The Federal Open Market Committee raised the federal funds rate by 75 basis points at its meeting today. That means the upper limit of the target range now sits at 1.75 percent.
Members of the committee estimated that inflation will be 5.2 percent overall this year, up from March, when they thought it would be only 4.3 percent. Those numbers might seem low, but the Fed doesn’t use the consumer price index to measure inflation. Instead, it uses the personal consumption expenditure index, which measures inflation to be a few points lower than the CPI. For April, the PCE showed inflation at 6.3 percent over the preceding twelve months.
That means the FOMC still believes inflation will begin to go down quite soon. It will have to if it is to average 5.2 percent on the year. Exactly how remains unclear.
There’s an inconsistency in the Fed’s stance on inflation, as reflected in Jerome Powell’s comments after the meeting. He said, “We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.” He then went on to talk about supply constraints, commodity prices, the war in Ukraine, and logistics concerns as factors contributing to higher-than-expected inflation.
The Fed does not have any tools to fix supply constraints, commodity prices, the war in Ukraine, or logistics concerns. If those things are causing inflation, the Fed will have a very hard time restoring price stability.
Later on, Powell mentioned that things such as the price of gas affect inflation expectations as well as actual inflation. That’s certainly true, and he expressed a commitment to keeping the public’s inflation expectations anchored at 2 percent in the long run.
But that still doesn’t resolve the fundamental tension in the Fed’s position. It’s basically, “We got this! — but also there are all these things we can’t control that keep catching us by surprise and driving inflation up.” The first part is difficult to believe if you also believe the second part.
Powell also repeatedly emphasized overly strong aggregate demand in the economy, and that’s something the Fed can control through tighter monetary policy. That’s the direction it’s going in, and Powell said the FOMC continues to think it will need to raise interest rates for the rest of the year.
But nominal GDP for April continued to outpace its pre-pandemic trend by a lot. Interest rates have gone up, but conditions have not really tightened yet, as Ramesh pointed out in the cover story for our June 13 issue.
After being set on a 50-basis-point hike for this meeting, markets had been predicting the possibility of a 75-basis-point hike after the May CPI report came out. Markets had probably already priced in a 75-basis-point hike.
Based on market predictions and overall economic conditions, and given that the Fed — both in recent history and over its entire history — is usually behind the curve, a hike higher than the markets were expecting would have been welcome. Instead of talking about how the Fed got surprised yet again, Powell should have been the one doing the surprising.
So, while a 75-basis-point hike was a good thing to do, 100 basis points would have been better. Remember, real interest rates are still well in negative territory, and a 2 percent federal funds rate would hardly be radical.
Fortunately, Powell didn’t talk about the “soft landing” this time and put the cart back behind the horse where it belongs. “Inflation can’t go down until it flattens out,” he said. Indeed — and better to flatten it out sooner rather than later.