How the Speed of Rate Increases Could Shape Fed Policy in 2023

This week, Federal Reserve officials will debate how much further to raise interest rates, based on their expectations for how much the economy will slow down this year.
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At their two-day policy meeting, key discussions will revolve around estimating how much previous rate increases will affect growth and inflation over time. This is what Nobel Laureate Milton Friedman called the "long and variable" lags of monetary policy.
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"There will be a lot of thinking about 'Are the effects we're getting about on the track that we expected? Are they coming sooner, or are they coming bigger?' said William English, a former senior Fed economist who is now a professor at the Yale School of Management.
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Fed officials are lifting rates to lower inflation by restraining growth. They are expected to raise their benchmark federal-funds rate on Wednesday by a quarter percentage point to a range between 4.5% and 4.75%. This would extend the most rapid adjustment in interest rates since the early 1980s.
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If the lags are long, last year’s rate increases are just beginning to have an impact on the economy and will curb economic activity in the year ahead. That implies the Fed doesn’t have to raise rates much more or keep them high for very long.
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If the lags are shorter, the previous hikes will have already taken effect and the central bank may need to raise rates higher or hold them at a higher level for a longer period of time to achieve the desired effect.
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If the Fed were to moderate the pace of interest rate increases, it would have more time to assess the impacts of its policy decisions. For example, a quarter-point increase this week would be the second consecutive meeting where rates have been raised by a smaller margin, after officials raised rates by a half point last month and by 0.75 point at four consecutive previous meetings.
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Many investors believe that the time it takes for the Fed to lower rates will be lengthy: They are anticipating that the Fed will cut rates later on this year and continue to do so through 2024. The reasoning behind this belief is that the Fed has already lifted rates to levels that are likely to cause a recession. Because of this, medium- and longer-term interest rates that are set by markets (such as most U.S. mortgages) have either stopped increasing or have decreased, even though the Fed has kept raising short-term rates.
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Goldman Sachs economists believe that the economy will rebound more quickly than anticipated, which could mean a longer period of higher interest rates. They say that markets are overly pessimistic and that the economy will prove to be more resilient than expected.
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According to David Mericle, chief U.S. economist at Goldman Sachs, the drag on economic growth from monetary policy tightening will diminish substantially in 2023.

This is due to the lagged effect of rate hikes, which is expected to cause a recession this year. However, the reduced federal government spending last year will have a similar effect this year, offsetting the negative impact of the rate hikes.
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Some Fed officials say that interest-rate moves have a more immediate impact on the economy because they send a clearer signal of the Fed's policy intentions than in the past. For example, thirty years ago, the Fed did not publicly announce whether or not it had made any changes to interest rates at its meetings.
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Fed governor Christopher Waller said earlier this month that it takes policy a while to influence the economy. By contrast, today's Fed provides guidance about its coming moves, shortening the lags. Waller said that this means we're seeing a lot of the impact for monetary policy coming through in the next quarter.
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Some say that this view does not take into account the important changes that have lengthened the lags. They argue that even though Fed officials have shortened the time it takes between changing the benchmark rate and influencing financial conditions, they haven’t shortened the time it takes for financial markets to influence economic activity. According to Aneta Markowska, chief economist at Jefferies LLC, these secondary effects may be taking longer now than in the past because of pandemic-fueled distortions.
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The government's response to the pandemic in 2020-2021 prevented the usual crisis pattern of rising joblessness and amplifying declines in income and spending, triggering a recession. This left private-sector balance sheets in a historically strong position.
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Donald Kohn, a former Fed vice chairman, noted that the current business cycle is very different from the last several cycles. He pointed out that the last several cycles haven't had pandemics or land wars in Europe, but the current cycle does.
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Rate increases can have a more immediate impact on the economy when growth is being driven by credit growth, rather than income growth or government stimulus. This means that it could take longer for the Fed's actions to be felt through the economy, said Ms. Markowska.
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At the end of last year, both consumer spending and income growth slowed down, along with a slowdown in inflation. The Commerce Department reported last week that one gauge of underlying demand, final sales to domestic purchasers (which exclude inventories and trade), rose at a meager 0.8% seasonally adjusted annualized rate in the fourth quarter.
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Ray Ferris, chief economist at Credit Suisse, believes that the economy is slowing down. "Things are grinding down," he said. "If you look under the hood, it's clear that things are slowing."
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The Fed's rate moves didn't slow the economy as much last year as might have been anticipated because the economy was still being supported by fiscal and monetary stimulus, Fed Vice Chair Lael Brainard said in a speech this month.
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"The full effect of the cumulative tightening that is in the pipeline is still likely to be felt in terms of demand, employment, and inflation," she said.
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The construction sector provides a clear example of how strong demand can lead to continued growth even in the face of challenges. Despite the Fed's rate increases, the construction industry has remained strong due to the high demand for housing and the bottlenecks in the supply chain. This is especially true for apartment construction, which is at a 50-year high and takes longer to complete than single-family housing. As a result, the construction industry has been able to avoid layoffs.
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Ms. Markowska said that construction jobs have not been lost, but there is a large backlog of work that needs to be completed. She said that the middle of the year will be when the most pain is felt.
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Large companies have been able to weather the Fed's rate hike campaign so far because they were able to lock in low borrowing costs for several years in corporate bond markets. Small businesses, by contrast, could face more pressure this year from higher rates because they rely on bank loans or shorter-term loans that will face higher borrowing costs sooner.
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Consumer spending is one of the key factors that will determine how much the economy slows down this year. Households have not yet significantly reduced their spending in response to higher inflation and rising interest rates, partly because many people accumulated large savings early on during the pandemic.
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Ms. Markowska believes that low-income consumers have likely used up all of their financial buffers, as credit-card borrowing is on the rise. She expects that many more households will have depleted their savings by November, which will limit their spending.
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Mr. Mericle of Goldman Sachs believes that there is less reason for consumers to retrench, as inflation-adjusted incomes are set to rise if overall inflation continues to slow down. With price increases having less of an impact on household paychecks, he believes that it is not realistic to expect people to draw down their savings to the same degree in 2023 as they did in 2022.