Surging energy prices have complicated the Federal Reserve’s dual mandate on inflation and unemployment.
Key takeaways
Fed projections appear optimistic despite the risk of stagflation and the decreasing likelihood of rate cuts.
Policy uncertainty dominates as war-driven energy risks push potential rate cuts out to a later date.
The recent energy shock has put the Federal Reserve in a quandary.
It has a dual mandate of maintaining price stability and fostering maximum sustainable employment. High energy prices only make this job more difficult.
At its March meeting, the Federal Open Market Committee took a wait-and-see approach amid the uncertainty of the war in the Middle East, deciding to keep its policy rate in a range of 3.5% to 3.75%. The Fed forecast one 25-basis-point rate cut this year—which we think will most likely be pushed to later in the year—and one next year.
But figuring out what will happen next is proving difficult. The FOMC, in its Summary of Economic Projections, raised its growth forecast to 2.4% this year—up from its previous 2.3%—while maintaining its unemployment outlook at 4.4% and increasing its inflation forecast to 2.7%.
The SEP revealed divergent opinions among committee members, as well as the potential for trouble in the economy. Higher inflation with higher growth points to a greater risk of stagflation. We are somewhat skeptical that the economy will just charge through this heightened period of risk; if so, it would signal that the economy is on a strong footing and that rate cuts should not be in the cards this year.
But hope is not a strategy. One gets the sense that the Fed’s current economic projections are dead on arrival and that central bankers, like the rest of us, are in a wait-and-see mode on the war’s duration and its residual long-term damage to oil production.
A simultaneous increase in prices, rising unemployment and what we expect will be a decline in aggregate demand create a toxic supply-side mix that central bankers are ill-equipped to address. That is why the March SEP does not add up.
Traditionally, when there is tension within its dual mandate of stable prices and maximum sustainable employment, the Fed leans toward containing inflation. Stable prices, after all, are a precondition of full employment.
Currently the FOMC simply is not well aligned on what to do in the near term. For this reason, uncertainty and the need for risk management are the primary takeaways from the March policy decision.
Contact RSM for help navigating this challenging environment.
Looking ahead
The revised dot plot, which is the FOMC’s interest rate forecast, strongly implies one rate cut this year and one next year. Three committee members reduced their rate cut forecasts from three to one this year.
We think the probability of a rate cut has declined, and that if there is one, it will come later in the year, most likely at the September or December meeting. For each day the war continues, the probability of a rate cut dissipates.
Notably, the March SEP increased the inflation estimate to 2.7% in both the top-line and core personal consumption expenditures index, while lifting the estimate for next year to 2.2% for both.
But inflation has been well above the Fed’s 2% target for the past five years, and we expect the PCE and the consumer price index to move to a range of 3.5% to 4% in the March and April inflation reporting periods.
The FOMC’s unemployment rate estimate of 4.4% is below our expectations of 4.6% this year.
Additionally, though the Fed lifted its estimate of the long-run terminal federal funds rate to 3.1%, that forecast is still well below our estimate of 3.5%.
Policy statement
In its March policy statement, the FOMC observed that “the implications of developments in the Middle East for the U.S. economy are uncertain.” Based on that statement, the SEP and the press conference, the Fed continues to be attentive to risks to both sides of its mandate.
There was one dissent, as expected, by committee member Stephen Miran.
Press conference
Fed Chair Jerome Powell, in his remarks after the meeting, noted the difficulties around creating a forecast.
At the same time, Powell signaled that price stability remains a precondition for maximum sustainable employment, which is why the focus on risk to both sides of the mandate was an important part of the press conference.
As for Powell’s term as chair, which ends in May, he said that he intends to remain on the Fed until the investigation into his congressional testimony is complete. He added that he would be willing to stay in his role longer if the nomination of Kevin Warsh, Powell’s replacement, remains stuck in committee in the Senate.
The takeaway
While the Fed will look through a temporary increase in inflation because of the war, it will focus intently on inflation expectations and any hint of an increase in core inflation, which excludes food and energy.
We do not expect a rate hike in the near term or this year, but we cannot discount it given the rising risk to the outlook.
The Fed must be patient as it assesses the impact of the war beyond the obvious. But all parties should be careful not to discount short-term public inflation expectations, which were underestimated and contributed to policy error in 2021−22.
The Fed must plan for all contingencies, including possible rate hikes should pricing expectations spike and core inflation increase.
Until the war ends, risk management will be the analytical framework in which monetary policy should be understood.
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