The risk of higher US interest rates

The Fed’s Open Market Committee has left the range for the funds rate unchanged at 3½-3¾% for the second meeting in a row, where there was one vote in favour of a rate cut (in January, there were two votes in favour of a cut).

CCI’s policy rules – which key off the Fed’s economic outlook and rely on a range of estimates of both the neutral funds rate and the NAIRU – continue to suggest that the funds rate should be held steady at a higher rate of about 4%.

The policy rules point to a higher funds rate because core inflation is still well above the Fed’s 2% target, while most estimates of the neutral policy rate are higher than the median FOMC estimate of about 3%. This is despite the evidence of some slack in the labour market, where employment has barely grown for a long time and the unemployment rate is slightly above estimates of the NAIRU.

Officially, the Fed has a different view in that the FOMC’s updated outlook still has a median forecast of one rate cut this year and another one next year, the same as expected in December. This trajectory largely reflects the view that inflation will ease once the impact of tariffs starts to fade around the middle of the year, as well as ongoing concern about the low rate of hiring in the labour market.

However, the ground looks to be shifting in the face of slower-than-expected progress on inflation and the fresh threat to inflation expectations posed by the Iran war.

Asked whether some FOMC members had again wanted the Fed to provide “two-sided guidance” on policy – which is just an awkward way of saying the next move in rates might be a cut or it might be a hike – Powell said:

“[T]he possibility that our next move might be an increase did come up at the meeting, as it did the last meeting. The vast majority of participants don't see that as their base case, [but], of course, we don't take things off the table. But you correctly characterised … what was in the [January] minutes, that several participants indicated something very much like that conversation did happen.”

As for the Iran war, Chair Powell was very careful to highlight the extreme uncertainty around the duration of the conflict and its impact on prices and consumers (“Like everybody else, we have to wait and see what happens … [and] I really wouldn't speculate”).

However, Powell spelled out that while the “longstanding [central bank] thinking is that you do look through energy shocks”, this was “conditioned on inflation expectations [remaining stable]”, adding that the fact that inflation had been above target for five years was a factor in the FOMC’s decision-making.

Inflation expectations have been remarkably stable for many years, shrugging off both the long period of low inflation after the global financial crisis and the sustained high inflation of the pandemic, but all central banks are acutely aware of how the large sustained energy shocks of the 1970s fed into higher inflation expectations, underpinning a disastrous mix of high inflation, high unemployment, and high interest rates.

Finally, while this was ostensibly Powell’s penultimate meeting as Fed Chair, he indicated he might need to stay in the role past the expected handover to former Fed governor Warsh in mid May if the Senate had not confirmed Warsh by that time, pointedly adding that, “I have no intention of leaving the board until the [Department of Justice] investigation [into him and the Fed] is well and truly over with transparency and finality”. He went on to say, “on the question of whether I will serve as a governor after my term ends and the investigation is over, I have not made that decision yet. I will make that decision based on what I think is best for the institution and for the people we serve.”