If the consumer price index report for August that showed inflation remains much hotter than forecast was not enough of a shocker, then talk that the Federal Reserve needs to raise interest rates in even bigger chunks starting with its meeting next week surely is.
The idea that the central bank must lift its target for the overnight rate between banks by 100 basis points — something it hasn’t done since the 1980s — after increasing it by 75 basis points in both June and July is not some fringe notion. Money market traders are pricing in a not insignificant 33% chance that it will happen. The thinking is that the Fed needs to get radical if it truly wants to get control of inflation, which rose 8.3% in August from a year earlier.
There are two primary reasons an increase of such magnitude would be a bad idea. The first and most obvious is that it would signal the Fed is in panic mode, which is not a good look for any central bank, let alone the most important one in the world. Risk premiums might blow out to compensate traders for the heightened risk of uncertainty around monetary policy. That would upend credit markets, the lifeblood of the financial system. This is a Fed that has long sought to ensure the smooth functioning of financial markets by preparing them for what’s coming, when it’s coming and by how much well in advance. That’s what forward guidance is all about.
And this Fed hasn’t prepared the market for anything like a full percentage-point increase in the target federal funds rate, which would push the upper bound to 3.50% from 2.50%. The best move for Chair Jerome Powell and his fellow policy makers would be to reassure the market that the central bank understands the challenge and is acting deliberately. The rates strategists at BMO Capital Markets, regularly ranked as the best in the business in Institutional Investor’s widely followed annual surveys, agree. Here’s how they put it in a note to clients on Wednesday:
Some pundits have made the case for 100 (basis points) next week, noting that it would enhance Fed credibility. It would ostensibly help, but simultaneously indicate that the Fed is still chasing inflation as opposed to confidently addressing its persistence with monetary policy. ‘No need to panic, nothing to see here’ is undoubtedly the message policymakers will seek to communicate to the market and 100 (basis points) would be counterproductive in this regard.
Let’s not forget that the CPI report is just one data point, and a lagging one at that. The Fed puts a tremendous amount of weight on inflation expectations. The worry is that if expectations for high inflation become embedded among consumers, it will become a self-fulfilling prophecy and much harder to tame. But the opposite is happening. Consumer expectations for inflation over the coming years declined sharply in the latest survey by the Federal Reserve Bank of New York, which was released this week. Expectations for inflation three years ahead fell to 2.8% in August from 3.2% the previous month and 3.6% in June. It’s a similar story in the derivatives market, where the outlook based on swap rates has dropped from around 6% in June to less than 3%.
The second reason the Fed might not want to get too aggressive is that it would perhaps make financing too expensive for real estate developers when a lack of supply is causing rents to soar. Shelter costs, which posted their biggest monthly gain since 1991, were a big factor in pushing up core CPI by 0.6% in August from July, double the forecast. The August increase brought shelter inflation over the last 12 months to 6.3%, the highest over any such stretch since 1986, according to Bloomberg News’s Matthew Boesler. Shelter costs are the largest component of CPI, accounting for about a third of the measure.
There are a few reasons rents are rising so fast. One is that the high cost of single-family housing has priced many potential homebuyers out of the market and kept them renting. Apartment List’s recently released September National Rent Report showed vacancy rates are a tight 5.1%, below the pre-Covid range of 6% to 7%. Another reason is that supply has been constrained relative to demand and population growth for many years, largely because of tighter lending standards used by banks coming out of the financial crisis. To be sure, some relief is on the way. Government data show 862,000 multifamily units are under construction, the most since since the early 1970s. So now would not be the time to make it harder for developers to deliver the housing that so many consumers need.
Fed policy makers are surely aware that raising rates in even bigger increments would send the message that the only way they can defeat inflation is by pushing the economy into a recession — even if that’s not their intention. In such a scenario, though, a recession would likely become a self-fulfilling prophecy as businesses fire workers and delay new investment. Developers might stop work on new projects. Renters would stay put in their current dwellings, exacerbating the supply crisis and keeping shelter costs elevated.
There’s no doubt monetary policy needs to be tighter if the Fed wants to get inflation back under control. But a panicky approach now is not worth the potential risks.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
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