Opinion: Fed rate hikes could soon come to an end

Editor’s note: Steven Kamin is a Senior Fellow at the American Enterprise Institute (AEI), where he studies international financial and macroeconomic issues. He served as director of the Federal Reserve’s international finance division from 2011 to 2020. The views expressed in this commentary are his own. Sight more opinion on CNN.

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Considering how dramatically inflation has risen in the last two years and how much damage this increase has done to household budgets, savings, and confidence in the economy, the Federal Reserve has done well to raise interest rates aggressively. These rate hikes have been necessary to cool the economy, curb inflation expectations and, therefore, alleviate the pressures that push prices up.

On Wednesday, the central bank is widely expected to announce that it is boosting rates more, but only a quarter of a percentage point, compared with the increase of half a percentage point in December and a series of three-quarter point increases before that. This slowdown in the pace of monetary tightening would likely mean that the Fed’s rate hikes will soon come to an end. That would be great news for the economy, and a smart move for a few different reasons.

First, and most importantly, inflation is trending downward. After reaching a maximum of 9.1% last June with respect to its level of the previous year, the growth of the Consumer’s price index fell to 6.4% in December.

Undoubtedly, much of this decline reflects falling Energy prices. But even the so-called “core” inflation rate, which excludes volatile energy and food prices and thus provides a more reliable read of price trends, has also come down a bit in recent months, to 5.7% year-on-year in December. .

Price pressures are likely to continue to ease as supply-side bottlenecks are resolved, the economy slows in response to rising interest rates, and labor markets contract as a result.

A second reason why the Fed should be slowing its rate hikes is that the actual level of interest rates needed to curb inflation is unknown. The Fed has economic models that can give some guidance on how high to raise rates, but these Models It proved incapable of predicting the inflationary surge that materialized in 2021, and its implications for the optimal level of interest rates need to be viewed more carefully.

Consequently, as some federal officials As they have pointed out, it makes sense to slow the pace of monetary tightening to assess the effects it is having on inflation and the economy, which is exactly what the Fed has been doing.

In 2018, Fed Chairman Jerome Powell He described the Fed’s approach to raising rates as similar to being in a dark room with furniture and having to move carefully to avoid bumping into something. Well, as dark as that room was in 2018, it’s a lot darker now. Inflation is much higher, the forces driving it are more opaque and, in light of the higher increase in commercial debt since then, the consequences of excessive monetary tightening are likely to be greater.

Finally, while the Fed has repeatedly signaled its concern that tight labor markets are driving salary growth above levels consistent with its 2% inflation target, the risk of a wage-price spiral, where rising wages lead to rising prices, which in turn stimulates new wage demands, appears under.

Measures of inflation expectations, both those derived from financial markets and those based on household surveysremain above pre-pandemic levels, but have moved down since the beginning of last year. Perhaps most importantly, since the beginning of the pandemic, wages have barely kept up with rising priceswhile Labor productivity it is up 4%.

In other words, workers have not received compensation for increases in productivity. The consequence, recognized by the vice president of the Fed Lael Brainard, is that “the labor share of revenue has declined over the past two years and appears to be at or below pre-pandemic levels, while corporate profits as a share of GDP remain near postwar highs” . This suggests that, in the future, wages may rise faster than prices as workers regain their share of corporate revenue. But that shouldn’t force companies to raise additional prices, and therefore shouldn’t impede the Fed’s ability to reduce inflation, since companies should be able to absorb those wage increases by cutting profit margins instead of increase prices.

All told, it appears that, assuming inflation continues to trend downward, and assuming the economy slows further, there will be room for the Fed to start cutting interest rates later this year. In fact, this is what markets They expect: a quarter-point rise this Wednesday and possibly another in March, followed by several cuts in the second half of the year.

Now the key risk to the economy is not that the Fed will stand firm and keep rates near current levels. In fact, keeping rates high might increase the risk of a recession, but it probably wouldn’t be a very deep or long recession. Rather, the key risk is if inflation stops falling. That would require substantial additional monetary tightening to check, and would have more serious implications for the US economy and financial markets.