Decoding the Fed's interest rate policy

For more than a year, Fed policymakers have consistently held the view that it is better to raise interest rates sharply than to increase them slowly, suggesting that the US central bank is particularly concerned about the risk of persistently high inflation. However, that view is changing.

Over the past year, the Fed has used the weakening economy as the argument to explain its decision to stop raising interest rates. (Source: Reuters)

The risk of high inflation is constant.

Some Fed officials still favor higher interest rates, citing the possibility of cutting them later. But others see the risks as more balanced, worried that raising rates and weakening the economy is unnecessary or that it could trigger a new financial crisis.

The shift to a more balanced view on interest rates is supported by data: Inflation and the labor market have softened. In addition, the unusually rapid rate hikes implemented over the past year and a half will continue to weaken consumer demand in the coming months.

Fed officials have decided to raise interest rates in 11 of the last 12 meetings, most recently a 0.25 percentage point increase in July 2023, bringing the base rate to 5.25-5.5%, the highest in 22 years. They seem to have reached a broad consensus on keeping interest rates unchanged at the meeting from September 19-20, to have more time to assess and evaluate how the economy reacts to the interest rate increase.

The more important question is what factors will push the Fed to raise interest rates in November or December.

In June 2023, most officials of this agency reserved the view that there should be two more modest interest rate hikes, which means a quarter-point increase between now and the end of 2023 (after the quarter-point increase in July). However, whether or not to raise interest rates is still an open question.

Over the past year, the Fed has used a weakening economy as the justification for holding off on raising interest rates. As inflation eases, that “burden” is shifted to a growing economy – using this as a reason to anchor interest rates higher.

That's exactly what Fed Chairman Jerome Powell recently said: The risk that better-than-expected economic activity will offset recent progress in the fight against inflation.

Evidence of stronger-than-expected growth “could put progress against inflation at risk, possibly forcing further tightening of monetary policy,” Mr. Powell said at the Jackson Hole conference last August.

Promote defense policy

There is a school of thought within the Fed that remains concerned about inflation and wants to hedge against it by raising interest rates this fall. These policymakers fear that ending the tightening campaign will only lead to the Fed realizing a few months later that it has not done enough.

This shortcoming would be particularly disruptive if financial markets, having been swept up in the view of falling inflation and falling interest rates, now realized the opposite reality.

“There is a risk of overtightening,” Cleveland Fed President Loretta Mester said in an interview last year. “But we have underestimated inflation. Letting inflation run longer would be damaging to the economy. I would be prepared to cut rates fairly quickly next year.”

Some Fed officials worry that raising interest rates and weakening the economy is unnecessary, or will trigger a new financial turmoil. (Source: AP)

Last week, Fed Governor Christopher Waller also said that the US central bank should raise interest rates if it deems it necessary, because a small increase in interest rates will not necessarily push the world's No. 1 economy into recession.

Sharing the same view is Dallas Fed President Lorie Loga, who said that not raising interest rates this September does not mean the Fed has stopped the rate hike path.

Keep interest rates high for longer

Another school of thought favors a pause in rate hikes. They want to shift the focus from how high to raise rates to how long to keep them where they are. The US economy maintained a growth rate of 2.1% in the second quarter of 2023 and could reach over 3% in the third quarter.

But this group of Fed officials doubts the possibility of stable growth, especially when the Chinese and European economies are declining, and the US will also suffer the negative impact of interest rate hikes due to the lag effect.

The risk of higher and longer-term inflation now needs to be balanced against the risk that excessive monetary tightening will lead to a sharper economic downturn, said Susan Collins, president of the Boston Fed. The Fed needs to be patient at this stage of the policy cycle.

The yield on the 10-year US government bond has risen from 3.9% to 4.25% since the Fed's policy meeting in July. This has increased the cost of borrowing, especially mortgage rates, which recently hit a 22-year high.

Many also worry that if a new rate hike later proves unnecessary, the rate-cutting process will be more complicated and have worse consequences than the hawks have predicted.

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