships over the past decade, it’s much harder to find a consensus on whether these changes are temporary or permanent.
Those who believe the aggregate supply-demand imbalances caused by Covid are largely temporary claim that 2% core inflation is on the horizon. This group notes that slow GDP growth (near 1.5%), a relatively stable federal deficit share of GDP, and the proportional shares of capital and labor in national income look similar to pre-Covid. In econometric models, these variables largely underpin estimates of the so-called neutral real policy rate, or the rate that keeps potential output and prices stable. For most of the previous decade, the neutral US real interest rate was estimated at 0–1%, consistent with the estimate of the long-term nominal policy rate of 2–3% in the Federal Open Market Committee’s Summary of Economic Forecasts. As long as the structural configuration of the economy has not changed, this argument works; Inflation should eventually ease off the current elevated levels and return closer to its long-term neutral stance of around 2% for the nominal Fed Funds rate. The question is when, not if.
Others believe structural changes have been underway for some time, whether caused or accelerated by Covid. This camp points to signs of a shifting aggregate supply-demand balance that could keep inflation elevated compared to pre-Covid levels. On the supply side, such changes include resource constraints such as labor shortages in developed economies, both caused by and coincident with Covid, and upcoming net-zero transition processes. However, I believe that changes in the labor market alone would be enough to create sustained upward inflationary pressures.
The US job market currently has a shortage of almost 5 million people compared to pre-Covid levels, which is unlikely to reverse. Recall that a key US economic theme in 2021 was hopes for a significant increase in labor force participation once Covid-related benefits are phased out. This hope has never been fulfilled. Instead, US labor supply growth continues to be constrained by Covid-19-related deaths and retirements, baby boomer exits from the labor market, and low immigration. With a persistent shortage of workers compared to the previous decade, existing workers can demand larger wage increases. In fact, average hourly wages in the US are up about 5% year over year, over 3% higher than levels consistent with the stable 2% core inflation rate. Wage increases are particularly pronounced in the service sector, particularly in leisure and hospitality, but also in healthcare, education and more broadly in professional and business services. Monthly gains in average hourly earnings (a more volatile series) have moderated recently, but remain above the pre-pandemic trend.
If labor markets remain tight and wage growth stays high for an extended period, inflationary expectations could eventually dissipate. This would unsettle econometricians, whose predictive power depends crucially on stable inflation expectations. More importantly, this would be a major headache for the Fed, as the success of central bank policy initiatives depends critically on stable long-term inflation expectations. An unanchoring of this stability could lead to a loss of credibility for the Fed and make the implementation of monetary policy significantly more difficult.
In a relatively closed and service-dominated economy, service inflation tends to be closely related to wage pressures, particularly when labor supply is constrained. The longer the momentum lasts, the greater the danger that a “wage-price spiral” will develop; a situation where higher prices encourage workers to negotiate higher wages, which in turn allows firms to charge higher prices rather than increase production. Once a wage-price spiral has set in, it can usually only be reversed by destroying demand or by weakening the labor market.
The Fed could choose to wait in the first half of 2023 rather than continue raising rates. Weakness in the goods sector and favorable base effects from significant price increases in the first half of 2022 make for an overall better inflation outlook. This would mean raising the target rate by another 50 to 100 basis points in early 2023 and then staying in place to observe the so-called lagged effects of monetary policy. The US could also enter a recession in 2023, which would result in job losses and therefore some fall in demand. However, a mild recession could do little to ease the structural tightness of the labor market, nor would it finally ease core service inflation.
In this case, the central bank could face a very difficult decision. One way would be to acknowledge that the core inflation trend consistent with full employment is structurally higher than in the previous decade. This would allow the central bank to drop its exposure to the 2% inflation target. The Fed could then keep jobs and stay true to the second half of its mandate. However, the vacillation of its inflation target could undermine the central bank’s credibility and further unanchor inflation expectations. The other option would be to create a deep recession that would destroy enough jobs to create job hysteresis (a persistent job shortage) and bring inflation to its knees. This would allow the Fed to maintain its commitment to the 2% inflation target, but could displease Congress, the White House and the public at large. Neither option is attractive, and both could ultimately spell a loss of credibility for the institution, which has been working hard to rebuild itself from the days of former Chairman Paul Volcker and his famous anti-inflation campaign.
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