There are two main reasons why an increase of this magnitude would be a bad idea. The first and most obvious is that it would signal that the Fed is in panic mode, which is not a good idea for any central bank, let alone the largest in the world. Risk premia could explode to compensate traders for the increased risk of uncertainty around monetary policy. It would disrupt credit markets, the cornerstone of the financial system. This is a Fed that has long sought to keep financial markets running smoothly by preparing them for what is coming, when it is coming and by how far in advance. That’s what it’s about.
And this Fed hasn’t prepared the market for anything like a full one percentage point increase in the target fed funds rate, which would raise the upper limit from 2.50% to 3.50%. The best move for Chairman Jerome Powell and his fellow policymakers would be to reassure the market that the central bank understands the challenge and is acting deliberately. Rate strategists at BMO Capital Markets, consistently ranked as the best in the industry in Institutional Investor’s widely-watched annual polls, agree. Here’s how they put it in a note to customers on Wednesday:
Some pundits argued for 100 (basis points) next week, noting that would boost the Fed’s credibility. This would ostensibly help, but simultaneously signal that the Fed is still chasing inflation instead of confidently addressing its persistence with monetary policy. “No need to panic, nothing to see here” is no doubt the message policymakers will seek to communicate to the market and 100 (basis points) would be counterproductive in this regard.
Let’s not forget that the CPI report is just a data point, and a lag at that. The Fed places a lot of weight on inflation expectations. The concern is that if expectations of high inflation become entrenched among consumers, it will become a self-fulfilling prophecy and much harder to tame. But the opposite is happening. Consumer expectations for inflation over the next few years have fallen sharply in the Federal Reserve Bank of New York’s latest survey, released this week. Three-year inflation expectations fell to 2.8% in August, from 3.2% the previous month and 3.6% in June. It’s a similar story in the derivatives market, where the outlook based on swap rates has fallen from around 6% in June to less than 3%.
The second reason the Fed might not want to get too aggressive is that it might make financing too expensive for developers as a lack of supply drives up rents. Shelter costs, which posted their biggest monthly increase since 1991, were a big part of pushing core CPI up 0.6% in August from July, double the forecast. The August increase took shelter inflation over the past 12 months to 6.3%, the highest over such a period since 1986, according to Bloomberg News’ Matthew Boesler. Shelter costs are the largest component of the CPI, accounting for about one-third of the measure.
There are several reasons why rents are rising so rapidly. The first is that the high cost of single-family homes has pushed many potential buyers out of the market and forced them to rent. The September National Rent Report released recently by Apartment List showed vacancy rates at 5.1%, below the pre-Covid range of 6% to 7%. Another reason is that supply has been constrained relative to demand and population growth for many years, largely due to tighter lending standards applied by banks emerging from the financial crisis. Certainly, some relief is on the way. Government data shows 862,000 multi-family units are under construction, the most since the early 1970s. So now is not the time to make it harder for developers to deliver the homes so many consumers need.
Fed policymakers are surely aware that raising rates in even larger increments would send the message that the only way to defeat inflation is to push the economy into a recession – even if that is not their intention. . In such a scenario, however, a recession would likely become a self-fulfilling prophecy, with companies laying off workers and delaying new investment. Developers can stop working on new projects. Tenants would stay in their current accommodation, worsening the supply crisis and keeping housing costs high.
There is no doubt that monetary policy must be tighter if the Fed is to control inflation. But a panic approach now isn’t worth the potential risks.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Robert Burgess is the editor of Bloomberg Opinion. Previously, he was Global Editor of Financial Markets for Bloomberg News.
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