By Milton Ezrati
Financial markets sank when the Federal Reserve (Fed) added 0.75 percentage points to its benchmark federal funds rate on Sept. 21. Markets, having anticipated just this rate increase, responded less to it than to what Fed Chairman Jerome Powell promised for the future. He not only indicated additional rate hikes, but revealed how ready policymakers are to risk recession.
Forecasts from the Fed’s Open Market Committee (FOMC) tell the story. Those projections put the target federal funds interest rate at 4.5 percent by year-end. That is more than a full percentage point above today’s level. More telling is how this forecasted rate has risen over time. Last December, when Fed Chairman Jerome Powell was still describing inflationary pressure as “transitory,” the Fed forecast that the rate would be 0.9 percent at year-end 2022. Last June, the forecast upped the number to 3.4 percent. Now it has approached 4.5 percent.
Investors can extrapolate this pattern to anticipate still higher targets into 2023. Powell certainly has encouraged them in this belief, making it clear that controlling inflation is now the Fed’s No. 1 priority, almost regardless of any collateral damage that effort might cause.
History reinforces these interpretations. For anyone who can remember or has studied the last great inflation of the 1970s and 1980s, it is apparent that monetary policy cannot make headway against inflation until interest rates rise to levels that rival the inflation rate itself. Consider that today, even after pushing the federal funds rate above 3.0 percent and with 10-year treasury yields at almost 4.0 percent, inflation of over 8 percent still allows borrowers to repay loans with dollars that have lost more real buying power than those borrowers pay in interest.
This encouragement to use credit must end before the monetary policy can put a crimp on inflation. The need for powerful monetary actions is especially acute now because the fiscal policy does nothing to slow the flow of federal monies into the economy. On the contrary, recent policy, such as student debt forgiveness, has only accelerated that dollar flow.
In the face of this reality, investors are increasingly coming to terms with the increasing likelihood of a recession. Rate increases have already made such a prospect clear by crimping housing sales and putting downward pressure on real estate prices. Even with a construction uptick in August, new housing starts still stood nearly 13 percent below levels of last April when the interest rate increases began.
Actual new home sales, though up in August, have fallen almost 20 percent from their highs of last January, while the National Association of Realtors reports that the median sales price of an existing home declined 2.4 percent between June and July, the most recent month for which data are available. There is every reason to expect that still higher interest rates will redouble such effects in this important sector of the economy and have similar adverse effects on the economy generally.
The members of the FOMC have begun to recognize this prospect. Last December, they were forecasting 4 percent real growth for this economy. By June, they had reduced that expectation to 1.7 percent. They now expect only 0.2 percent growth in the nation’s real gross domestic product (GDP) for 2022—statistically no different from zero.
To some extent, this assessment simply accounts for the effect of outright declines in real GDP in the year’s first and second quarters. But the assessment also accounts for the ongoing economic effects of Fed policy. That the forecast now is a little different from recession speaks volumes.
There is always the hope that inflation might dissipate quickly on its own. Though anything is possible, such an event remains highly unlikely. The inflation relief in July and August, though the White House has seized on it, offers no such sign. Without what is clearly a one-time decline in gasoline prices, inflation in August would have shown a rise of close to 9 percent over the past 12 months.
The gasoline price declines cannot last. Daily gasoline prices have stabilized in September, suggesting that the September CPI will, at best, see flat gasoline prices, relief of a sort, to be sure, but not the sharp declines incorporated into the July and August figures. And with winter coming, upward energy pressures will likely return, especially with Russian natural gas off the European market.
Meanwhile, core inflation—excluding food and fuel—accelerated in August.
This picture leaves a future with four key attributes. First, continued concerns over inflation will persist. Second, the Fed will continue to raise interest rates. Third, the Fed’s actions will continue to retard the pace of economic activity. Fourth, the financial/economic environment will continue to weigh on stock and bond prices.