Over the past year and a half, the Federal Reserve’s actions have strongly indicated that its monetary policy officials, responsible for setting interest rates, felt the central bank was lagging behind in addressing inflation. In March 2022, the Fed initiated a series of interest rate hikes, starting with a 25 basis point increase. Subsequently, it implemented a 50 basis point hike in May and four consecutive 75 basis point hikes from June to November of the same year, ultimately raising the federal funds rate target from 0% at the beginning of the year to a range between 4.25% and 4.50% by the end of 2022.
Additional 25 basis point hikes in 2023 have brought the federal funds rate to its current level, ranging between 5.25% and 5.50%. While the central bank’s summary of economic projections suggests another rate hike this year, the minutes from the Fed’s recent monetary policy meeting reveal signs that it is increasingly hesitant to raise rates again in the near future.
As articulated in the minutes, “A number of participants judged that, with the stance of monetary policy in restrictive territory, risks to the achievement of the Committee’s goals had become more two-sided, and it was important that the Committee’s decisions balance the risk of an inadvertent overtightening of policy against the cost of an insufficient tightening.”
In simpler terms, the Fed is beginning to worry that further rate hikes could hinder its other primary objective: attaining maximum sustainable employment.
Understanding the Fed’s Dual Mandate
The Federal Reserve operates with a dual mandate to promote price stability (low and stable inflation) and maximum sustainable employment. These two goals are generally complementary. However, when one aspect of the mandate deviates significantly from the target, the Fed must prioritize addressing the underperforming component while temporarily disregarding the other.
Historically, the Fed’s target for price stability has been a fixed 2%. This changed slightly in August 2020 when the Fed adopted a policy of targeting “2% inflation on average.” This adjustment meant that the Fed would tolerate inflation exceeding 2% temporarily, as long as the average inflation rate over time remained at 2%.
Before this change, the Fed often raised interest rates preemptively, even before inflation became evident. Consequently, during periods of economic recovery, the central bank struggled to meet its 2% inflation target. In such cases, inflation remained too low to sustain consistent economic growth that would lead to full employment.
On the other hand, the full employment component of the Fed’s dual mandate has never had a fixed target. Fed officials have traditionally considered “a wide range of indicators” when determining the strength of the labor market without causing inflation to surge. This flexibility stems from the belief that the Fed has limited influence over full employment compared to its ability to manage inflation. There is substantial evidence indicating that the supply-side inflation experienced in the United States during the pandemic recovery was not alleviated by Fed rate hikes but rather by the resurgence of the global economy’s production capabilities. Consequently, relying solely on central bankers to combat inflation may not be the most prudent approach.
The Federal Reserve is now returning to its dual goals of maintaining stable inflation around 2% while ensuring that the US labor market reaches full employment. This shift is welcomed news, particularly for those at risk of job loss if the Fed continued raising rates solely based on unemployment levels. Presently, US unemployment stands at 3.5%, compared to 3.6% at the start of the Fed’s rate hikes in March 2022.
Will the Fed Continue to Raise Interest Rates?
The meeting minutes released on August 16 indicate that several Fed officials are still in favor of a rate hike in September. If the Fed’s summary of economic projections is any indication, this could be the final rate hike before a prolonged period of maintaining rates at elevated levels, contingent on the central bank’s belief that high inflation has been addressed and economic stimulus measures can be implemented through rate cuts.
Economists at Morgan Stanley have suggested that Fed Chair Jerome Powell may use this opportunity to emphasize the uncertainty surrounding the Fed’s decision for September’s meeting, contingent on incoming data.
Michael Feroli, Chief US Economist at JPMorgan, argues that the meeting minutes reveal the Fed’s uncertainty regarding both policy and economic prospects. While the Fed staff has removed the possibility of a recession from its forecasts, it still anticipates slower-than-typical economic growth over the next two years.
In Feroli’s words, “Both the Committee and the staff … don’t know what’s going to happen next. Like the rest of us, they’ll just wait for the data.”