Fed to keep interest rates above 4% beyond 2023, economists predict

The US central bank will raise its benchmark interest rate above 4 percent and keep it there beyond 2023 in its bid to stem high inflation, according to a majority of leading academic economists polled by the Financial Times.

The latest survey, conducted in collaboration with the Initiative on Global Markets at the University of Chicago’s Booth School of Business, suggests the Federal Reserve is a long way from ending its campaign to tighten monetary policy. It has already raised interest rates this year at the most aggressive pace since 1[ads1]981.

With close to zero as recently as March, the federal funds rate is now between 2.25 percent and 2.50 percent. The Federal Open Market Committee meets again on Tuesday for a two-day policy meeting, where officials are expected to implement a third consecutive rate hike of 0.75 percentage points. This move will raise the exchange rate to a new target range of 3 percent to 3.25 percent.

Nearly 70 percent of the 44 economists surveyed between Sept. 13 and 15 believe the Fed Funds rate in this tightening cycle will peak between 4 percent and 5 percent, with 20 percent of the view that it must pass that level.

“The FOMC still hasn’t come to terms with how high they need to raise rates,” said Eric Swanson, a professor at the University of California, Irvine, who predicts the fed funds rate will eventually peak between 5 and 6 percent. “If the Fed wants to slow the economy now, they have to raise the funds rate above [core] inflation.”

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While the Fed typically targets a 2 percent interest rate for the “core” personal consumption expenditures (PCE) price index — which strips out volatile items such as food and energy — it also closely monitors the consumer price index. Inflation unexpectedly accelerated in August, with the core measure up 0.6 percent for the month, or 6.3 percent from a year earlier.

Most respondents project core PCE will fall from its last July level of 4.6 percent to 3.5 percent by the end of 2023. But nearly a third expect it to still exceed 3 percent 12 months later. Another 27 percent said it was “about as likely as not” to stay above that threshold at the time — indicating major unease about high inflation becoming more deeply entrenched in the economy.

“I fear that we have come to a point where the Fed is facing the risk of its credibility being seriously eroded, and so it needs to start being very aware of that,” said Jón Steinsson of the University of California, Berkeley.

“We’ve all been hoping that inflation would start to fall, and we’ve all been disappointed over and over and over again.” More than a third of the economists surveyed warn that the Fed will fail to adequately control inflation if it does not raise interest rates above 4 percent by the end of this year.

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In addition to raising interest rates to a level that limits economic activity, the majority of respondents reckon that the Fed will keep them there for a longer period.

Easing price pressures, financial market instability and a worsening labor market are the most likely reasons the Fed will pause its tightening campaign, but no cut in the Fed Funds rate is expected until 2024 at the earliest, according to 68 percent of respondents. Of that, a quarter do not expect the Fed to lower its benchmark interest rate until the second half of 2024 or later.

Few, however, believe the Fed will step up its efforts by shrinking its nearly $9 billion balance sheet via outright sales of the agency’s mortgage-backed securities holdings.

Such aggressive actions to cool the economy and stamp out inflation will have costs, a point Chairman Jay Powell has made in recent appearances.

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Nearly 70 percent of respondents expect the National Bureau of Economic Research — the official arbiter of when U.S. recessions begin and end — to declare one in 2023, with the majority of the view that it will happen in the first or second quarter. That compared to the around 50 percent who see Europe tipping into a recession by the fourth quarter of this year or earlier.

A U.S. recession is likely to last two or three quarters, most economists expect, with more than 20 percent expecting it to last four quarters or more. At its peak, unemployment could be between 5 and 6 per cent, according to 57 per cent of respondents, well above today’s 3.7 per cent. A third see it eclipsing 6 percent.

“This is going to fall on the workers who can least afford it when we have increases in unemployment because of these rate increases at some point,” warned Julie Smith of Lafayette College. “Even if it’s small amounts — a percentage point or two of the increase in unemployment — it’s real pain for real households that aren’t prepared to deal with this kind of shock.”

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An easing of supply-related constraints linked to the war in Ukraine and Covid-19 shutdowns in China could help minimize how much the Fed needs to curb demand, meaning a less severe economic contraction in the end, said Şebnem Kalemli-Özcan of the University of Maryland. But she warned that the outlook is very uncertain.

“Obviously, this is one shock after another, so I’m not sure this is going to happen right away,” Kalemli-Özcan said. “I can’t tell you a time frame, but it’s moving in the right direction.”