The Fed has decided to raise the official interest rate by 75 basis points to the 1,5 to 1,75% range. That is more than 50 basis points previously forecast. The reason for that extra step is that inflation not only remains high, but that it has taken the Fed by surprise.
The bank had expected currency depreciation to stabilize around this time of year. In May, however, inflation was higher than a month earlier. Hence, according to Fed chairman Jerome Powell, a bigger step was needed in the eyes of the interest rate committee. It's when Powell talked about the - say - overarching reason that the listener got a strong impression of how the Fed sees the situation and on the basis of which confidence in the central bank took a boost.
Powell said, "We can't have the economy and labor market we want without low inflation. Low inflation is the foundation for a strong economy. Many are experiencing high inflation for the first time, people don't like high inflation. We understand that very good, that's why we're determined to bring inflation down. The policy to do that isn't popular, but we're doing it."
Towards a tight monetary policy
Powell also stated that the medium-term neutral interest rate level (that is, the interest rate level at which inflation is neither fueled nor slowed down) has a 2 before the decimal point. And that's an important point. He then indicates that the members of the committee find it necessary to bring the official interest rate to 2022% in 3 and to raise it further in the course of 2023. Then he's basically telling the financial markets that the Fed is moving towards tight monetary policy. Not cramping, that's the way to get there, but tight. In other words, a policy that slows down the increase in demand for goods and services for a period of time in order to bring down price increases.
This is the sound you like to hear from your central bank, that low inflation is so valuable to the economy that unpopular short-term measures must be taken anyway. The above also indicates that Powell's promise that the Fed will continue to hike rates is not an empty phrase. According to the interest rate committee, the Fed must raise the official interest rate above 3% this year to bring inflation down, followed by about 3,8% in 2023. Powell also indicated that 75 basis point steps are not the norm. But that the next time the interest rate committee meets, another increase of 50 or 75 basis points is needed.
December meeting unchanged
That could mean that the official interest rate in the US at the end of July is between 2 and 2,5%. With three more meetings after that, in September, November and December, and the official interest rate target of 3 to 3,5%, that could mean the Fed reverts to its usual rate steps of 25 basis points. Or raise interest rates one more time by 50 basis points and keep rates unchanged for at least one meeting this year. I expect that could be the December meeting, because there is a good chance that inflation will have peaked by then.
Powell also sees that it will take several months of falling inflation for the Fed to take a break, which could be the case in November or December. In that respect, I found his comment fascinating that after the next interest rate increase (to between 2 and 2,5%) the bank brought the interest rate to a more normal level. A level at which the bank has more leeway with regard to the speed of interest rate hikes in the rest of this year. Because of all that, after July I expect a rate hike of 3 basis points or one time of 25 basis points, followed by one of 50 basis points and a month without a rate hike.
Risk of recession
Doesn't that put the Fed in danger of triggering a recession? I totally agree with Powell when he says it's hard to see how an interest rate between 1,5 and 1,75% is too high now or even 2% and more later this year. Those are simply not interest rates that trigger a recession. And if such interest rates do cause a recession in the US, then I think we have a much bigger problem than high inflation. Because if the American economy can't handle 2 percent interest from the Fed, then you can describe that as a big problem.
This does not mean that I think a recession is unlikely. No, there's a good chance. But I think the reasons for that are other than the Fed's rate hikes alone. All in all, the Fed is expected to continue its fight against inflation in the coming months and quarters. In addition, interest rates hold back economic activity, but do not reach the level at which the economy is plunged into recession by the Fed. In addition, the bank can test the speed of interest rate increases time and again against developments in the economy and, if necessary, slow it down.
Peace, skill and empathy
During the press conference, Powell radiated calm, expertise, empathy (on several occasions he said he understands very well what inflation does to ordinary Americans) and a sense of reality. The latter was evident from the fact that he said more than once that the Fed does not know or is not sure about something. That is worlds apart from the ECB and President Christine Lagarde. With its press conferences, blogs and other communications, the ECB creates more uncertainty and less confidence in the bank rather than more confidence and less uncertainty.
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