Jai Kedia
From the moment the Fed announced its decision last month to hold target rates steady, it seemed a future rate hike was inevitable. Minutes from that FOMC meeting already showed some disagreement, with a few voices such as Dallas Fed President Lorie Logan publicly calling for further rate increases. Additionally, Fed Chair Powell’s description of June’s rate pause as a “skip” (he immediately walked it back) indicated that future FOMC meetings would conclude with rate hikes.
In a post last month, we credited the Fed for its decision to keep target rates unchanged, an improvement from its earlier Covid‐era policymaking. The available evidence from macro indicators such as inflation and unemployment simply did not warrant a rate hike. With the Fed seemingly set to increase rates again, we reiterate our recommendation that the Fed should keep its target unchanged.
Our previous post detailed the flattening of average month‐to‐month inflation (as measured via the Consumer Price Index). The inflation numbers released today continue along the same trend. The CPI increased only 0.2% from May to June – an annualized rate of 2.4% — keeping it within range of the Fed’s 2% inflation target. As we have pointed out before, the correct measure of inflation is short‐term indicators like month‐to‐month, not year‐over‐year price changes (which is currently at 3%). This is because the annual rate may remain elevated, especially when keeping last year’s extreme inflation in mind, even though the monthly changes stay flat.
The newest CPI numbers do not indicate any need for a rate hike. The Taylor rule, an approximate relation between Fed policy and its dual mandate macro indicators – inflation and unemployment, would not advise a rate increase either. Here is a simple version of the Taylor rule:
FFRt = 0.8 x FFRt‑1 + ( 1 — 0.8 ) x [ 1.5 x Inflationt –
0.5 x ( Unemployment Ratet — NAIRUt ) ]
In June, the realized federal funds rate (FFR) was 5.08%. Latest month‐to‐month CPI inflation was 0.2% – annualized to 2.4%. Using June’s unemployment rate of 3.6% and a 4.42% natural rate (NAIRU), the implied FFR for July should be:
FFRJuly 2023 = 0.8 x ( 5.08% ) + 0.2 x [ 1.5 x ( 2.4% ) –
0.5 x ( 3.6% — 4.42% ) ] = 4.866%
So, the Fed’s target range of 5.0 to 5.25% is already above the rule implied rate. The standard policy rule does not indicate any reason to keep raising rates; if anything it suggests a slight lowering of the target to a 4.75 to 5% range.
To reiterate, there are dangers to the Fed raising its rate target by too much, or too quickly. It may worsen credit market conditions and reduce economic activity, triggering a recession.
We restate the recommendation from our prior article:
The recent inflation figures appear to be on the right track, with annualized rates getting closer to the Fed’s regular 2 percent target. Given the stakes, holding steady makes perfect sense.