Fed’s Powell poised to dash hopes for an end to punishing rate hikes

Wall Street is betting that Federal Reserve Chair Jerome Powell’s campaign to raise borrowing costs will finally end after this week, with investors driving up stocks for weeks partly in anticipation.

Powell is likely to ruin the party.

Even though the Fed has already lifted interest rates to their highest level since 2006 and inflation is easing, central bank officials are still worried about key industries — mainly services like restaurants, hospitals and auto insurance — where prices are still climbing faster.

So some of them are signaling publicly and privately that the Fed will probably have to push up unemployment to curb wage gains — jeopardizing President Joe Biden’s central economic pitch to voters for his reelection. That means, even after the rate hike that's widely expected Wednesday, Powell will defy market expectations by keeping his finger on the trigger for further potential increases to ensure that inflation is broken.

“The market is, of course, lobbying for the Fed to be done,” said Doug Duncan, chief economist at Fannie Mae, the government-controlled company that backs some $4 trillion in residential mortgages. “But the Fed has a position that’s reasonable, that says: It’s not clear.”

The prospect of higher interest rates indicates that the threat of a recession still hangs over the economy, even as a number of Wall Street banks have scaled back their forecasts for a slump this year. That could get in the way of the White House’s messaging on "Bidenomics."

Biden has been talking up his stewardship of the economy all summer, citing the robust job market and easing price spikes. “We’re beginning to come back, folks,” he said in a speech last week. “We’re giving workers a chance. Unemployment is down. But to the surprise of a lot of economists, so is inflation.”

Administration officials regularly stress the Fed's independence and won't criticize the central bank, but economic growth was 2 percent in the first quarter of the year and may be headed lower in the April-June period, so any further tightening of borrowing costs could hurt.

Indeed, the Fed’s approach has grown increasingly controversial. When costs were surging across industries, the conventional wisdom was clear: The central bank needed to raise interest rates to help rein in spending and take away the impetus for fast-rising prices. Now, a growing chorus of economists are arguing that there’s not much left for the Fed to do without risking unnecessary pain to the job market.

Rate increases are a blunt tool, and central bank policymakers can't be sure that their moves will only affect the service economy. That's particularly true since those industries are often less vulnerable to higher borrowing costs than, say, housing or manufacturing.

“Could they crush the economy? Absolutely,” said Norbert Michel, director of the libertarian Cato Institute’s Center for Monetary and Financial Alternatives. “But why the hell would you do that?”

Omair Sharif, president of Inflation Insights, underscored that point, noting that a large chunk of services inflation has actually come from the transportation sector — in particular, auto insurance and repair. Those are both primarily issues of lack of supply, which the Fed does not control, he said.

It’s hard to get your car serviced this summer, and “one big element is there’s just a shortage of people who are graduating from trade schools,” Sharif said. Similarly, car insurance has gotten more expensive as vehicles themselves and their parts have risen in price. “That’s probably going to keep going through at least the end of this year,” he added. “They can’t really do anything about that.”

Another significant driver of inflation is rent. Mortgage rates soared in reaction to the Fed’s belt-tightening campaign, but prices haven’t come down as much as experts had predicted because there just aren’t enough homes available for sale. New leases have slowed their ascent, but the housing market overall is also showing some signs of a rebound.

Inflation data doesn’t directly include the purchase price of homes, but those prices affect what they do examine — rents and what’s known as owners’ equivalent rent, which measures how much someone could charge to rent out their home.

“The Fed can’t create housing supply,” Fannie Mae’s Duncan said. “What they can do is destroy demand.”

That dynamic is one big reason a mild recession is still such a relevant possibility. While strong wage growth might just be one component keeping inflation from returning to the Fed’s target of 2 percent, the central bank can best guarantee reaching that goal by causing a generalized decrease in spending by hitting Americans’ wallets.

The fact that the job market has been so resilient in the face of aggressive rate hikes demonstrates just how strong consumer demand has been. Despite some signs that higher borrowing costs are weighing on employment prospects — fewer CEOs in June said they expected to hire more workers this year, and job openings fell in May — it’s hard to see anything that gloomy in recent data.

“From the Fed’s perspective, fighting inflation is more like chemo and less like surgery,” said Adam Ozimek, chief economist at public policy think tank Economic Innovation Group. “The Fed is not going to be able to decide whether it hits goods or services. All they can try to do is cool it down.”

A recent analysis from White House economists found that roughly half of non-housing services inflation is sensitive to shifts in wages, suggesting that the Fed has some ability to cool prices in those sectors. They also found that wage-sensitive services inflation lags trends in worker income by roughly 10 months.

Rates are already at punishing levels and even holding them where they are is expected to further slow growth, as higher borrowing costs can take time to wind their way through the economy.

But the Fed is worried that it can’t take a chance, particularly given the risk that inflation could rebound as it did in the 1970s and 1980s, which led then-Chair Paul Volcker to cause multiple recessions in his bid to defeat price spikes.

“We can’t just hold out hope that lags are going to solve all our problems,” San Francisco Fed President Mary Daly said in an interview with CNBC after the latest inflation data was released this month. “We have to remain resolute.”