Federal Reserve Chair Jerome Powell struck a relatively hawkish tone in congressional testimony this week, indicating that higher-than-previously anticipated interest rates would likely be needed to fight inflation and opening the door to a 50 basis point (bps) rate hike later this month, despite the central bank downshifting to a 25 bps increase at the February policy meeting.
Although the headlines focused on the level of interest rates and incremental Fed moves, we believe the real story on monetary policy is the likely mid-summer arrival of a pause in the central bank’s hiking campaign. We think the Fed chair’s acknowledgment of stronger January data was warranted but that he failed in not discussing the trade-offs involved with hiking rates from current levels. We hope his oversight was merely a communication misstep but have some concern that it could indicate a willingness to raise rates meaningfully beyond the 5.5 percent peak reflected in interest rate futures prices.
The logic for the Fed to emphasize rate hikes and tighter policy is relatively straightforward. The Fed has a mandate to maximize employment consistent with stable prices. Prices are emphatically not stable and employment is full, so the Fed should do its job with the best weapon it has—rate hikes. The time to stop hiking is only when the Fed has achieved—or is on an irreversible track to achieve—its two percent inflation target.
Proponents of ongoing increases often point to the Taylor Rule, a guideline from the 1990s that incorporates deviations between actual and desired economic growth and inflation to determine optimal policy rates. Depending on the precise formulation, the Taylor Rule would currently justify overnight rates of 6.5 percent and 7.75 percent compared to 4.75 percent today.
The Taylor Rule – larger swings, better policy?
Federal funds rate
The line chart compares a federal funds rate as implied by a version of the Taylor Rule and the actual federal funds rate on a quarterly basis from February 1961 through February 2023. Since early 2020, there has been a greater divergence between the two measures than was observed since the late 1970s, with the Taylor Rule indicating that the federal funds rate should be almost 2% higher than current levels.
Source - RBC Wealth Management, Atlanta Fed; quarterly data; actual federal funds rate is average daily rate during preceding quarter
Reality is more nuanced
The Taylor Rule is theoretically impressive but at times impractical. We think this is one of those times.
One problem is tail risk, or a low probability but high-impact negative event. The U.S. economy is in many ways an engine firing on a single piston. Of the four components of GDP, consumption is the primary plausible source of growth. Net trade is too small to matter for the U.S., divided government has likely sidelined major fiscal initiatives, and significant business investment is unlikely with elevated interest rates and economic uncertainty. With mortgage rates too high for widespread, cash-out refinancing, consumption—and by extension near-term GDP growth—is largely dependent on wage income.
For the Fed, that is a particularly troubling backdrop. Bringing down inflation means slowing wage growth, but with the overall economy largely dependent on that one variable for growth, we believe policymakers need to avoid pushing too hard, risking a significant economic contraction and potentially deflation. How hard is too hard? No one is sure, since labor market models have been increasingly inaccurate during the pandemic and post-pandemic eras. For a theorist, it may be acceptable to run a risk based on knowingly flawed models, but for those with real world responsibilities, a measured hand is called for.
Pushing interest rates ever higher has other drawbacks. The impact is disproportionately felt by small businesses and lower-income households that rely on bank or credit card loans that typically vary with overnight interest rates. It is questionable economics, and undoubtedly poor politics, to create gains for large banks and wealthier households and shift costs to lower-resourced segments. Driving a small business into bankruptcy because it cannot afford loan payments has permanent costs. There are already signs that some households are under stress with credit card borrowing at record levels and consumer confidence in their financial future at the lowest level for at least a decade.
Household financial concerns mount
National Housing Survey shows declining confidence in employment, finances
The line chart shows the percentage of National Housing Survey respondents who expect their personal financial situations to improve in the next 12 months, as well as the net percentage of employed persons who feel secure in their jobs, from February 2013 through February 2023. Optimism on personal financial improvement is currently at the lowest level in at least a decade, and the net job security measure declined 15 percentage points in February, matching the lowest level since 2013.
Source - RBC Wealth Management, Bloomberg; based on Fannie Mae’s monthly survey questions about expectations for the next 12 months
Another issue for dialing rates higher without a break is dealing with success. What happens when inflation hits two percent? Does the Fed reverse course and cut rates with the same speed? Policy stability is one of the attractions of the U.S. dollar as a global savings vehicle and rapid shifts in interest rates could have important domestic and international impacts.
A measured approach is better
We think the Fed is approaching the point where it will de-emphasize the level of rates and instead focus on how long rates stay elevated. For us, that peak rate is likely to be 5.5 percent, although the ultimate end point remains data dependent.
One indication that a pause is nearing is the Fed’s prior actions. The central bank raised rates by 25 bps at its February meeting, a downshift from its earlier 75 and 50 bps increases. We believe that the thinking then was for two additional 25 bps hikes, taking the peak rate to 5.25 percent. While the robust 517,000 reported gains in January nonfarm payrolls may push policymakers to take rates marginally higher, we do not see a single data point—particularly one driven largely by questionable seasonal adjustments—as likely to warrant more than a single additional hike, if even that.
It’s notable that the Fed chief adjusted his testimony between Tuesday and Wednesday to emphasize that no decision has been made on the pace of future hikes—a meaningful pushback on early reporting of his initial remarks. While upcoming employment and inflation data may lead the central bank to opt for the larger increase in March, there will be significantly more information available to the Fed by this summer, the time we think it will be ready to pause.
Another reason why the Fed may want to plateau rates near the 5.5 percent level is because monetary policy acts with a lag and data can be noisy, particularly around economic inflection points. We think a midyear pause would be helpful to allow for the full impact of tighter policy to hit and for some of the less frequent—but we believe higher-quality—economic data to be reported.
Costs and benefits
Powell’s testimony and the press coverage that followed emphasized the upside risk to the central bank’s prior interest rate forecasts. They fell short, in our view, when discussing the contraindications of excessive tightening and in preparing the market for what we still see as a likely midyear pause—and potential end—to this hiking cycle.