Fed Expects Milder Interest-Rate Rise in February

Federal Reserve officials are preparing to slow interest-rate increases for the second straight meeting and debate how much higher to raise them after gaining more confidence that inflation will ease further this year.

The Fed could begin discussing at its next meeting how much more evidence of softening in labor demand, spending, and inflation it would need to see before pausing rate increases this spring.

In recent public statements and interviews, Fed officials have said that slowing the pace of rate increases to a more traditional quarter percentage point would give them more time to assess the impact of their increases so far. They are trying to determine where to stop and how high to make rates.

Officials noted that it takes time for the full effect of higher rates to cool economic activity when they stepped down to a half-point rate rise in December, following four consecutive increases of 0.75 point.

"I believe that logic is still very applicable today," said Fed Vice Chair Lael Brainard in remarks last week. Raising rates in smaller increments "gives us the ability to absorb more data...and probably better land at a sufficiently restrictive level."

In order to fight high inflation last year, the Federal Reserve implemented a series of rapid interest rate hikes, the most since the early 1980s. If the Fed raises rates by a quarter point next month, the benchmark federal-funds rate will be between 4.5% and 4.75%.

In December, most Federal Reserve officials projected that interest rates would rise to a peak between 5% and 5.25%. This would imply two more quarter-point increases after the likely increase next month. According to CME Group, investors in interest-rate futures markets expect the Fed to make two more quarter-point increases at the coming meeting and again at the Fed’s subsequent meeting in mid-March.

The Fed raised rates seven times last year in an effort to curb demand and bring down inflation. The likely decision to approve a smaller increase in February reflects officials’ growing confidence that the economy is responding to their efforts.

Government data and business surveys have pointed to a sharp drop in manufacturing activity and new orders for service-sector firms, as well as a pullback in consumer spending on goods, in recent weeks.

The central bank's rate increases are designed to slow inflation by reducing demand. According to Fed governor Christopher Waller, this is having the desired effect in the business sector. Waller said he would favor a quarter-point rate rise at the upcoming meeting.

This week, the Commerce Department is set to release the December figures for the Fed’s preferred inflation gauge, the personal-consumption expenditures price index. According to Ms. Brainard, the index is expected to show a 4.5% year-over-year increase, and a 3.1% three-month annualized rate in December when food and energy prices are excluded.

Officials could use their postmeeting statement on Feb. 1 to indicate they expect to continue raising rates as they probe where to pause. However, they are unlikely to provide precise guidance because coming decisions will depend heavily on new data about the economy.

Some have suggested that even if the Federal Reserve holds interest rates steady this summer, they will still signal that they are more likely to raise rates than to cut them. After the Fed pauses, Dallas Fed President Lorie Logan said in a recent speech that "we'll need to remain flexible and raise rates further if changes in the economic outlook or financial conditions call for it."

At the upcoming meeting, officials will be able to discuss two important questions: How long does it take for the full effects of the Fed’s rate increases to influence hiring and overall economic demand? And how much could inflation slow down due to other factors such as easing supply-chain bottlenecks or lower costs of fuel and other commodities?

Some people think that the Fed should not pause in its rate hikes if the economy does not weaken significantly in the coming months. They believe that the time between when the Fed raises rates and when the economy slows down is relatively short, and that the economy will soon feel the worst effects of any policy-induced slowdown.

Some people might argue for a pause that happens somewhat earlier because they believe that the effects take longer to happen or could be more powerful.

Divisions have surfaced within the Federal Reserve over the best way to handle interest rates. St. Louis Fed President James Bullard recently said that he would prefer a larger half-point rate increase at the coming meeting, because he doesn’t think rates are high enough to thoroughly beat inflation.

“You’d probably have to get over 5% to say with a straight face that we’ve got the right level,” he said in an interview. “Why not go to where we’re supposed to go?…Why stall and not quite get to that level?”

Several of his colleagues have argued for greater flexibility to see if the easing of pandemic- and war-related disruptions brings inflation down more rapidly. As evidence builds that higher rates are working as intended, "why would we try to…really put the clamps down on the economy and really risk losing the good things we have going, like the labor market?" Philadelphia Fed President Patrick Harker said last week. "I just don't see doing that."

Fed officials had been expecting inflation to fall as supply-chain bottlenecks and commodity-market disruptions eased, but inflation instead rose through the first half of 2022 before leveling off, according to the Commerce Department’s gauge.

Inflation has declined over the past three months due largely to falling fuel prices and prices of goods, such as used cars. There are signs that rents and other housing costs are set to cool notably amid a sharp slowdown in demand, though that isn’t expected to show up in official inflation measures until later this year.

As a result, Fed Chair Jerome Powell and several colleagues have shifted their focus recently toward a narrower subset of labor-intensive services. Inflation in that category has been around 4.4% on both a 12- and three-month basis, up from around 2.3% on average between 2010 and 2019.

Officials believe that analyzing wage costs could reveal whether they are being passed on to consumers in the form of higher prices.

If services inflation is high because paychecks are rising in lockstep with prices, as occurred during the 1970s, then Fed officials would want to see hiring slow more. This would help to keep inflation in check and prevent the economy from overheating.

If prices for services like restaurant meals, car insurance, and airfares reflect the ripple effects of global dislocations that are now reversing, then services inflation might moderate faster without as significant a weakening of labor markets.

The recent slowdown in inflation, coupled with the lagging impact of the Fed's interest rate hikes, may provide some reassurance that we are not currently experiencing a wage-price spiral similar to what happened in the 1970s, said Ms. Brainard.

Fed officials revised their projections for inflation upwards last month, due in part to fears that wage growth was running too high. Signs that wage growth is slowing down since then could play a significant role in the debate over how soon to pause.

Officials will have two more months of data on key economic indicators before their March 21-22 meeting. They will be closely watching the employment-cost index, a detailed measure of worker compensation, which is set for release on Jan. 31.

The report could offer further confirmation that wage growth slowed at the end of last year. This would be in line with other data that has shown a slowdown in the economy.