With inflation higher than anyone expected, Fed Chairman Jerome Powell has laid out a policy path in which the Fed will move quickly to bring the policy rate up to “a more neutral level” of interest rates, and perhaps higher if necessary. .
“There is an obvious need to move quickly to return monetary policy stance to a more neutral level, and then move to more restrictive levels if that is what is required to restore price stability,” Powell said in late March. month later.
The aggressive policy starts with an interest rate increase of half a percentage point on Wednesday.
Read: Fed’s half percentage point interest rate increase seen baked in the cake
But what is this neutral rate?
For several months, the talk has been about a rate of 2.4%. Some Fed officials have pointed this out. This is in line with the Fed̵[ads1]7;s quarterly economic forecast for the “long-term” key policy rate for the Fed. which set the “long-term” Fed funds interest rate at 2.4%
But that is not the right goal for neutral, said Andrew Levin, an economics professor at Dartmouth College and a longtime Fed employee, including a role as special adviser on monetary policy strategy and communications to the Fed between 2010 and 2012. He advises central banks in Norway and Sweden and is also a guest fellow at the International Monetary Fund.
With the core target of the Fed’s favorite inflation rate of 5.2 percent, it means that the neutral fund interest rate is actually in the range of 5-6 percent, Levin said in an interview.
The interest rate of 2.4% that is often mentioned is really only the “neutral” level when inflation is running on the Fed’s inflation target is at 2%, he added.
A guiding principle for fighting inflation is actually spelled out on the Fed’s website, in a section titled “Principles for Implementing Monetary Policy.”
It reads: “The central bank should raise the key interest rate, over time, by more than one-to-one in response to a sustained rise in inflation and lower the key interest rate more than one-to-one in response to a sustained decline in inflation.” For example, if the inflation rate rises from 2% to 3% and the increase is not caused by temporary factors, the central bank should raise the key interest rate by more than one percentage point.
Core PCE inflation has risen to an annual rate of 5.2% in March from 2% in the same month last year.
The key, of course, is how much of the recent rise in inflation is temporary. It remains to be seen, although the Fed has already been burned by calling last year’s price increases “temporary”.
Powell should say that while there is a lot of uncertainty, the Fed must “go for a neutral stance which means we need to move the federal funds rate to be roughly in line with, or slightly above, the level of inflation.” in Levin.
“If Powell wanted to communicate that on Wednesday, I think markets will understand that the federal fund rate is likely to go up to 4% or 5% by the end of the year,” he said.
Market expectations, based on CME’s Fed Watch tool, are that the Fed will raise the key interest rate to an area of 3% -3.25% by the end of the year and interest rates will go to an area of 3.5-3.7% by July 2023
Economists at Deutsche Bank see the Fed raising interest rates to 3.6% by mid-2023. Combined with the effects of closing the balance sheet, which has similar effects of interest rate hikes, the Fed will deliver more than 4 percentage points in effective austerity, Wall Street estimates. the bank.
“This tightening should begin to significantly reduce growth in the second half of 2023 and induce a recession that begins late next year,” said Matthew Luzzetti, US chief economist at Deutsche Bank, in a note to customers.
“We would be interested to hear how the FOMC interprets the appropriate nominal neutral interest rate in an environment where inflation is significantly above the Fed’s 2% target,” he added.
Some interest rate expectations believe that the Fed’s reference rate may reach 6%, while other economists and strategists believe that the Fed will not be able to raise interest rates to 3%.
Read: Some see prospects for more painful sales of the treasury in the future
Ellen Gaske, chief economist at PGIM Fixed Income, said she believes, subject to much uncertainty, that the Fed will raise interest rates to just 2% by the end of this year and 2.5% by 2023.
She said that companies will lose their pricing power and that there will be some moderation in wage gains.
These views are informed by the Fed’s latest tightening cycle, where the Fed tried to bring interest rates up to a “neutral” – which it said was around 3% – but made a complete reversal after interest rates reached a range of 2.25% -2.5% . in December 2018 and the financial markets fainted.
Marvin Loh, a senior global macro strategist at State Steet, said the Fed will stop raising interest rates “somewhere in the 2.25% -2.5% range” either late this year or early next.
“I think it’s as high as it gets,” he said.
Loh said there could be some friendly inflation imprints later this year. “I think there is a chance that we have seen peak inflation, and then it really becomes a question of how fast it is coming down,” he said.
Loh said he does not think the economy will be able to withstand much tighter economic conditions, and there is a chance that the core CPI will reach the 4% range by the end of the year.
The yield on the 10-year government bond TMUBMUSD10Y,
reached 3% on Monday before falling back into late session trading.