By Tiffany Wilding, North American Economist, at PIMCO
Last week the Federal Reserve launched a series of trial balloons on its intent to slow the pace of rate hikes after one more 75-basis-point (bp) adjustment at the upcoming November meeting. In the last week before the customary communications blackout period before a Fed meeting, regional Fed presidents James Bullard and Neel Kashkari, who have recently been on the hawkish side of the policy debate, shifted the focus of their public comments to emphasize the need to stop raising rates in early 2023. In separate comments, San Francisco Fed President Mary Daly also mentioned the need to “step down” the pace despite still-too-high inflation.
However, it was Nick Timiraos, a reporter at The Wall Street Journal, who provided perhaps the clearest indication of the Fed officials’ thinking: “Federal Reserve officials are barreling toward another interest-rate rise of 0.75 percentage point at their meeting Nov. 1-2 and are likely to debate then whether and how to signal plans to approve a smaller increase in December” (Wall Street Journal, 21 October 2022). He went on to say in social media that “some officials are more eager to calibrate their rate setting to reduce the risk of overtightening. But they won’t want to dramatically loosen financial conditions if and when they hike by 50 bps (instead of 75).”
The timing of the Fed communication is interesting because it came (1) on the heels of another positive inflation surprise from the September U.S. CPI report and (2) well before the December Fed meeting. As a result, it reads like an implicit pre-commitment to slow down rate hikes in December and pause in the 4.5% to 5% range, regardless of the data between now and then. If this interpretation is correct, it’s a notable shift from previous statements that officials need to see clear evidence that inflation is moderating before slowing and pausing.
Why is the Fed shifting? Since the beginning of the year, the Fed has engineered a dramatic tightening in U.S. financial conditions. According to PIMCO’s measure, the speed of the change is now more pronounced than what we witnessed after the 2008 Lehman bankruptcy, which drove one of the most severe recessions in modern history. While there are still good reasons to believe that the size of the coming U.S. economic contraction will be more moderate than what was realized in 2008 (e.g., stronger balance sheets, a near-term reacceleration in transfer payments from the California lump sum payment and the Social Security cost of living adjustment, and relatively orderly market conditions to date), the sheer speed and magnitude of the financial tightening against a backdrop of already weak real GDP growth – final domestic demand growth is averaging below 1% so far this year – risks overdoing it, if the Fed maintains the current pace.
Clearly, the Fed can’t hike 75 bps forever. However, two factors have complicated the communication of when and how the Fed will shift from actively tightening financial conditions to holding them at tight levels. First, U.S. inflation is still elevated and likely to remain so near-term. The latest piece of bad inflation news came in the form of Hurricane Ian, which will likely temporarily boost demand and prices for autos among other things and keep core annualized Consumer Price Index (CPI) inflation running around 6.5% for several more months. And second, just a few months ago, many Fed officials were saying they need to see inflation on a sustained downward path before pausing rate hikes – guidance they would now need to alter.
So the challenge is not only how to communicate the pause while inflation is still elevated, but to communicate it in a way that convinces markets that the Fed is still focused on bringing down inflation, and that it isn’t going to quickly pivot to dropping rates in the face of what is likely to be increasingly weak economic activity. Putting it differently, the Fed should want to avoid loosening financial conditions by convincing markets that after the pause, the next move is just as likely to be up as it is down.
The Fed doesn’t have history on its side. Historically, pausing for a meeting or more after a series of rate hikes has tended to precede a series of rate cuts. Perhaps it’s this difficulty that has prompted what appears to be an implicit commitment to the pause. Nevertheless, the Fed may be better served by emphasizing uncertainty as it shifts monetary policy. In particular, we believe the Fed could emphasize three points while communicating the pause:
- Labor market resilience, sticky inflation. The monetary policy adjustment to date has started to cool U.S. activity in the most interest-rate-sensitive sectors, most notably housing, where real activity likely contracted by around 25% q/q saar (quarter-over-quarter seasonally adjusted annual rate) in the third quarter after an 18% contraction in the second quarter. U.S. home prices have also decelerated, along with listings, sales, and traffic, and the slowing is spilling over into real estate finance and related business services. Nevertheless, other areas of the economy still look strong. Despite the productivity recession in the first half of 2022, U.S. corporate profits and hiring have remained surprisingly resilient on aggregate, and the labor market resilience has, in turn, pushed up wages and prices in services categories, where inflation appears poised to remain elevated.
- Long and variable lags. However, because monetary policy works with long and variable lags, we haven’t yet felt the full effect of higher rates. By our models, tighter financial conditions tend to start to impact the economy anywhere from 3 to 6 quarters after the initial shock. As such, we should expect to see U.S. growth start to more materially decelerate (and contract) in late 2022 or early 2023.
- Uncertainty. And, of course, there is a general layer of uncertainty around when and by how much the U.S. economy will slow as a result of the Fed’s actions to date. On the one hand, still pent-up demand from pandemic-related bottlenecks may provide larger economic supports, while on the other hand, rising stress in pockets of financial markets – just look at the latest developments in the real estate investment trust (REIT) market – could spread, and eventually result in a significantly more severe downturn.
So where does all of this leave investors? As the WSJ’s Timiraos stated, another 75-bp rate hike appears likely when the Fed officials meets in early November. However, the December meeting now looks likely to result in a more modest 50-bp hike, before another step down in January (25 bps) and an eventual pause thereafter. This path is likely to put the Fed at the middle of the 4.5%–5% range that we forecasted in our latest Cyclical Outlook (“Prevailing Under Pressure”).
Since this trajectory looks likely even in the case that U.S. inflation reaccelerates into year-end, the Fed appears to be balancing the risk of inducing a needlessly severe recession with the risk of losing price stability. However, convincing markets that conditions are tight enough to bring down inflation while avoiding a more severe recession is a tall task even for the most seasoned central banker. Shifting communication to emphasize uncertainty and a balanced distribution of risks for rates might just thread the increasingly small needle that the Fed now holds.