Ready to Push Fed Funds Rate Above Neutral Rate

• The FOMC minutes demonstrate the committee’s determination to push inflation back to 2%.
• The FOMC expects to continue raising the fed funds rate throughout 2022, to a point where it is actively weighing on economic growth.
• The minutes implicitly acknowledge that this policy path could lead to a recession, but the committee views achieving 2% inflation as very important for long-run economic growth.
• With the Fed aggressively tightening, the risk of recession over the next couple of years is elevated.

The minutes from the June 14-15 meeting of the Federal Open Market Committee indicate the committee’s commitment to pushing inflation down to 2%. The minutes say that “participants observed that a return of inflation to the 2% objective was necessary for creating conditions conducive to a sustainably strong labor market over time.”

Participants viewed containing inflation now, in part to maintain the FOMC’s credibility, as important to keeping inflation near the 2% objective over the long run. “Many participants judged that a significant risk now facing the Committee was that elevated inflation could become entrenched if the public began to question the resolve of the Committee to adjust the stance of policy as warranted. On this matter, participants stressed that appropriate firming of monetary policy, together with clear and effective communications, would be essential in restoring price stability.”

The minutes also say that the FOMC is willing to weaken the labor market to achieve 2% inflation. “Participants also judged that maintaining a strong labor market during the process of bringing inflation down to 2 percent would depend on many factors affecting demand and supply. Participants recognized that policy firming could slow the pace of economic growth for a time, but they saw the return of inflation to 2% as critical to achieving maximum employment on a sustained basis.” Although the minutes do not make this explicit, this suggests that FOMC members would countenance recession if that would be necessary to push inflation down to 2% over the long run.

Given this, the FOMC signaled that it is willing to continue to raise rates aggressively in the near term to slow inflation. The minutes say that an increase of 50 or 75 basis points in the fed funds rate “would likely be appropriate at the next meeting,” on July 26 and 27.

The minutes also say that “participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.” That is, the FOMC expects to push the fed funds rate above the neutral rate, which is the rate where monetary policy is neither adding to or subtracting from economic growth, by the end of this year. By the end of 2022 the committee “would then be well positioned to determine the appropriate pace of further policy firming and the extent to which economic developments warranted policy adjustments.”

Another reason the FOMC provided for pushing the fed funds rate to above neutral rate in the near term is to address the risk of even higher inflation: “such a stance would be appropriate from a risk management perspective because it would put the Committee in a better position to implement more restrictive policy if inflation came in higher than expected.”

The committee also noted that aggressive monetary tightening so far in 2022 had already worked to bring down inflation expectations and long-term interest rates. “Many participants noted that the Committee’s credibility with regard to bringing inflation back to the 2% objective, together with previous communications, had been helpful in shifting market expectations of future policy and had already contributed to a notable tightening of financial conditions that would likely help reduce inflation pressures by restraining aggregate demand.”

The minutes from the June 14-15 FOMC meeting demonstrate the committee’s obligation to slow inflation. Although the minutes say that “likely take some time for inflation to move down to the Committee’s 2% objective,” they view this as essential to the long-run stability of the US labor market. The committee expects to push the fed funds rate above its neutral value by the end of this year, recognizing that this boosts recessionary risks for the US economy, and is willing to take those risks to bring down inflation.

PNC expects the FOMC to increase the fed funds by 0.75 percentage point at this next meeting, in late July, bringing it to a range of 2.50% to 2.75%. PNC then expects the FOMC to continue raising the fed funds rate through the end of this year and in early 2023, bringing it to a peak range of 3.50% to 3.75% by late winter. At this point the fed funds rate would be actively weighing on economic growth. PNC then expects the FOMC to start reducing the fed funds rate in late 2023 as inflation falls toward 2%.

Given the difficult task ahead for the FOMC, the risk of recession is elevated. Although the committee could succeed in slowing economic growth enough to bring down inflation without causing a recession, the margin for error is small. The FOMC could overtighten. Or it could be that the only way for inflation to get back down to 2% is with a recession. PNC puts the probability of recession over the next couple of years at about 40%, double what it was prior to the Russian invasion of Ukraine.

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