Editor’s Note: Steven Kamin is a senior fellow at the American Enterprise Institute (AEI), where he studies international macroeconomic and financial issues. From 2011 to 2020, he served as Director of the International Financial Division of the Federal Reserve. The opinions expressed in this commentary are his own. See more opinion on CNN.
Given how sharply inflation has risen over the past few years, and how much damage this growth has done to household budgets, savings, and confidence in the economy, the Federal Reserve has been right to raise interest rates aggressively. These rate hikes were necessary to cool the economy, curb inflationary expectations, and thus ease upward price pressures.
On Wednesday, the central bank will announce widely that it is raising interest rates further, but by just a quarter of a percentage point, compared with half a percentage point in December and three quarters of a point before that. This slowdown in the pace of monetary tightening is likely to mean that the Fed’s interest rate hikes will soon end. That would be great news for the economy and a smart move for a few different reasons.
First, and most importantly, inflation is on a downward trend. Consumer price index growth fell to 6.4% in December.
Of course, 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 of price trends, has also fallen slightly in recent months, to 5.7% year-on-year in December. .
Price pressures are likely to continue to ease as remaining supply-side bottlenecks are resolved, the economy slows in response to rising interest rates, and labor markets tighten as a result.
The second reason the Fed should slow its rate hikes is that the actual level of interest rates needed to slow inflation is unknown. The Fed has economic models that can provide some guidance on rate hikes, but these models have proven incapable of predicting the inflationary gains realized in 2021, and their impact on the optimal level of interest rates should be considered more than a grain of salt. from salt.
Accordingly, as some Fed officials have signaled, it makes sense to slow the pace of monetary tightening to assess its impact on inflation and the economy, which is exactly what the Fed has been doing.
Back in 2018, Fed Chairman Jerome Powell described the Fed’s approach to raising rates as akin to being in a dark room with furniture and moving carefully to avoid bumping into something. Well, as dark as that room was in 2018, it’s much darker now. Inflation is much higher, the forces driving that inflation are more opaque, and in light of further increases in business debt since then, the effects of excessive monetary tightening are likely to be greater.
Finally, while the Fed has repeatedly expressed concern that tight labor markets are driving wage growth in line with its 2% inflation target, the risk of a wage-price spiral, where rising wages lead to rising prices, which in turn spurs further growth : Salary requirements appear to be low.
Measures of inflation expectations, both from financial markets and based on household surveys, remain at pre-pandemic levels but have fallen. since the beginning of last year. Perhaps more importantly, wages have barely kept up with rising prices since the start of the pandemic, while labor productivity has risen by about 4%.
In other words, workers did not receive compensation for increased productivity. The result, as Fed Vice Chairman Lael Brainard acknowledged, is that “labor’s share of income has declined over the past two years and appears to be at or below pre-epidemic levels, while corporate profits as a share of GDP remain is in the post-war period. heights”. This suggests that wages may rise faster than prices in the future as workers regain their share of corporate income. But it shouldn’t force companies to increase prices further, and therefore shouldn’t hinder the Fed’s ability to reduce inflation, because companies should be able to absorb those wage increases by reducing profit margins, not by raising prices.
Overall, it appears that assuming inflation continues its downward trend, and assuming the economy is slower, there will be room for the Fed to start cutting interest rates later this year. Indeed, this is what the markets are waiting for. a quarter-point increase this Wednesday and possibly one more in March, followed by a few cuts in the second half of the year.
Now, the main risk to the economy is not the Fed sticking to its guns and keeping interest rates near current levels. Indeed, keeping interest rates high may increase the risk of a recession, but it probably won’t be a very sharp or prolonged recession. Rather, the main risk is if inflation stops falling. That would require significant further monetary tightening to bring it under control, and would have more serious implications for the US economy and financial markets.