Editor’s Note: Steven Kamin is a senior fellow at the American Enterprise Institute (AEI), where he studies international macroeconomic and financial issues. He served as director of the international finance division of the Federal Reserve from 2011 to 2020. The opinions expressed in this commentary are his own. View more opinion on CNN.
Considering how dramatically inflation has surged in the past couple of years, and how much damage this surge has done to households’ budgets, savings and confidence in the economy, the Federal Reserve has been right to raise interest rates aggressively. These rate hikes have been necessary to cool the economy, rein in inflation expectations, and thus alleviate the pressures pushing prices upward.
On Wednesday, the central bank is widely expected to announce that it is boosting rates further, but by only a quarter percentage point, compared with half a percentage point rise in December and a string of three-quarter-point hikes before that. This slowing in the pace of monetary tightening would likely mean that the Fed’s rate hikes will soon be coming to an end. That would be great news for the economy, and a smart move for a few different reasons.
First, and most importantly, inflation is trending downward. After peaking at 9.1% last June over its year-earlier level, the growth of the Consumer Price Index fell to 6.4% in December.
To be sure, much of this decline reflects falling energy prices. But even the so-called “core” inflation rate, which excludes volatile energy and food prices and thus provides a more reliable reading on price trends, has also moved down a bit in recent months, to 5.7% year-over-year in December.
Price pressures are likely to continue to ease as remaining supply-side bottlenecks are resolved, the economy slows in response to the rise in interest rates, and labor markets tighten as a result.
A second reason the Fed should be slowing its rate hikes is that the actual level of the interest rates needed to slow inflation is unknown. The Fed has economic models that can provide some guidance on how high to raise rates, but these models proved unable to predict the inflationary surge that materialized in 2021, and their implications for the optimal level of interest rates must be taken with more than a grain of salt.
Accordingly, as some Fed officials have signaled, it makes sense to slow down the pace of monetary tightening in order to assess the effects it is having on inflation and the economy, which is exactly what the Fed has been doing.
Back in 2018, Fed Chair Jerome Powell described the Fed’s approach to raising rates similar to being in a dark room with furniture and having to move carefully to avoiding running into something. Well, however dark that room was in 2018, it is a lot darker now. Inflation is much higher, the forces driving that inflation are more opaque, and in light of the further rise in business debt since that time, the consequences of excessive monetary tightening are likely to be greater.
Finally, though the Fed has repeatedly signaled its concern that tight labor markets are boosting wage growth above levels consistent with its 2% inflation target, the risk of a wage-price spiral, where rising wages lead to rising prices, which in turn spur further wage demands, seems low.
Measures of inflation expectations, both those derived from financial markets and those based on household surveys, remain above pre-pandemic levels, but have moved down since earlier last year. Perhaps more importantly, since the beginning of the pandemic, wages have barely kept up with rising prices, whereas labor productivity has risen about 4%.
In other words, workers have received no compensation for increases in productivity. The consequence, as acknowledged by Fed Vice Chair Lael Brainard, is that “the labor share of income has declined over the past two years and appears to be at or below pre-pandemic levels, while corporate profits as a share of GDP remain near postwar highs.” This suggests that, going forward, wages may rise faster than prices as workers regain their share of corporate income. But that should not force firms into additional price increases, and therefore shouldn’t impede the Fed’s ability to reduce inflation, since firms should be able to absorb those wage hikes by reducing profit margins rather than increasing prices.
All told, it appears that, assuming inflation continues to trend downward, and assuming that the economy slows further, there will be scope for the Fed to start reducing interest rates later this year. Indeed, this is what markets are expecting: a quarter-point hike this Wednesday and possibly another in March, followed by several cuts in the second half of the year.
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Now, the key risk to the economy is not that the Fed sticks to its guns and keeps rates near current levels. Indeed, keeping rates elevated could heighten the risk of recession, but it likely wouldn’t be a very sharp or prolonged downturn. Rather, the key risk is if inflation stops declining. That would require substantial further monetary tightening in order to get it under control, and would have more serious implications for the US economy and financial markets.