The Case For High(Er) For Longer Is Still Intact

We know that the markets continue to second guess the Federal Reserve’s (Fed’s) commitment to staying high(er) for longer with respect to interest rates. In fact, markets continue to have the Fed decreasing the federal funds rate considerably, to 4.25%-4.5%, later this year. The assumption from markets is that since the U.S. economy is going to enter a recession, the Fed is going to have to cut interest rates to help bring the economy out of recession.

This would probably be a good expectation had inflation remained at or below the Fed’s target as was the case on previous occasions when the Fed actually started decreasing the federal funds rate at the first sign of trouble. But inflation, depending on whether you look at the CPI or the PCE price index, is still too high for the Fed to digest. In fact, year-over-year CPI inflation was 6.04% in February of this year. However, 12-month average CPI inflation, which is how inflation actually affects consumers’ purchasing power, was still 7.75% in February of this year. If you prefer to look at the PCE price index, the year-over-year PCE price index was at 5.00% in February of this year while the 12-month average PCE price index was at 6.08%. And adding monetary stimulus into an economy that is still experiencing very high inflation is not what the ‘doctor’ recommends in these cases because it risks inflation remaining higher than the Fed’s target and threatens a ‘de-anchoring’ of inflation expectations, especially long-term inflation expectations.

Weekly Economics Chart 3.31.23
Click here to enlarge

Since the U.S. economy is still growing above potential output today, Fed officials cannot be accused of presiding over a ‘stagflation’ period, at least not yet. That is, a period in which the economy grows below potential (i.e., stagnant), and inflation is very high. Today, the U.S. economy is still growing above potential and thus is still generating high inflation, consistent with an economy that is putting pressure on resources and pushing those resource prices higher.

But this environment will not last much longer as we are expecting a recession to start during the second half of the year. As the U.S. economy enters a recession, economic growth will fall below potential growth. This means that the Fed needs to bring inflation down fast toward its target or risk being accused of driving the U.S. economy into a stagflation period, something Fed officials don’t want to be accused of doing. Thus, there are plenty of incentives for the Fed to continue with its hawkish stance on interest rates.

However, here is where we, respectfully, disagree with Fed officials. We believe that there is no need to continue to increase interest rates further to achieve their inflation goal. We think that 5.00% for the terminal rate today, plus the tightening effects of the recent banking sector turmoil, will be enough to take the U.S. economy into below potential growth while at the same time bringing inflation down to the 2% target over the next several years.