Fed ponders resilient US economy

Washington, July 25 (BNA): With the Federal Reserve heading toward another rate hike this week, policymakers are facing a choice about how much weight to place on recent economic data that has made desired outcomes on inflation and unemployment seem more likely while also posing risk to the economy that is too strong to keep prices in the same direction.

Since the US central bank’s policy meeting in June, inflation has slowed more than expected toward the Fed’s 2% target, with many analysts seeing a cycle of moderate price increases underway and should continue without further price increases beyond the quarter-percentage-point rise widely expected to be announced on Wednesday.

But optimism in the Fed’s ‘soft landing’ — a scenario in which inflation falls, unemployment remains relatively low, and a recession is averted — has also supported financial markets in ways that may run counter to central bank objectives, something policymakers are likely to guard against with a strong anti-inflation message despite where the data points to.

Diane Swonk, chief economist at KPMG, wrote Monday that the Fed “doesn’t want to be phony about the recent slowdown in inflation and declare victory too soon,” concluding that the central bank will leave its options open for further increases in borrowing costs. “Financial markets have been constantly running the Fed… That has already eased credit conditions and could fuel an acceleration in growth.”

The rate-setting Federal Open Market Committee is expected to raise the base rate to a range of 5.25%-5.50% when it releases its latest policy statement at 2 PM ET (1800 GMT) on Wednesday. Fed Chairman Jerome Powell will hold a press conference shortly after to explain the decision.

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In the six weeks since the June 13-14 meeting, Fed policymakers have digested data that offers a mirror image of what they faced a year ago. At the time, six months of economic contraction seemed to show the development of a recession, prices were rising rapidly, and central bankers quickly raised interest rates to a pace expected to make any downturn worse.

The issue now is how much blue skies need to be acknowledged. Last summer’s Fed meetings took place in an atmosphere of deep concern about inflation rising to four-decade highs and the fate of the economy as the Fed attempted to write it off. Since then, the unemployment rate hasn’t changed much at 3.6%, and growth has been consistently above trend. However, the Fed’s preferred measure of inflation has fallen from 7% in June 2022 to 3.8% as of last May.

That’s still nearly double the central bank’s 2% target, and some officials fear it will prove increasingly difficult to cover the remaining ground if the economy remains as resilient as it currently appears.

There are certainly signs of a slowdown, and some policymakers predict that more weakness is coming – an argument for caution when considering rate hikes.

But with monthly job growth still above 200,000 as of June and wage increases outpacing inflation, households may be able to sustain spending and thwart the consumption slowdown that some Fed officials feel the need to mop up the rest of the excess inflation.

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US stock markets were on the rise and other measures of financial conditions showed that some conditions are fading even as the Fed tries to constrain the economy. Indeed, a new indicator of the central bank’s financial conditions shows that the peak of malaise may have hit late last year.

Over the course of the second quarter, the Atlanta Fed “nowcast” for economic growth for that three-month period jumped from 1.7% annual rate to 2.4% based on boosted consumer spending, stronger business investment, and a larger contribution from government spending.

The change crossed a significant line, going from just below the Fed’s estimate of 1.8% for trend growth – and the level it should therefore continue to ease inflation – to significantly above it. The first estimate of GDP for the second quarter will be released on Thursday, with economists forecasting a growth rate of 1.8% versus 2.0% in the first quarter.

However, unless there is a sharp decline in activity soon, it could mean that Fed officials have underestimated the strength of the economy and may become skeptical about the prospect of continued low inflation.

Fed officials in June expected GDP to grow just 1.0% in 2023, projections that “essentially require a sudden stop in the economy in the second half of the year,” wrote Tim Dowe, chief US economist at SGH Macro Advisors. “We already have enough visibility into the third quarter to know that’s not going to happen.”

This will likely keep the door open for further price increases – for now. US central bankers got stuck in 2021 when their initial analysis of soaring inflation attributed it to forces, such as a pandemic-era supply and spending shock, that they believed would pass over time. Even if it looks like it’s happening now two years later, they’re probably just slow to catch a win.

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“It’s not yet clear how much growth the Fed will tolerate during a period of low inflation numbers,” Doi said, with focus likely to shift toward real economic development along with price-related data.

“We believe Powell will lead market participants to broaden their focus beyond inflation numbers by making clear that for the Fed to be confident it will restore price stability, it needs to see a further slowdown in demand manifested by significantly slower GDP growth, softer job growth, and more downward pressure on wage growth.”

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