Price stability for the past three decades has been defined as a 2% inflation target, far below the elevated levels of the past year. Now, after a year of aggressively raising interest rates to bring down inflation, the Federal Reserve faces the monumental choice on when to pause its rate hikes.
On Wednesday, the Fed’s answer was not yet. The central bank hiked its policy rate by 25 basis points to a range between 4.5% and 4.75%, its eighth straight increase, though lower than the recent hikes.
In our estimation, the Fed is approaching the point at which it may choose to engage in a strategic pause to create space for the economy to absorb past rate hikes and for the central bank to ascertain if inflation is moving back toward its 2% target.
Inside the Federal Open Market Committee’s policy statement, the key phrase was: ”The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”
Moreover, Federal Reserve Chairman Jerome Powell went out of his way to dampen any expectations that the central bank will soon turn away from its near-term focus on price stability.
“Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions,” he said at his news conference after the decision was announced.
All of which underscores the risk that the lagged impact of the 475 basis points of rate hikes over the past year will cause a mild contraction in economic activity later this year.
The only major change was in the outlook paragraph on inflation where the language was changed to “inflation has eased somewhat but remains elevated.” That change reflects a removal by the committee of references to the causes of inflation including the pandemic while also removing a reference to considering public health as a factor in decision making.
In short, calls for the February rate hike to be the last in the cycle are likely to prove erroneous, and more rate hikes are on the way.
The takeaway
We expect rate hikes of 25 basis points at both the March and May meetings, which reflects the forward-looking information on rate expectations published in December’s Summary of Economic Projections. That underscores our forecast that the central bank will most likely be on pause until early next year.
