The Federal Reserve is set to raise interest rates for the first time since 2018, but faces a dilemma over how aggressively to tighten monetary policy as war in Ukraine threatens to dent growth and worsen the highest inflation in 40 years.
At this week’s meeting of the Federal Open Market Committee, US central bankers are all but guaranteed to raise the federal funds rate by a quarter of a percentage point – their most forceful step to date to shift monetary policy away from the ultra-loose settings put in place at the onset of the pandemic.
The move comes despite a sharp escalation in geopolitical tensions following Russia’s invasion of Ukraine, which has attracted some of the most punitive financial sanctions ever from the US and its allies.
Energy prices have soared higher as a result, with the international oil benchmark at one point topping $ 130 a barrel after the US moved to ban Russia’s imports. It has fallen back somewhat, but the impact of oil prices well above $ 100 a barrel is likely to mean higher headline inflation and more constrained consumer spending.
“This is probably one of the hardest times for the central bank,” said Aneta Markowska, chief financial economist at Jefferies. “We’ve obviously had big events in the past like the pandemic and the global financial crisis, but the direction of policy was clear. It was to cut [rates] and the only questions were how much and how quickly.
“This time you have two-sided risks, with downward pressure on growth but upward pressure on inflation. The question is which one does the Fed go with? ”
Economists are broadly of the view that concerns about inflationary pressures will far outweigh any fears of a growth slowdown – especially given the strength of the labor market – and compel the Fed to proceed with a series of interest rate increases this year.
“If this shock had happened when inflation was running at 1.5 per cent, the Fed would likely have looked past the inflation effects and worried more about growth,” said Brian Sack, director of global economics for the DE Shaw group and a former senior Fed official. “Obviously, we’re now in a different environment.”
Alan Detmeister, another ex-Fed staffer who now works at UBS, says that in terms of the inflation outlook, the war is “all upside”. He reckons the current surge in oil prices could add as much as a percentage point to price levels as measured by the consumer price index and push the annual rate above 8 per cent in March. Depending on how long these gains are sustained, the magnitude by which inflation moderates this year may also be curtailed.
Detmeister expects the Fed to revise higher its year-end forecast for core inflation, which is based on the personal consumption expenditures price index, to above 3 per cent.
In December, the last time the Fed published the individual economic projections of its top officials, a majority thought core inflation would settle at 2.7 per cent in 2022 before dropping to 2.3 per cent the year after. It currently hovers at 5.2 per cent.
Economists also anticipate officials will shift lower their forecast for economic growth this year, having previously projected a 4 per cent expansion. The median estimate could drop to 3.3 per cent, according to Barclays.
Back then, officials expected to deliver only three quarter-point interest rate increases this year, a pace that is now seen as far too slow given the economic backdrop.
The meeting will yield yet another update to the “dot plot” of individual interest rate projections, with five increases potentially pencilled in for this year and four more next year. Market expectations have run slightly ahead of what is expected to be signaled, with at least six adjustments scheduled for 2022.
In congressional testimony earlier this month, Jay Powell, the Fed chair, endorsed a steady shift toward tighter monetary policy, including a “predictable” reduction in the $ 9tn balance sheet. Further details on the Fed’s plans to do so are also expected this week.
While Powell vowed the Fed would be “careful” about how it conducts monetary policy given the vast uncertainty clouding the outlook, he has also kept more aggressive tools on the table should inflation fail to ebb.
He told lawmakers the central bank may need to raise interest rates above “neutral”, a level that neither supports nor constrains economic activity. The median forecast among Fed officials as of December was 2.5 per cent.
And to get there, he said the Fed would consider revisiting a tactical last used in 2000 and raise interest rates by double the typical quarter-point cadence at one or more meetings.
Betsy Duke, a former Fed governor, warned a half-point rate rise could “all of a sudden signal alarm” and send the message that the Fed has seriously misjudged the inflation situation and the appropriate policy response. She said it may also signal their estimate of neutral is higher, meaning more interest rate increases than currently anticipated.
For Bill English, a Yale professor and former director of the Fed’s division of monetary affairs, the risks of a policy mistake are uniquely high.
“If they move too quickly now and it turns out that the economy is just slowing a lot for the reasons they already anticipated and maybe also because of the Russia-Ukraine [crisis]they could end up with a recession a year from now, ”he said.
“But I’m sure they’re also worried that if they do not react now. . . and they’ve got to push back against inflation that seems to be settling in well above their target and tighten a lot, then they’ve got a recession maybe in 2024. ”