Stubborn inflation makes the Fed’s interest rate decision a difficult task

The latest inflation data released on Tuesday promised to make next week’s interest rate decision by the Federal Reserve even tougher, with rising prices showing signs of lingering stubbornness that normally calls for higher rates, but the data came amid turmoil , which engulfed the banking system, some economists call for caution.

Year-on-year price growth eased slightly, with the consumer price index up 6% in the year to February, the Labor Department said on Tuesday. That was down from 6.4% in January and in line with the slowdown expected by economists. That seemed like an encouraging sign, but the key details of the report made the data even more troubling.

Inflation looked much stronger under the surface. The price index rose 0.5% from the previous month after stripping out food and fuel prices – both of which have been jumping sharply – creating a sense of underlying price pressures. That was up from 0.4% in January and more than economists had predicted.

In essence, the rise was the fastest monthly rise in the so-called core index since September, not the kind of progress central bankers are hoping for in a year to fight inflation. Many Fed watchers expected the central bank, which meets next week, to raise interest rates by a quarter of a point after the data, a gradual move that will try to balance the risks of rapid price increases with the threat of further hikes. financial instability as shocks rip through the banking system.

“It’s a strong report,” Priya Misra, head of global rates strategy at TD Securities, said of the inflation report. “It’s really hard for the Fed to respond with no hikes or cuts, that’s crazy.”

The Fed was waiting for this inflation report before its March 22 decision. The latest data on prices, the labor market and growth suggest that the economy will remain stronger than expected in early 2023. Policymakers looked to February’s consumer price index reading to try to gauge whether the rise was a spurt from mild January weather — which tends to spur consumer spending and construction — or a genuine signal that the economy may be recovering.

Just last week, Fed Chairman Jerome Powell suggested that if the data came in hot, the Fed could raise rates by half a percentage point at its meeting. That would be a big shift: After raising rates quickly last year, including four big three-quarter point hikes, the Fed slowed its move to half a point in December and a quarter point in January.

But within days, the Fed’s decision became extremely complicated. Three prominent banks imploded last week, a spate of turmoil that is partly the result of rising interest rates.

The collapse of Silicon Valley Bank late last week, followed by the seizure of Signature Bank just days later, prompted a strong government response aimed at reassuring depositors that their money was safe to prevent bank raids from spreading across the country.

Silicon Valley Bank’s demise is linked to a recent burst of inflation, and the Fed is trying to contain it. The bank held many long-term government bonds, the market value of which fell sharply amid unexpected price increases and the Fed’s response to rate changes. This limited the bank’s ability to sell them to raise enough money without realizing large losses when customers pulled out.

It was clear to experts that Silicon Valley Bank had done a poor job of managing interest rate risk, but there is a possibility that other institutions in the financial system could find themselves in a similar position. And the question is whether the Fed can continue to raise borrowing costs when rising interest rates could threaten further financial instability.

Inflation “was strong — in normal times, the data would have supported a significant increase in the Fed funds rate,” said Aichi Omemiya, senior economist at Nomura. He had outlined a half-point increase before the bank explosions, but said after them that he didn’t think the Fed would stick with a plan to push up borrowing costs.

Instead, Amemiya expected the Fed to cut rates at its meeting. “If they get the looming financial risks wrong, it could affect the economy” too much to be worth the risk, he said.

Nomura’s call for rate cuts was exceptional. Investors are heavily betting on a quarter-point rate hike next week, based on market prices after the data release.

Misra said that if officials don’t raise interest rates amid continued high inflation, “it sends a different signal, like, ‘What does the Fed know?’ — and this can cause nervousness among investors and depositors.

Still, the debate over what the Fed might do underscores that the path forward for the central bank is uncertain and complicated as the institution tries to figure out which risk to focus on — the risk to the financial system or the threat of prolonged inflation to leave rising prices entrenched in the economy. economy.

“The Fed’s financial stability and inflation targets may be under tension right now, so it’s especially important to use the right tools for the right job,” Renaissance Macro’s Neil Datta wrote in a note reacting to the inflation report. The latest data “suggests that efforts to curb inflation are far from over.”

Americans have seen some inflationary relief in recent months as supply chains have recovered and the rapid consumer goods inflation that fueled price increases in 2021 and early 2022 has calmed. At the same time, the prices of long-term storage goods remained unchanged in February.

But policymakers are watching with concern as price increases spread across service categories that include purchases such as manicures, travel and dining out. These areas more closely reflect underlying economic momentum, and price pressures may be more difficult to stem.

In February, a measure of inflation in services that excludes housing — a measure the Fed watches very closely — rose markedly on a monthly basis. The Bloomberg version of the gauge rose 0.43% last month, up from 0.27% in January.

This was the firmest reading since September and is bad news for central bankers because it signals that price pressures are still very strong.

There were reasons to hope that inflation could slow in the coming months – for example, housing inflation measures are expected to calm after months of easing market rents – but there are also factors that could push prices higher. Used car prices fell in the report, but the recent jump in prices at auto auctions may soon be reflected in inflation data.

Also, the inflation number came after a strong February employment report. Employers added more than 300,000 workers on top of the 500,000 they hired in January. Taken together, the data suggest that key sectors of the economy are still looking forward to success.

The size of the interest rate change isn’t the only question officials will have to grapple with next week: Policymakers are also set to release fresh forecasts for the economy, including an estimate of how high rates could rise by the end of 2023.

In December, officials expected to raise rates to about 5.25% — which would mean three more quarter-point changes, including this month. Officials suggested that the solid data might prompt them to predict a higher rate in their updated forecasts, but that was before the bank was shaken.

Ian Shepherdson, chief economist at Pantheon Macroeconomics, said he expects them to possibly make another rate change.

He said there might be “some perception that we don’t need to be as big a fan as we thought we were.”

Still, many economists on Tuesday suggested the central bank should remain focused on raising prices as they cut into household incomes and show unexpected resilience.

Betsy Stevenson, an economist at the University of Michigan, noted on Twitter that raising rates to cool inflation is always fraught with risk: It was expected to slow the labor market and put people out of work. Risks to the financial system, she said, are not the only ones to keep in mind.

“The Fed should keep an eye on inflation,” she wrote. “It’s still too hot.”

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