A happy dance is not in the cards when the Fed contemplates a recovering US economy

By Howard Schneider

WASHINGTON, July 25 (Reuters) –

As the Federal Reserve heads toward another interest rate hike this week, policymakers face a choice about how much weight to put on recent economic data that has had promising effects on inflation and unemployment.

Since the U.S. Federal Reserve’s policy meeting in June, inflation has fallen more than expected toward the central bank’s 2% target, with many analysts arguing that a cycle of moderate price increases is underway and should continue without further rate hikes beyond a quarter-point hike to be announced on Wednesday.

But the Fed’s planned 'soft landing’ – a sense of optimism that inflation will fall, unemployment remains relatively low and a recession will be avoided – has buoyed financial markets in ways that could counter the Fed’s objectives.

The Fed „doesn’t want to be blindsided by the recent drop in inflation and declare victory too soon,” Diane Swank, chief economist at KPMG, wrote on Monday, and concluded that the Fed will keep its options open to increase borrowing costs. „Financial markets continue to lead the central bank…it has already eased credit conditions and may accelerate growth.”

The rate-setting Federal Open Market Committee is expected to raise its benchmark overnight interest rate to a range of 5.25%-5.50% when it releases its latest policy report at 2pm EDT (1800 GMT) on Wednesday. Fed Chairman Jerome Powell will hold a press conference soon and make a decision.

Equilibrium risks

In the six weeks since the June 13-14 meeting, Fed policymakers have digested data that provides a mirror image of what they faced a year ago. At the time, six months of economic activity showed a recession was brewing, prices were rising fast, and central bankers accelerated rate hikes, expected to make any downturn worse.

The story continues

Now the issue is how much to acknowledge the blue sky. Last summer’s central bank meetings were held against a backdrop of inflation rising to four-decade highs and deep concern about the fate of the economy. Since then, the unemployment rate has remained unchanged at 3.6%, growth has continued to be above trend, and yet the central bank’s preferred rate of inflation has fallen from 7% in June 2022 to 3.8% last May.

That’s still more than double the central bank’s 2% target, and some officials worry that if the economy is as resilient as it currently appears, it will be more difficult to cover the remaining ground.

There are signs of a slowdown, of course, and some policymakers expect more weakness to come — and should be cautious about considering rate hikes.

But with monthly job growth of more than 200,000 as of June and wage increases outpacing inflation, households can spend and avoid a slowdown in consumption that some central bank officials think should reduce the remaining inflation.

There is no 'sudden stop’

U.S. stock markets are rising, and other measures of financial conditions show some easing of conditions, even as the central bank tries to rein in the economy. In fact, a new central bank financial conditions index shows that peak tightening may have hit late last year.

During the second quarter, the Atlanta Fed „nowcast” economic growth rose to 2.4% from a 1.7% annualized rate in the three-month period, based on strengthened consumer spending, stronger business investment and a larger contribution from government spending.

The change crossed a significant line, going from below the central bank’s trend estimate of 1.8% growth – and a further reduction in inflation – to significantly above it. The first estimate of second-quarter gross domestic product will be released on Thursday, with economists expecting a growth rate of 2.0% from 1.8% in the first quarter.

However, unless there is a sharp drop in activity soon, central bank officials may be underestimating the strength of the economy and may be skeptical about the prospect of a sustained decline in inflation.

Central bank officials in June forecast GDP growth of just 1.0% in 2023, which „essentially calls for a shutdown in the economy in the second half of the year,” wrote Tim Duy, chief U.S. economist for SGH Macro Advisors. „We already have enough visibility in the third quarter to know that’s not happening.”

That leaves the door open for higher rate increases — for now. U.S. central bankers were caught in 2021 when their initial analysis of inflation increases they thought would pass over time, driven by forces such as supply shocks and pandemic-era spending. Although it seems to be happening two years from now, they will be slow to achieve success.

„It’s not yet clear how much growth the central bank will tolerate during the soft inflation numbers,” Duy said, adding that data on prices could shift the focus toward the evolution of the real economy.

„We think this will lead market participants to expand beyond the inflation numbers by interpreting the Fed’s confidence to restore price stability, which should see further cooling in demand due to significantly slower GDP growth, softer job growth and further downward pressure on wage growth.”

(Reporting by Howard Schneider; Editing by Don Burns and Paul Simao)