On Wednesday, the Federal Reserve raised its policy rate by 0.5%, to a range of 4.25% to 4.5%, in line with expectations. But the messaging alongside the announcement raised some eyebrows. The central bank’s new projections show slightly less growth, more unemployment and higher inflation in 2023 than its last announcement suggested, together with a predicted “terminal rate” — or the point where policymakers expect to stop hiking — at just over 5%, slightly above its previous estimate.
In short, the Fed says it has more to do.
Tuesday’s inflation report had persuaded some investors that the central bank could afford to lighten up on monetary policy. Prices excluding food and energy rose by 6% in the year to November, down from 6.3% in the year to October. For the second month running, that was a greater decline than expected. Signs of subsiding inflationary pressure were also apparent across a wider range of price components.
Taken together, such data suggests that price increases have peaked. Yet the Fed is right: It’s too soon to say that the inflation rate is securely on course back to its target of 2%. In his remarks on Wednesday, Chair Jerome Powell stressed that the labor market is still tight. Companies report a “huge” overhang of vacancies, he said: It’s as though the economy is facing a “structural labor shortage.” A steady decline of growth in wages consistent with a gradual return to 2% inflation still isn’t apparent and can’t be taken for granted.
Time will tell whether a terminal rate of just over 5% will suffice. If it does, the soft landing that the central bank and everybody else is hoping for might still be possible. The median of Fed policymakers’ projections for growth in output next year is 0.5%, with unemployment at 4.6% in the fourth quarter. This looks consistent with a policy rate that, by then, would be (slightly) restrictive. It’s slow growth, to be sure, and doesn’t rule out a technical recession during the course of the year, but the Fed isn’t planning for an outright slump.
If things continue to unfold as it predicts, the bank will deserve to be congratulated on a job well done, despite its admitted error in failing to start raising interest rates sooner.
One other point is worth noting. Powell was asked during his press conference whether the Fed might consider changing its inflation target if getting back to 2% proves too difficult — an option that some economists advocate. The chairman dismissed the idea briskly. This was something the Fed hadn’t discussed and wouldn’t discuss, he said: The inflation target is 2% and that’s that.
If core inflation threatens to settle between 3% and 4% next year, he can expect to be pressed more aggressively on the matter. Yet here, too, Powell is right. Things are roughly on track because nobody doubts the Fed’s commitment to a low inflation rate. If that changes, all bets are off.