The US Federal Reserve building in Washington. Photo: AFP
by David Brown
by David Brown

Is the Federal Reserve backing off from interest-rate overkill?

  • The Fed says it is still serious about curbing inflation, but with the United States in a technical recession, the central bank must tread carefully
  • Politics may also be an unofficial factor; the Fed wouldn’t want to be blamed for a deeper recession that could influence the midterm elections in November

Is the Federal Reserve easing its grip on US monetary policy? After the release last week of the minutes of the Fed’s July 26-27 policy meeting, there is a growing sense the US central bank will back off from a more aggressive interest rate tightening in the next few months.

Instead, it may be favouring a more gradual approach while it tries to rationalise the conflicting policy signals between the US recession, the spike in inflation and global supply-side price pressures beyond its control.

US interest rates are still going up, but perhaps at a slower pace than previously expected; the next expected interest rate rise in September is more likely to be a half-point rather than a three-quarter point move.

The Fed would deny it, but politics may be entering into the equation, too. It doesn’t want to go overboard with tightening and be blamed for a deeper recession which could influence the results of the US midterm elections in November.

The Fed certainly seems to have taken the heat out of forward interest rate expectations with traders now only factoring in a 47 per cent chance of a 0.75 percentage point rate hike at the next Federal Open Market Committee (FOMC) policy meeting in September, compared with a 53 per cent chance of a 0.5 percentage point rise in the Fed funds rate, according to data from the CME Group’s Fedwatch tool.

The Fed maintains it is just as determined to get inflation back under control, but clearly not at any cost. Now that the US has spilled into a technical recession, the odds have clearly shifted. US gross domestic product fell at a 0.9 per cent annualised rate in the second quarter of 2022 following a 1.6 per cent decline in the first quarter. The Fed needs to tread carefully or else risk a full-blown rout.

The markets are already sensing the economy can’t afford another 0.75 percentage point hammer blow, but might the Fed have woken up to the collateral damage it risks inflicting as well? If that is the case, then the FOMC’s assumption that the official Fed funds target will peak at 3.8 per cent in 2023 before receding to 3.4 per cent in 2024, and 2.5 per cent longer term, might be as much as it needs to do.

The Fed insists it is still serious about the longer term inflation outlook, but this may simply be bravado for the market’s benefit. With so much monetary super-stimulus pumped into the economy since the 2008 crash, it is time to be erring on the side of caution again. The Fed’s monetary credibility is still on the line.

Interest rate overkill is not needed. Since the start of the Ukraine war in February and the subsequent spike in global energy prices, headline US inflation has surged as high as 9.1 per cent in June, but eased off to 8.5 per cent in July. The chances are the peak has passed, global energy prices are easing and potential demand-pull inflation risks are low considering the vulnerability of US growth prospects right now.
The Fed’s central projections for inflation envisages the headline rate coming down to 2.7 per cent in 2023 and around 2 per cent longer term, so the outlook seems reasonably contained for the time being. Of course, much depends on the outlook in Ukraine and whether global energy prices continue to stay inflated. But the Fed stresses watching the data will be key.
Cars wait at a petrol station in Massachusetts on July 19 amid still-high energy prices. Photo: AFP

Another factor which may be throwing a curve ball into the Fed’s policy reckonings is the looming US midterm elections on November 8, which could lead to policymakers treading more cautiously going into the September FOMC meeting.

The Fed is officially bound to be politically neutral but wouldn’t want to be blamed for a deeper near-term recession which might tip the balance of power in Congress. Jerome Powell was former Republican US president Donald Trump’s choice for Fed chair so the central bank will be extremely keen to distance itself from any accusation of political bias.

If the Fed is heading for a less hawkish 0.5 percentage point rise in the funds rate in September, it could be the market balm needed to keep stocks and bonds rallying in tandem. And it is still dollar positive bearing in mind other major central banks are struggling to keep up with the Fed’s tightening.

David Brown is the chief executive of New View Economics