Fed “Stays the Course”

One of the most frequently quoted phrases of Federal Reserve officials in recent weeks has been to “stay the course.”  It was almost as if they all got the same memo. The goal is to slow the pace of rate hikes as they close in on what the Fed sees as the terminal or peak rate. The current consensus is to raise rates to a 5%-5.25% range. They would hit that rate in May if the Fed slowed rate hikes in quarter point moves starting February 1. 

Why wouldn’t the Fed just stop after the next rate hike given the deceleration in inflation? Governor Christopher Waller summed it up best. He said, “Back in 2021, we saw three consecutive months of relatively low readings of core inflation before it jumped back up. We do not want to be head-faked.” 

The largest risk the Fed wants to avoid currently is stopping too soon and having to raise rates again. However, we are seeing some cracks in the consensus as inflation cools. The statement following this meeting is expected to include the phrase “ongoing increases” when it refers to rate hikes. The fear the Fed has is that financial markets will front-run a pause in rates and stem or undo the progress the Fed has made on inflation to date. As we get into March and May, debate within the Fed over the persistence of rate hikes is likely to flare. 

Doves are more willing to space out rate hikes. Watch for the debate over the end point and the pace of rate hikes within the Fed to intensify in 2023 with more doves rotating into voting roles on the Federal Open Market Committee (FOMC) – the policy setting arm of the Fed. 

The four regional Fed presidents who rotate onto the FOMC in 2023 are: Austan Goolsbee of Chicago, who just started in January; Lorie Logan of Dallas; Neel Kashkari of Minneapolis and Patrick Harker of Philadelphia. Logan and Harker have been more openly questioning the level and pace of rate hikes than their peers. Goolsbee is assumed to be more dovish but one never knows until they enter the doors of an actual Federal Reserve meeting. Kashkari was previously one of the most dovish members of the FOMC and is now among the most hawkish.

Doves are in the minority but they may lose an ally on the Board of Governors.  Vice Chair Lael Brainard is the frontrunner to be the next head of the National Economic Council for the White House and is seen as an eventual replacement for Treasury Secretary Janet Yellen. This is a position she was previously considered for and has experience as Deputy Treasury Secretary for International Affairs from 2010-2013. 

That leaves Susan Collins of the Boston Fed as another dove. It is unclear who would replace Brainard on the Board of Governors. 

The Fed’s leadership ranks were fully staffed for the first time since 2013 in 2022. Diversity among the Fed’s leadership has increased as well, which is showing up in a broader spectrum of research within the Fed system. The result will trigger more debate as the Fed attempts to narrow in on a terminal rate and decide when it has seen enough of a deceleration in inflation to cut rates. That may ruffle markets, which hate uncertainty and dissonance within the Fed ranks, but it could boost the quality of Fed decisions.

What does the Fed need to see before cutting rates? A decisive move in core PCE inflation toward 2%. Fed officials have rejected calls to stop with 3% inflation as that would seem as though they are moving the goal posts to declare victory. They are not likely to cut rates until core inflation appears to be moving through the 3% threshold. History has taught us that getting inflation off its peak is easier than getting inflation down to a pace that no longer distorts behaviors. 

The last line is said with pure humility as history has been a poor predictor of an economy that moves as rapidly as the post-pandemic economy is shifting. It is more difficult to measure, let alone predict, than it once was. The latter is another reason that the Fed doesn’t want to get ahead of the economic data, even though officials know there is some lag in how rate hikes play out. 

The silver lining is that Fed-induced slowdowns are easier to rebound from than balance sheet recessions. That, coupled with a healing of household and corporate balance sheets, suggests that the economy will respond more rapidly to rate cuts once the Fed reverses course.