Chair Jerome Powell and the Fed will take these steps largely in the dark. No one knows just how high the central bank’s short-term rate must go to slow the economy and restrain inflation. Nor do the officials know how much they can reduce the Fed’s unprecedented $9 trillion balance sheet before they risk destabilizing financial markets.
“I liken it to driving in reverse while using the rear-view mirror,” said Diane Swonk, chief economist at the consulting firm Grant Thornton. “They just don’t know what obstacles they’re going to hit.”
Yet many economists think the Fed is already acting too late. Even as inflation has soared, the Fed’s benchmark rate is in a range of just 0.25% to 0.5%, a level low enough to stimulate growth. Adjusted for inflation, the Fed’s key rate — which influences many consumer and business loans — is deep in negative territory.
That’s why Powell and other Fed officials have said in recent weeks that they want to raise rates “expeditiously,” to a level that neither boosts nor restrains the economy — what economists refer to as the “neutral” rate. Policymakers consider a neutral rate to be roughly 2.4%. But no one is certain what the neutral rate is at any particular time, especially in an economy that is evolving quickly.
If, as most economists expect, the Fed this year carries out three half-point rate hikes and then follows with three quarter-point hikes, its rate would reach roughly neutral by year’s end. Those increases would amount to the fastest pace of rate hikes since 1989, noted Roberto Perli, an economist at Piper Sandler.
Even dovish Fed officials, such as Charles Evans, president of the Federal Reserve Bank of Chicago, have endorsed that path. (Fed “doves” typically prefer keeping rates low to support hiring, while “hawks” often support higher rates to curb inflation.)
Powell said last week that once the Fed reaches its neutral rate, it may then tighten credit even further — to a level that would restrain growth — “if that turns out to be appropriate.” Financial markets are pricing in a rate as high as 3.6% by mid-2023, which would be the highest in 15 years.
Expectations for the Fed’s path have become clearer over just the past few months as inflation has intensified. That’s a sharp shift from just a few month ago: After the Fed met in January, Powell said, “It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate.”
Jon Steinsson, an economics professor at the University of California, Berkeley, thinks the Fed should provide more formal guidance, given how fast the economy is changing in the aftermath of the pandemic recession and Russia’s war against Ukraine, which has exacerbated supply shortages across the world. The Fed’s most recent formal forecast, in March, had projected seven quarter-point rate hikes this year — a pace that is already hopelessly out of date.
Steinsson, who in early January had called for a quarter-point increase at every meeting this year, said last week, “It is appropriate to do things fast to send the signal that a pretty significant amount of tightening is needed.”
One challenge the Fed faces is that the neutral rate is even more uncertain now than usual. When the Fed’s key rate reached 2.25% to 2.5% in 2018, it triggered a drop-off in home sales and financial markets fell. The Powell Fed responded by doing a U-turn: It cut rates three times in 2019. That experience suggested that the neutral rate might be lower than the Fed thinks.
But given how much prices have since spiked, thereby reducing inflation-adjusted interest rates, whatever Fed rate would actually slow growth might be far above 2.4%.
Shrinking the Fed’s balance sheet adds another uncertainty. That is particularly true given that the Fed is expected to let $95 billion of securities roll off each month as they mature. That’s nearly double the $50 billion pace it maintained before the pandemic, the last time it reduced its bond holdings.
“Turning two knobs at the same time does make it a bit more complicated,” said Ellen Gaske, lead economist at PGIM Fixed Income.
Brett Ryan, an economist at Deutsche Bank, said the balance-sheet reduction will be roughly equivalent to three quarter-point increases through next year. When added to the expected rate hikes, that would translate into about 4 percentage points of tightening through 2023. Such a dramatic step-up in borrowing costs would send the economy into recession by late next year, Deutsche Bank forecasts.
Yet Powell is counting on the robust job market and solid consumer spending to spare the U.S. such a fate. Though the economy shrank in the January-March quarter by a 1.4% annual rate, businesses and consumers increased their spending at a solid pace.
If sustained, that spending could keep the economy expanding in the coming months and perhaps beyond.