Oliver Mangan: Inflation will ultimately decide the timing of the Fed's interest rate hike

Oliver Mangan: Inflation will ultimately decide the timing of the Fed's interest rate hike

Federal Reserve chairman Jerome Powell said current US interest rate hike projections should be taken with a "big grain of salt".

There were no major revisions made to the US Federal Reserve’s economic forecasts at its monetary policy meeting last week.

While the projections for growth and inflation were revised up somewhat for 2021, the 2022-23 forecasts were left virtually unchanged. Yet, there was a significant movement in the Fed’s interest rate projections, with a large majority of the Fed policymakers now believing that interest rates will start to rise in 2023 compared to 2024 at the earliest, previously.

Fed chair Jerome Powell said the rate projections should be taken with a “big grain of salt” as they encompass a timeframe that is still full of uncertainty. It is a fair point, as nobody can say with certainty what course rates will take over the next two to three years.

However, markets are certainly not dismissing Fed projections that rates are likely to be increased earlier than it had been previously guided.

The tightening of the Fed’s rate hike timeline has seen the dollar make significant gains over the past week, a sell-off in stock markets and sparked a bout of very volatile trading in bond markets. 

Markets see the first such rate increase occurring during the second half of 2022. The Fed sees US GDP growth running at 7% at the end of this year and a still strong 3.3% by the end of 2022, with the country’s unemployment rate getting back down to 3.5% by 2023.

It may also be that the Fed is building in scope for earlier rate increases in case their view that the rise in inflation this year proves transitory turns out to be incorrect. They still see core inflation falling back close to 2% by the end of next year, despite recent stronger than expected price rises, with headline inflation hitting 5%.

Rate hikes are still some way off for the Fed. Its near-term focus is on when it should start to taper or scale back asset purchases under its quantitative easing programme. This will be its first step in tightening policy. Chair Powell emphasised again last week that the economic recovery needs to make further progress for this process to begin.

The conversation around tapering, though, has started at the Fed, with markets expecting that guidance on a timeframe could come by the end of the summer. 

A close eye, though, needs to be kept on inflation data next year. Should inflation not fall back as expected in 2022, then the Fed will have to move quickly and aggressively on tightening policy. Persistently higher inflation is the biggest threat to the Fed’s view that there is no great hurry with policy tightening, be it tapering or rate hikes.

  • Oliver Mangan is chief economist at AIB

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