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As expected, the Federal Open Market Committee (FOMC) increased interest rates by 75 basis points (bps) at its November 2022 meeting, bringing the target federal funds rate to a range of 3.75% – 4.00%. There was no change to existing plans for reducing the size of the US Federal Reserve’s (Fed’s) balance sheet. The FOMC statement included a sentence acknowledging the lagged effect of US monetary policy on the real economy and inflation. During Fed Chair Jerome Powell’s press conference, he suggested that the terminal policy rate for this economic cycle might be higher than he assessed it to be in September, but also that the pace of rate increases will slow in December or early 2023.
The Fed’s challenge
The Fed signaled that it intends to slow the pace of rate increases at upcoming meetings and to maintain the policy rate at the higher terminal level for a prolonged period. Monetary policy typically operates with long and variable lags, and the full impact of recent policy tightening is likely not yet reflected in the real US economy. Additionally, the speed at which the Fed is shrinking its balance sheet is extraordinary and its effects on the real economy, financial stability, and liquidity conditions still unclear.
However, there are early signs that Fed policy tightening is starting to affect economic indicators. US home prices have decreased from their June peak, financial conditions have tightened somewhat, upward pressure on average hourly earnings has eased, and job vacancies may have finally topped out. All of this should give the Fed some comfort with regard to slowing the pace of rate increases going forward. The challenge for the Fed is that while the changes in these economic indicators may be reassuring, their absolute levels remain inconsistent with the Fed’s goals:
- While home prices have fallen off their highs from earlier this year, they remain over 40% higher than pre-pandemic levels.
- Financial conditions have tightened from previously loose levels but are not particularly tight from a long-term historical standpoint.
- Wage increases have stabilized but remain around 5% in annualized terms, which is inconsistent with the Fed’s 2% inflation target.
Looking ahead
The pace of Fed rate hikes from here is likely to depend on the resilience of the labor market. To materially slow the pace, the Fed will need to see moderation in both wage gains and core inflation readings. At present, the labor force participation rate is 62.3%, a full percentage point below pre-pandemic levels, while the unemployment rate of 3.5% is half a percentage point below the FOMC’s longer-run estimate. The October Employment Situation Report, to be released this Friday, will provide insight into the strength of recent wage gains and the likely magnitude of the Fed’s policy move in December.
Additionally, the Fed is likely to remain attentive to market liquidity conditions, given the uncertain impact of quantitative tightening on market functioning. This is apt to be a higher priority following the recent instability caused by the rise in UK government bond yields, which prompted intervention by the Bank of England. Indeed, the Fed has recently released several papers related to financial market stability, including a consideration of “all-to-all” Treasury market trading and research regarding the relationship between monetary policy and financial market stability. While market volatility alone is unlikely to alter Fed policy, material market disruptions could impact the Fed’s balance-sheet reduction plans.
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