Last week’s consumer price index (CPI) report tolled the bell on the pandemic-induced, near-zero Federal Funds Rate. CPI inflation (including food and energy costs) has climbed since April 2021, while the Federal Reserve has kept the benchmark rate at its ultra-low April 29, 2020, setting. Now Fed policy has to catch up with the greatest surge in consumer prices in 40 years.
What’s ahead? The financial markets and economists expect anywhere from 5 to 7 interest rate increases in 2022. That’s remarkable considering that, as of December 15, 2021, most Fed members were forecasting three rate hikes.
The Federal Open Market Committee’s (FOMC) next meeting is March 16. According to the CME Group's FedWatch tool, which tracks market-implied probabilities of rate hikes, at 8 a.m. EDT on February 14 there was a 64% chance the first hike would be 50 basis points. At the September 21 meeting, the highest probability (38%) is for the Fed Funds rate to be 1.5% to 1.75%, a level unseen since October 2019. (The probabilities update in real-time and can change quickly.)
Keep in mind the neutral rate of interest is probably higher — possibly 2% to 2.5%. That's the theoretical rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive, and there is full employment and associated price stability.
While rates are coming into focus, less certain is how aggressively the FOMC will end and then reverse another stimulus tool — large-scale asset purchases. The Fed said those will end next month, but as of now, the Fed is still buying.
The problem is the time it takes for monetary policy changes to work their way through the economy. Milton Friedman pointed that out in his famous “fool in the shower” metaphor — comparing it to the journey hot and cold water have to make through a house’s plumbing to the showerhead. The time it takes for monetary policy to work is months or years, Friedman said.
Meanwhile, in the present, inflation rolls on. The Federal Reserve Bank of Philadelphia’s survey of professional forecasters on February 11 showed the median projection for this quarter's increase in headline CPI had been raised to 5.5% from 3%. The forecast for the second quarter was lifted 100 basis points to 3.8%.
That’s due, at least in part, to consumer demand taking a while to simmer down. In a January 28 blog post, Jason Furman, a senior fellow at the Peterson Institute of International Economics, and Wilson Powell III of the Harvard Kennedy School wrote that demand may stay elevated “because of higher bank balances, extremely accommodative financial conditions, and [spending of stimulus dollars]."
At the same time, supplies of goods and services will continue to face shortfalls “because full labor market recovery will take time and because of other pandemic-related scarring and protracted supply chain problems,” they wrote.
The FOMC may burst out of the gate with a 50-basis-point hike in March. But chief financial officers will be fighting on their own for a while. In Grant Thornton’s latest CFO survey fielded in December 2021, more than half (53%) of finance executives expected inflation to impact their business for at least another six months. One-third said it will be a year.
The Fed letting inflation take off for 9 or 10 months may not have been the worst move.
“Finance leaders will have to help manage cost structures while addressing and communicating potential margin erosion as material and workforce costs skyrocket,” said Enzo Santilli, national managing partner of transformation at Grant Thornton.
Even that is not a certainty, however. A few economists (not many) think the macroeconomy is not strong enough to withstand an extended course of the Fed's medicine.
While that view has been waning since January’s CPI result, it's a reminder the Fed letting inflation take off for 9 or 10 months may not have been the worst move — the last thing the Fed wants to do is plunge the economy into recession.