Massive rates complicate Fed’s anti-inflation strategy

Federal Reserve officials have spent the past two months getting investors to adjust to their plans to slow economic growth and fight inflation by raising interest rates in half-percentage point increments until price pressures subside.

Next week’s policy meeting will show whether officials remain comfortable with this approach in light of reports on Friday that inflation surged in May, hitting a new 40-year high, and that consumers’ long-term inflation expectations rose to a new 14-year. high. The survey’s scale is important to central bankers because they believe such expectations can be self-fulfilling.

While some analysts believe Federal Reserve Chair Jerome Powell could surprise markets with a larger-than-expected 0.75 percentage point increase in the interest rate, such a move remains unlikely as it would be a marked departure from the way the central bank has pursued policy this year.

This is particularly the case when officials have other devices at their disposal to indicate a more aggressive stance, including the new rate and economic forecasts due out on Wednesday. the master. Powell will explain the price forecast at his press conference later that day.

Wednesday’s biggest questions center around how top officials see price hikes this year and next, and whether Mr. Powell opened the door for a 0.75 percentage point rate increase at the central bank’s monetary policy meeting in July.

Federal Reserve officials have said in recent weeks that they are likely to follow an expected rate hike of half a point next week and another in July. But that was before Friday’s reports, which were worse than officials expected.

So far this year, mr. Powell noted that markets’ expectations about how much monetary policy rates will rise over the next year matters more than how much the Fed will raise interest rates at any given meeting. He and his colleagues have relied heavily on communicating the Fed’s policy intentions as a way to influence borrowing costs before effective interest rates rise, an illustration of former Fed Chairman Ben Bernanke’s saying that monetary policy is “98% call and 2% action.”

Already, the borrowing costs that markets set have risen faster than the Federal Reserve’s benchmark interest rate in anticipation of its policy moves.

The Federal Reserve has raised its benchmark interest rate by three-quarters of a percentage point this year, to a range of 0.75% to 1%. But due to the Fed’s signals, the average 30-year mortgage rate has risen by more than two percentage points over the past six months, a historically rapid rise, rapidly slowing housing demand.

Such federal communications, sometimes called forward guidance, have been important this year because investors have little recent experience to guide them on how the Federal Reserve should set policy in response to the current environment for such high inflation — the so-called reactive function.

“The central bank is getting more ambitious in trying to get the market to understand the reaction function,” said John Stinson, an economist at the University of California, Berkeley. “They’ve been behind the curve for months, but they’ve turned around” using verbal guidance.

Future guidance has been part of the Federal Reserve’s arsenal for most of the past two decades. When officials began raising interest rates in 2004, they hinted in their policy statements that the increases would be done in a way that would not demolish markets, unlike the experience of the previous decade, when the Fed raised rates sharply without warning.

the master. Powell and his colleagues did not use this type of written guidance this year because they lack confidence in their ability to predict inflation. But other devices, including its quarterly price forecast and press conferences, have enabled it to affect borrowing rates across the economy.

Where is the inflation of US household budgets most affected? John Hilsenrath of the Wall Street Journal traces the roots of rising prices to see why some sectors are rising more than others. Photo caption: Laura Kammermann / WSJ

This is one reason why they did not discuss after the larger increases of 0.75 percentage point. Alternatively, they can raise borrowing costs for long-term loans by indicating a faster pace or higher end point—for example, by raising rates in half-point increments for a longer period.

Without these communication tools, the Fed may have to raise interest rates “in a more random way,” Chicago Fed President Charles Evans told reporters last month.

Some fault direct and frequent contacts of the Federal Reserve. Former Treasury Secretary Lawrence Summers recently compared the kind of sudden swings in the market that sometimes accompany Mr. Powell’s press conferences with patient-afflicting medical treatments.

Federal Reserve Chair Paul Volcker and Alan Greenspan “understood what the Delphic Oracles understood and what subsequent central bankers did not: if you are widely believed to be omniscient and omnipotent, and you know you really aren’t, it is better to speak in ways vague and somewhat verbal,” Mr. Summers said at a conference last month.

the master. Steinson disagrees. “When the Fed was tightening or loosening in the past, the market was not expecting how long that would last as much as it is now,” he said. “This means that the tightening is showing up in long-term interest rates faster and affecting the economy much faster.”

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The upshot is that forward guidance has been the Fed’s most powerful tool in recent months. In his words, the Fed can really move the yield curve. If you’re not willing to do that, you give up that power,” he said.

Changes made to speed up or slow down the economy with interest rates take time to translate into borrowing and spending decisions. Economist Milton Friedman described these changes as “long and variable delays” in monetary policy. what mr. Mr. Powell and his colleagues said the achievements this year so far could shorten those periods. Steinson.

sure that mr. Powell had some luxury in providing guidance because his colleagues on the Federal Reserve’s rate-setting committee, heading into a lull a week ago, were united about tentative plans to raise rates by half a percentage point this week and again in July. Such a consensus may not last.

And looming tough debates on the horizon. Just as it can be hard to know when to start raising prices, it can be hard to know when to stop. the master. Powell faces two dangers down the road: moving too slowly or stopping early and allowing inflation to stay uncomfortably above the Fed’s 2% target, or raising rates too much and sending the economy into a sharp slowdown.

For now, try to show how the Fed doesn’t have to wait until its rate-adjusting meetings.

write to Nick Timiraos at nick.timiraos@wsj.com

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