Fed Battles Inflation Despite the Costs

The Federal Reserve ratchets up the pace of monetary tightening, raising questions about the U.S. growth outlook.

With the U.S. Federal Reserve signaling it is firmly focused on taming inflation, a swift pace of monetary tightening is likely to continue in the months ahead. U.S. inflation data, particularly the surprisingly strong and broad-based May CPI (Consumer Price Index) report, pressured the Federal Reserve at the June meeting to hike the fed funds rate 75 basis points (bps) for the first time since 1994. Fed officials’ new economic projections show they unanimously agree the fed funds rate needs to be above neutral by year-end, despite the likely costs of slower growth and higher unemployment in 2022 and 2023.

While the projections acknowledge a slower expected pace of growth in the year ahead, Fed Chair Jerome Powell at his press conference said the Fed still believes the U.S. economy can achieve a soft landing, and the Fed’s median forecasts point to this as well. However, looking ahead over the coming year or so, we believe today’s high inflation increases the risk that the Fed overtightens, and raises questions about whether the trend-like U.S. growth they are forecasting is achievable.

June meeting details: Getting serious

The 75-bp rate hike, economic projections, and Powell’s comments all indicate Fed officials are much more focused on fighting inflation than their previous guidance suggested. A 50-bp or 75-bp hike is likely at the next meeting in July, and the “dot plot” suggests we may see a total of two or more additional larger-than-25-bp hikes in the coming months before the central bank graduates down to the more conventional 25-bp-per-meeting pace toward year-end. Despite the sharp increase in guidance, only a few dots are meaningfully above the peak forecasts priced into markets.

Of note, the projections show Fed officials are now unanimous in thinking that the fed funds rate needs to rise above neutral (the Fed’s estimate of the neutral rate, or r*, is around 2.5%, as indicated by the median of their longer-run projections). While markets had already priced in rates moving above neutral, this suggests considerably more unanimity among Fed officials on the steeper path of rate hikes than what we heard after the May FOMC meeting.

As a result of the tighter monetary policy tightening path, Fed officials also downgraded their growth and unemployment forecasts. Unlike the most recent projection update in March, where higher rates did not correspond to a meaningful downgrading of the economic outlook, Fed officials signaled that they understand that a tighter monetary policy tightening path is not without costs.

A challenging and uncertain macro outlook

Longer term, we see risks that the Fed’s willingness to fight inflation at all costs does eventually come with a larger price for growth and employment. With inflation having shifted into slower-moving measures such as shelter prices, and the labor market tending to take several quarters to reflect slower growth, we see a risk that the Fed overtightens. As a result, we think there are downside risks to our forecast for the U.S. economy to slow to stall-speed.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.

Allison Boxer is an economist and regular contributor to the PIMCO Blog.

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