Fed Minutes Hint At Optimism On Inflation, But Forecast High Rates For 2023

The Federal Reserve (Fed) released the minutes from the 13-14 December 2022 policy meeting where they raised rates 0.5 percentage points. The minutes acknowledged that inflation has eased in recent months. Still the Fed is concerned that high wage growth could ultimately prevent inflation falling back to the Fed’s 2% goal.

The Fed worries that risks to inflation are “skewed to the upside” and wanted to underline that “ongoing increases in the target range for the federal funds rate would be appropriate.” Declining rates are not on the Fed’s agenda any time soon. Specifically, “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.”

Looking For More Evidence Of Improving Inflation

Despite not prompting much of a shift in their policy approach, the Fed acknowledged that inflation “stepped down” in October and November though remaining “unacceptably high”. Ultimately the Fed “stressed that it would take substantially more evidence of progress to be confident that inflation was on a sustained downward path.”

So the Fed sees that inflation is declining, but believes it could be a protracted journey back to a 2% annual rate. Generally, the Fed believes that prices for goods will remain subdued, and that falling housing costs will be picked up in the inflation numbers in 2023. It expects services costs to come down too, but is watching wage growth for clues that that trend is on track.

Mark-Ups

Another issue that the Fed is monitoring closely is mark-ups for goods and services. They believe that these mark-ups are relatively high today, though it is hard to be sure, and that slowing economic growth may be needed to bring them down, and hence tame inflation further.

Watching the Labor Market

As much as the Fed is targeting inflation, they are closely watching the labor market which was described in the minutes, as both “quite tight” and “very tight”. The importance of the labor market to the Fed is because they believe fast wage growth could keep inflation elevated.

Specifically in discussing the components of inflation the Fed argued, somewhat optimistically on their projections, that “inflation would decline markedly over the next two years. Core goods inflation was anticipated to slow further, housing services inflation was expected to peak in 2023 and then move down, while core non-housing services inflation was forecast to move down as wage growth eased.”

This implies that the Fed is cautiously optimistic on inflation overall, but they are watching wage growth especially closely. If wage growth does not ease, then the Fed may be concerned about inflation remaining stubbornly high.

Recession Risk Remains

The Fed’s projections for economic growth improved at the December meeting, compared to November’s, but with residential investment “contracting sharply” the Fed argued that “economic growth was still forecast to slow markedly in 2023”. The Fed saw the “possibility of a recession sometime over the next year as a plausible alternative to the baseline.” The Fed is not willing to forecast a recession yet, but acknowledges that it is a possibility for 2023.

A Balance Of Risks

The minutes also called out two main policy-risks. The first risk is that the Fed doesn’t do enough to fight inflation and it remains elevated for longer than necessary with “unanchored inflation expectations”.

The second is the Fed does too much to fight inflation by keeping policy “more restrictive than necessary” and that inflation falls, but the U.S. also sees a recession. In a sense, the Fed worries about doing too little and it worries about doing too much.

Policy Actions

The minutes strongly hint that the Fed will raise rates again when they next set rates on February 1. Also, it is important to note that even though we may be close to the top of the rate cycle, the Fed does not see rates coming down in 2023.

Past Cycles

If that holds, it would be different to most past cycles over recent decades when the Fed has moved relatively quickly from raising rates to dropping them. However, rates did plateau for almost a year in 2006-7, most other periods of peak rates have lasted a few months at most.

February’s Decision

However, if wage pressures ease and inflation continues to trend down then even if rates don’t fall they aren’t likely to rise much further in 2023 either. The Fed is watching the jobs market very closely for signs that may signal the fight against inflation is won.