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A hawkish pause at the Fed


Photo Credit: PIIE/Jeremey Tripp


The Federal Open Market Committee (FOMC or Fed) left its key policy rate unchanged today, but the bigger news was its signal that it is likely to raise the policy rate another 0.5 percentage point by the end of 2023. Markets were surprised; stock and bond prices fell on the news but retraced most of these losses later in the afternoon.

The Fed's signal is an appropriate reaction to recent data showing that the economy has barely begun to cool off and that inflation is persisting at a higher rate than the Fed and most private forecasters had expected. Indeed, there is a good chance that the Fed will end up raising its policy rate even more than 0.5 percentage point by year-end.

Since its May 2-3 meeting, the FOMC has received two months of new data on employment and consumer prices. Job growth continues at a pace that is faster than the growth of the working-age population and is thus not sustainable indefinitely. Although headline inflation has dropped markedly in response to falling energy prices and moderating food inflation, other components of inflation remain well above the Fed's 2 percent target.

Chair Jerome Powell regularly parses inflation into four broad categories: food and energy, core goods (excluding food and energy), housing, and non-housing services. All components rose strongly in 2021 and 2022, led by soaring food and energy prices. In 2023, energy prices have dropped substantially and food inflation has also slowed. Housing prices are expected to slow sharply in the second half of 2023, based on recent readings on new rental rates.

Powell noted that the other components of inflation show few signs of slowing. Non-housing services prices closely follow wages, and wage inflation has ticked down only a small amount this year. Perhaps more troubling is that core goods prices continue to rise because of strong consumer demand, suggesting that the Fed's rate increases to date are not sufficient to bring the economy and inflation in for a landing.

The Fed is willing to wait another month or more to see if its past rate increases begin to take effect or if the recent bank turmoil leads to tighter credit conditions and reduced spending. But it seems increasingly likely that more hikes will be needed.

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This publication does not include a replication package.

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