Sizzling Prices Complicate Fed’s Inflation-Fighting Strategy

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Federal Reserve officials have spent the past two months getting investors acclimatized to their plans to slow economic growth and combat inflation by raising interest rates in half-percentage-point increments until price pressures cool.

This coming week’s policy meeting will show whether officials are still comfortable with that approach in light of reports Friday that inflation sizzled in May, hitting a new 40-year high, and that consumers’ longer-term inflation expectations rose to a new 14-year high. The survey measure is important to central bankers because they believe such expectations can be self-fulfilling.

While some analysts think Fed Chairman Jerome Powell could surprise markets with a larger than anticipated rate increase of 0.75 percentage point, such a move remains unlikely because it would be a notable departure from how the central bank has conducted policy this year.

That is especially the case when officials have other devices at their disposal to signal a more aggressive posture, including in new rate and economic projections to be released Wednesday. Mr. Powell will elaborate on the rate outlook at his press conference later that day.

The bigger questions Wednesday center on how high officials see rates rising this year and next, and whether Mr. Powell opens the door to a 0.75 percentage point rate increase at the central bank’s July policy meeting.

Fed officials said in recent weeks they were likely to follow an anticipated half-point rate rise this coming week with another one in July. But that was before Friday’s reports, which were worse than what officials had expected.

So far this year, Mr. Powell has signaled that markets’ expectations of how high policy rates will rise over the coming year matter more than how much the Fed lifts rates at any given meeting. He and his colleagues have relied heavily on communicating the Fed’s policy intentions as a way to influence borrowing costs ahead of actual rate rises, an illustration of former Fed Chairman

Ben Bernanke’s

adage that monetary policy is “98% communication and 2% action.”

Already, borrowing costs set by markets have climbed faster than the Fed’s benchmark rate in anticipation of its policy moves.

The Fed has raised its benchmark rate by three-quarters of a percentage point this year, to a range between 0.75% and 1%. But because of the Fed’s signaling, the average 30-year mortgage rate has shot up by more than 2 percentage points over the past six months, a historically rapid rise, which is quickly cooling housing demand.

Such Fed communication, sometimes called forward guidance, has been important this year because investors have little recent experience to guide them on how the Fed will set policy in response to the current environment of such high inflation—its so-called reaction function.

“The central bank is getting more ambitious in trying to get the market to understand the reaction function,” said Jón Steinsson, an economist at the University of California, Berkeley. “They were behind the curve for several months, but they caught up” by using verbal guidance.

Forward guidance has been part of the Fed’s arsenal for most of the past two decades. When officials began raising rates in 2004, they hinted in their policy statements that increases would proceed in a manner that wouldn’t bulldoze markets, unlike the experience of a decade earlier, when the Fed raised rates sharply with no forewarning.

Mr. Powell and his colleagues haven’t used this kind of written guidance this year because they lack confidence in their ability to forecast inflation. But other devices, including their quarterly rate projections and his news conferences, have enabled them to influence borrowing rates throughout the economy.

Where in Americans’ household budgets is inflation hitting the hardest? WSJ’s Jon Hilsenrath traces the roots of the rising prices to learn why some sectors have risen so much more than others. Photo illustration: Laura Kammermann/WSJ

This is one reason they haven’t yet debated larger increases of 0.75 percentage point. Instead, they can raise borrowing costs for longer-dated loans by signaling a faster pace or higher ending point—for example, by lifting rates in half-point increments for longer.

Without such communications tools, the Fed might have had to raise rates “in a more haphazard fashion,” Chicago Fed President

Charles Evans

told reporters last month.

Some fault the Fed’s more direct and frequent communications. Former Treasury Secretary

Lawrence Summers

recently compared the type of abrupt market swings that sometimes accompany Mr. Powell’s news conferences with medical treatments that sicken a patient.

The Fed chairmen Paul Volcker and

Alan Greenspan

understood “what the Delphic oracles understood and what subsequent central bankers haven’t understood: If it is widely believed that you are omniscient and omnipotent, and you know that you are in fact neither, it is best to speak in somewhat vague and oracular ways,” Mr. Summers said at a conference last month.

Mr. Steinsson disagrees. “When the Fed was tightening or easing in the past, the market wouldn’t anticipate the extent to which that was going to continue nearly as much as it is right now,” he said. “That means the tightening is showing up in long-term interest rates much quicker and is affecting the economy much quicker.”

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The upshot is that forward guidance has been the Fed’s most powerful tool in recent months. “With its words, the Fed can really move the yield curve. If you’re not willing to do that, you’re giving up that power,” he said.

Changes made to speed or slow down the economy with interest rates take time to filter into borrowing and spending decisions. The economist Milton Friedman described these changes as the “long and variable lags” of monetary policy. What Mr. Powell and his colleagues have accomplished so far this year could shorten those lags, said Mr. Steinsson.

To be sure, Mr. Powell had some luxury providing guidance because his colleagues on the Fed’s rate-setting committee, heading into their premeeting quiet period one week ago, were united over tentative plans to raise rates by a half-percentage point this week and again in July. Such consensus might not last.

And difficult debates loom. Just as it can be hard to know when to start raising rates, it can be hard to know when to stop. Mr. Powell faces two risks down the road: Go too slow or stop too soon and let inflation remain uncomfortably above the Fed’s 2% goal, or raise rates too much and push the economy into a sharp slowdown.

For now, he has tried to show how the Fed doesn’t have to wait until its meetings to adjust interest rates.

Write to Nick Timiraos at [email protected]

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