Two Federal Reserve officials reinforced their message in favour of higher interest rates and for a longer period, stressing the need for patience as the central bank waits for further evidence of a decline in inflation.

Speaking on a panel, Cleveland Fed chief Loretta Mester said she wants to see “a few more months of inflation data that seems to come down” before cutting interest rates. Boston Fed President Susan Collins wanted to see more evidence that price pressures are moving closer to the central bank’s 2% target.

Whether traditionally viewed as “hawks” or “doves,” Federal Reserve officials have recently converged toward a noticeable uniformity in their policy, signalling high interest rates for longer durations. This comes when the margin of uncertainty in economic growth and inflation projections increases.  

Buffeted by a series of higher-than-expected figures for all significant inflation measures in the first quarter, the central bank became more cautious about its earlier expectations of a continued easing of price pressures. Chair Jerome Powell summed up this shift last week when he said his confidence in lower inflation was “not as high” as it was at the start of the year. With a more muted view of inflation and against the backdrop of a misinterpretation of inflation as “transitory” in 2021, recent speeches by Fed officials have uniformly underscored the importance of giving more time for a restrictive monetary policy to work. Officials lowered their expectations for rate cuts, saying April’s less worrisome inflation data was not enough to boost confidence.  

This uniformity raises questions. The first concerns the degree of responsiveness or the use of Fed expression, a “data-dependent” approach.

Such a reactive approach is problematic in a world of uncertainty. This is even more problematic for an institution whose policy tools act with a lag and where the other drivers of inflation are less sensitive to interest rates. The Fed needs to determine a course, an anchor with the economy.

The second risk is that this turnaround coincides with many companies expressing concerns about weakening consumer demand. This is especially the case for those serving low-income households where pandemic-related savings have been completely depleted, credit card balances have increased, and the ability to take on debt has been significantly reduced.

Weakness at the lower end of the income scale is beginning to spread upwards, increasing the economy’s reliance on the strength of the labour market as the sole and essential defence against a potential economic downturn.

The third risk is that the Fed’s policy signals are calibrated based on an inflation target not exceeding 2%. We have to keep in mind that 2% is not the result of a sophisticated econometric model seeking to find an optimal level of inflation in a steady state, consistent with the structural realities of the economy. Instead, it is an arbitrary target that originated in New Zealand in the 1990s and has been adopted by the Fed. This is a goal that has proven to be largely non-binding in a world that has enjoyed a favourable supply shock for nearly 20 years and where Paul Volcker has deeply rooted the credibility of the central bank.

As I have often repeated in previous articles, the Fed was wrong to explain the current inflation. The central bank explained to us until the end of last week that pandemic-related delays essentially explained “transitory” inflation. I favour another explanation: monetary policy may not be so tight. In other words, the neutral interest rate adjusted for inflation, the level that neither stimulates nor restrains growth, is higher than the Fed officials’ estimate. This would mean that the current federal funds rate is less restrictive for growth.

The argument finds justification in significant budget deficits and public investments for a decarbonized economy. Added to this is the end of Globalization, which was a deflationary phenomenon. The rise of protectionism and the emergence of regionalization in the global economy adds further weight to this explanation. These factors, some of which are structural, have pushed up the neutral interest rate.

Furthermore, the war in Ukraine has alerted governments worldwide to the need to invest in defence. The United States and its allies must invest nearly $10 trillion to rearm. Much of these expenditures would be recycled in the United States through purchases from the defence industry, adding to demand pressures on the US economy. In this context, the 2% target is too low and unsuited to today’s economic realities.

Contrary to the consensus that is still waiting for a rate cut in 2024 and especially in the next two years, depending on the evolution of the data and global geopolitics, the Fed could, at best, leave these rates unchanged or even resume a new hiking cycle if the US economy persists in its resilience.