The Federal Reserve building is pictured in Washington, DC, USA on August 22, 2018. REUTERS/Chris Wattie/File Photo
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WASHINGTON/SAN FRANCISCO, July 25 (Reuters) – Federal Reserve officials are likely to hit a key milestone this week with a rate hike that will effectively end pandemic-era support for the US economy and begin testing whether growth without the central bank can continue active help from the bank.
The Fed is expected to hike its funds rate by three-quarters of a percentage point to a target range of 2.25% to 2.50% at the end of a two-day monetary policy meeting on Wednesday. That would match the high hit before the COVID-19 pandemic, taking rates to levels that officials see as roughly “neutral” over the long term, or no longer supportive of the economy.
With that yardstick in mind, the debate shifts to questions that will determine whether the economy can avoid a recession in the coming months: How low must inflation fall before Fed officials decide it’s under control ? How high do interest rates have to rise for this? And what are the costs to be paid in the form of slower economic growth and rising unemployment?
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Fed officials have banded together behind aggressive rate hikes as they watch inflation accelerate this year. But for the moment they are facing, there is little precedent and little clarity about how monetary policy will be set once inflation eases and they start to interpret the outlook differently.
“As long as inflation is as high as it is and there is no sign of abating, you will have a united front,” said Luke Tilley, chief economist at Wilmington Trust. The Fed’s preferred measure of inflation is a four-decade high of more than 6%, which is about three times the formal target of 2%.
But even if officials promise a full-scale fight against destabilizing price hikes, it may be just two months before inflation slows before “the hawks and the doves make their presence felt rather quickly,” with renewed debate over how much risk the can reasonably be engaged with the economy to drive inflation down another notch, he said.
Hawks and Doves is a central bank shorthand for the tension between policymakers more concerned about inflationary risks – the hawks – and those who prioritize the Fed’s other goal of maximum employment – the doves.
That has become a difficult distinction when all policymakers say they are willing to raise interest rates as high as needed to cool inflation.
“NO REAL DISPUTE”
So far there has been no real decision to be made other than how much to approve a rate hike at each policy meeting.
Inflation has actually accelerated since the Fed began raising rates in March, leading officials to move from a quarter-point hike this month to a half-point hike in May and a 75-basis-point hike in June to switch That’s a development not seen since former Fed Chairman Paul Volcker’s fight against inflation in the 1980s.
At a press briefing on Wednesday, Fed Chair Jerome Powell could begin setting expectations for the next monetary policy meeting in September, but he is reluctant to speak beyond that.
The US unemployment rate, meanwhile, has been at a low 3.6% since March, with more than 350,000 jobs being added monthly, which still makes little sense that policymakers have reached a point where their efforts to contain it are of inflation require a direct trade-off in terms of jobs.
Rate hikes are designed to ease inflation by slowing the economy overall. This can also lead to rising unemployment and even an outright recession.
At the Fed’s June 14-15 meeting, even the least aggressive policymakers forecast interest rates above 3% by the end of this year, which would be the highest since the 2007-2009 financial crisis that ushered in an era of low interest rates benign inflation.
The current pace of job creation is “way too fast. That’s why there’s no real argument within the (Federal Open Market) Committee,” said Ethan Harris, Bank of America’s head of global research, referring to the policy the Fed body.
Similarly, the current unemployment rate is not viewed as being consistent with 2% inflation, and “they need to see some evidence that it’s rising” to gain confidence that inflation will fall consistently, Harris added.
BECOME LIMITING
A key unknown is how policymakers will react once inflation and unemployment change significantly.
The 75 basis point rate hike expected this week marks one of the fastest reversals ever from a bottom in interest rates back to neutral, a level that policymakers are desperate to reach sooner rather than later in order to stop stimulating the economy.
Each step from here goes deeper into what is considered “restrictive” territory. While the financial markets have priced in higher interest rates – exemplified by the increase in the cost of a 30-year fixed-rate mortgage – they also see an increased risk of a recession and, as a result, potential rate cuts by the Fed as early as next year.
Federal Reserve officials are likely to stick to their data-dependent mantra. However, the same data can mean different things to different policymakers and are usually assessed in terms of how the risks to their goals are shifting.
Some may insist on a strict return to 2% inflation, regardless of the economic losses required to get there; others have suggested that data convincingly moving in the right direction might suffice.
There are already signs that consumers are retreating – or being forced to do so – by prices rising faster than wages. Inflation-adjusted retail sales growth has slowed to a crawl. And in a sign of fiscal stress, AT&T said its overall cash flow has suffered because so many of its customers are behind on monthly bill payments. Continue reading
The federal funds rate was last seen in the 2.25% to 2.50% range in late 2018 after a series of rate hikes. Signs of economic weakness, however, caused the Fed to halt any further tightening and cut rates within about eight months.
Inflation was tame at the time, so the focus was on maintaining a labor market that had a similar unemployment rate as it is now, with solid gains for lower-income and less-skilled workers.
As Fed policymakers examine how the economy will respond to even higher borrowing costs, they may be faced with a number of tougher choices this time.
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Reporting by Howard Schneider Edited by Dan Burns and Paul Simao
Our standards: The Thomson Reuters Trust Principles.
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