The Fed Should Stay the Course

Financial markets expect the central bank to slow its monetary tightening. That would be a mistake.

The Editors

02 Feb 2023, 12:34 AM IST

Jerome Powell, chairman of the US Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, DC, US, on Wednesday, Nov. 2, 2022. Federal Reserve officials delivered their fourth straight 75 basis-point interest rate increase while also signaling their aggressive campaign to curb inflation could be approaching its final phase.

(Bloomberg Opinion) -- The Federal Reserve’s antidote to high inflation is working. Demand is cooling, wage increases are moderating, and prices are rising more slowly than before. Even so, it’s still too soon to be confident that, without further monetary tightening, inflation will fall all the way back to the Fed’s 2% target.

After their meeting today, the central bank’s policymakers should state this clearly, and raise the policy rate by another 50 basis points, to a range of between 4.75% and 5%. Financial markets are expecting a smaller increase of 25 basis points, following four consecutive hikes of 75 points and one of 50 points last year. Despite the recent good news, this would be to err on the side of timidity.

It’s true that headline year-over-year inflation fell from its peak of 9.1% last June to 6.5% in December. And as optimists point out, this understates the improvement during the past few months. Between September and December, consumer prices went up just 0.5%, or roughly 2% at an annualized rate, in line with the central bank’s target.

Unfortunately, stripping out volatile components, the price index for core personal consumption expenditures shows a milder decline — to 2.9% (annualized) in the last three months of the year. Lately Fed Chair Jerome Powell has drawn attention to an even narrower measure as a better guide to future price pressures — PCE core services excluding housing — which seems to be holding steady at about 4%.

The Fed also pays close attention to labor costs. These too are rising more slowly than before, but the recent pace of between 4% and 5% is still too high to be consistent with 2% inflation. Despite layoffs by some big tech companies and others, the US labor market is still tight by all but the most recent standards, with an unemployment rate of just 3.5% and a persistently high ratio of vacancies to job-seekers.

A third factor should also be kept in mind: Despite the rise in interest rates over the past year, broader financial conditions (which interest rates are intended to affect) have lately eased. According to measures that take account of risk, credit and leverage, the mood in financial markets is picking up — perhaps prematurely, and in a way that risks undermining the Fed’s efforts.

Setting the policy rate in such circumstances is far from an exact science. The Fed is struggling to find a narrow path between declaring the fight against inflation as good as won, which might allow higher-than-targeted inflation to get entrenched, and restraining demand too much, which might tip the economy into recession. Despite its late start in raising interest rates, its efforts so far have gone well.

Even so, today’s expected quarter-point increase risks signaling a slackening of its determination to get inflation all the way down. The Fed should remove any doubts about its commitment.