For the past two years, the Federal Reserve has been striving to combat inflation by tightening the reins on consumers through higher interest rates. The objective has been to curb spending, align demand with supply, and bring U.S. economic growth below its potential to alleviate price pressures.
However, this approach hasn’t yielded the desired results.
As financial markets anticipate the conclusion of the two-day policy meeting on Wednesday, where the U.S. central bank is expected to keep interest rates unchanged, policymakers now face a dilemma. They must determine whether the economy’s unexpected strength is merely a final surge in consumer spending that began during the COVID-19 pandemic or evidence that monetary policy remains insufficient to bring inflation back to the Fed’s 2% target.
Since the previous policy meeting in September, where rates were held steady, incoming data has consistently shown robust job growth, better-than-anticipated economic expansion, and modest improvements in the pace of inflation, which stood at 3.4% in September according to the Fed’s preferred measure, still well above the target.
The latest labor market data released on Wednesday echoed this trend, with the number of job openings remaining elevated compared to the number of job seekers. This disconnect has been a focal point for the Fed, signifying a persistent gap between labor demand and supply.
There are valid reasons for the central bank to exercise caution in approving further rate hikes. Most notably, market-based interest rates have risen independently of the Fed’s actions. Yields on long-term U.S. Treasury bonds have surged since the summer, and the average rate on a 30-year fixed-rate mortgage has reached nearly 8%, a level not witnessed in almost a quarter of a century. Fed officials believe these developments could ultimately slow business and household spending.
However, recent data have provided little clarity on when this potential slowdown might occur. Long-awaited declines in hiring, housing inflation, services spending, and other key indicators have been postponed by an economy that seems relentless.
Interestingly, the bond market’s reaction indicates that it may not be a reliable ally. Yields fell considerably after the U.S. Treasury announced it would issue less debt than anticipated. The 10-year Treasury interest rate dropped below 4.8% after reaching recent highs above 5%.
This announcement brought some relief, as Brian Jacobsen, chief economist at Annex Wealth Management in Menomonee Falls, Wisconsin, stated, “It wasn’t as bad as feared. The guidance that there may be only one more quarter where it increases was somewhat comforting.”
Even the rise in bond yields, considered by some Fed officials as an alternative to the central bank’s rate hikes, might simply reflect the economy’s strength and suggest that the Fed may need to take additional measures to combat inflation.
Citi analysts noted that they believe real rates are higher due to robust U.S. growth. They warned, “If we are right, the Fed risks falling behind the real growth and inflation curve,” even if the economy’s pace slows from the torrid 4.9% annual rate seen in the third quarter.
Fed’s Decision and the Consumer Spending Resilience
The Federal Reserve is scheduled to release its latest policy statement at 2 p.m. EDT (1800 GMT), followed by a press conference by Fed Chair Jerome Powell half an hour later.
It is widely expected that the central bank will maintain its benchmark overnight interest rate in the 5.25%-5.50% range set at its July meeting, with minimal expectations of further increases in the near term.
Since there are no updated economic or interest rate projections in this meeting, all eyes will be on whether the policy statement or Powell’s comments lean towards or away from more rate hikes.
At the September meeting, Fed officials indicated their belief that one more rate hike would likely be necessary. The data since then have left that possibility open.
The third-quarter gross domestic product growth exemplified the challenges the Fed is facing. Despite concerns that factors like renewed student loan payments and waning consumer confidence would lead to a slowdown, the pandemic-era savings, combined with a low unemployment rate and steady wage increases, have enabled consumers to continue driving robust economic growth. Notably, companies like McDonald’s and Amazon have reported earnings surpassing expectations, while home prices have continued to rise despite higher mortgage rates.
Economists have been grappling with when the extra savings accumulated during the pandemic would be exhausted. After the U.S. government reported exceptional economic growth in the third quarter, some analysts reevaluated and suggested that there might still be around $1 trillion left to fuel consumption and potentially push prices higher.
Nancy Vanden Houten, lead U.S. economist at Oxford Economics, noted, “Given the resilience of the consumer, the risk in the near-term may be for a faster drawdown.” She mentioned the concept of “revenge spending,” alluding to the surge in consumer spending during the recovery from the pandemic, implying that there may be more room for growth.
Consumer spending has continued to expand despite a dip in consumer confidence to recessionary levels. Rising prices, particularly for groceries and gasoline, alongside concerns about the political situation and higher interest rates, have been among the worries voiced by consumers. All these factors have been on the Fed’s radar.
Powell has emphasized that Fed policy is working as intended, gradually increasing borrowing costs and tightening financial conditions to eventually slow down the economy. However, the timeline for these adjustments may be delayed due to the lasting impacts of the pandemic, such as the savings accumulated and the persistent imbalance between supply and demand, especially in the labor market.
This process may represent a gradual, grinding return to the 2% inflation target – something the Fed is cautious not to rush, as the alternative might entail a substantial rise in unemployment and an unnecessary recession. Nevertheless, Powell has made it clear that if growth does not decelerate, it will necessitate higher policy rates.
In his words, “It’s a good thing that the economy’s strong. It’s a good thing that the economy has been able to hold up under the tightening that we’ve done. It’s a good thing that the labor market’s strong. But if the economy comes in stronger than expected, that just means we’ll have to do more in terms of monetary policy to get back to 2%. Because we will get back to 2%.”
