Higher interest rates might be with us longer than we feared

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There are two questions left hanging after the US Federal Reserve Board, as expected, raised US interest rates for the 11th time in 16 months.

Is the 25 basis point rise, which takes the federal funds rate target to between 5.25 per cent and 5.5 per cent, the last in the most aggressive series of hikes since the 1980s, the last of this cycle?

US Federal Reserve chairman Jerome Powell didn’t really clear up the interest rates picture.Credit: Bloomberg

Also, whether or not this is the last in the most aggressive series of hikes since the 1980s, how long will be before the Fed decides it has squeezed this inflationary burst out of the system and begins lowering rates?

The answers matter for Australia and the rest of the world, given the levels of interconnectivity between the major economies and financial markets and the influence the US economy, markets and currency have within them.

The Fed’s chair, Jerome Powell, wasn’t much help, essentially saying that all the Fed’s options remained open.

“I would say it is certainly possible that we would raise funds (the federal funds rate) again at the September meeting if the data warranted. And I would also say it’s possible that we would choose to hold steady at that meeting. We’re going to be making careful assessments, meeting by meeting,” he said.

While he went on to say that the Fed had “covered a lot of ground” and that the full effects of the rate rises had yet to be felt, he also said that “what our eyes are telling us is that policy has not been restrictive enough for long enough to have its full desired effect.”

In other words, the Fed might, or might not, have done enough to declare victory against what have been the highest inflation rates in 40 years, with the Fed’s bias tilted towards the “not enough yet” end of the spectrum of opinion.

The murkiness around the effectiveness, or ineffectiveness, of US monetary policy will probably have receded to some extent by the time the Fed next meets in late September, with two consumer price index readings and a similar number of employment data releases between now and then.

Reading the trajectory of inflation is at this point, however, more art than science. The truth is no-one can say, given the long lags between monetary policy actions and their effects, what hindsight will eventually reveal about the cumulative effects of the rate-hiking cycle to this point and beyond.

With the US headline inflation rate, which topped 9 per cent last year, now down to three per cent and the “core” rate (excluding food and energy prices) at 4.8 per cent against last year’s peak of 6.6 per cent there’s no argument that the aggressive monetary policies have the inflation rate heading in the right direction.

Indeed, given the lags between actions and outcomes, there’s probably a greater risk now of the Fed doing too much than too little and causing unnecessary, avoidable economic pain in the process. The same, given this week’s encouraging Australian inflation data, could be said of the Reserve Bank’s position.

The main drivers of the outbreak of inflation, the disruption to global supply chains caused by the pandemic and the massive monetary and fiscal policy responses to COVID-19, have essentially disappeared.

That means the biggest residual risk of inflation being entrenched at levels solidly above central banks targets (the Fed’s is two per cent, the RBA’s a range of 2 to 3 per cent) is the extent to which responses to the inflationary break-out are now baked into consumer and business expectations and actions.

It’s in no-one’s interests that the central banks do anything more than they have to bring inflation rates under control.

With historically tight labour markets in the US and Australia there are signs of wages growth in both economies, albeit not yet at levels that would spark a wages-prices spiral that would sustain or re-ignite inflation.

While Powell wouldn’t rule out, or in, further increases in US rates, in the absence of adverse data between now and the September Fed meeting it is probable, on the data to date, that this week’s move will be the last of this cycle.

The focus will then shift to the duration of the Fed funds rate at its current levels. Given the lags in monetary policy outcomes, how long the Fed maintains the highest rates since 2001 will be as significant, in terms of its economic impacts, as how high the rates might go.

There is an expectation in financial markets that the Fed will be cutting the Fed funds rate sometime next year but dividend opinions – inside the Fed and without – on when that process might start and how quickly rates might be lowered. The Fed is likely to be ultra-conservative even if that risks economic harm.

It is curious, and perhaps points to the unusual source of this bout of inflation, that the rate at which interest rates have been ratcheting up around the world and the levels to which they have reached hasn’t had more visibly damaging effects.

The US economy, perhaps helped by the massive boom in manufacturing and infrastructure investment Joe Biden’s economic program has fuelled, is chugging along quite solidly, as is Australia’s. That could be attributable to the residual effects of the fiscal binges or it could equally be that the full effects of the rate rises have yet to show up.

Whatever the explanation, where previously the Fed’s economic staff were forecasting a US recession, the Fed has now changed its outlook.

“The staff has a noticeable slowdown in growth starting later this year in the forecast,” Powell said.

The longer interest rates remain elevated the more economic harm they will doCredit: Dion Georgopoulos

“But, given the resilience of the economy recently, they are no longer forecasting a recession.”

Thus, soft landings in the US and here are achievable if the central bankers don’t overplay their hands.

It’s in no-one’s interests that the central banks do anything more than they have to bring inflation rates under control. With inflation rates subsiding but their policy rates set at historically high levels, they have the flexibility around the point and pace at which they eventually lower interest rates to try to fine tune the outcomes and engineer soft landings.

The US, and Australia, are on the brink of a new phase in monetary policies, even if the lagging effects and the of past rate rises and the pain they have inflicted and will inflict on households and businesses are yet to be fully felt.

If the central bankers get it right and are able to finesse the shift in policy without doing much avoidable harm it would be a welcome surprise.

Their history suggests that they will be overly cautious and, in their determination to crush inflation beyond any doubt, will end this inflationary episode having caused more economic and financial damage than was required to bring inflation under control.

Let’s all hope they’ve learned from the mistakes of the past because the longer interest rates remain elevated the more economic harm they will do and the greater the risk of unintended consequences, usually in the form of financial system and financial markets volatility and instability.

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