January 26, 2022 | Expert Perspective

When, and to what degree, the Fed may raise rates

Josh Hirt, Senior Economist, Vanguard Investment Strategy Group

Josh Hirt, CFA
Senior Economist, Vanguard Investment Strategy Group

Asawari Sathe, a Vanguard U.S. economist

Asawari Sathe
Vanguard U.S. Economist

Adam Schickling

Adam Schickling
Vanguard Economist, U.S.

With inflation at multidecade highs, the Federal Reserve appears prepared to raise its key interest rate target, perhaps as early as March. In this Q&A, Vanguard economists Josh Hirt, Asawari Sathe, and Adam Schickling discuss inflation, labor, and the risks of the Fed’s hiking rates either too aggressively or not aggressively enough.

In a related commentary, Vanguard global chief economist Joe Davis discusses why central banks need to use their powerful tools to rein in inflation and why, long-term, that can be good for investors.

What challenges does the Fed face in deciding when to raise rates and by how much?

Josh: The Fed's mandate from Congress is to ensure price stability and maximum sustainable employment. The broadest U.S. inflation measure is higher than it's been in nearly 40 years, and the unemployment rate is falling fast toward a pre-pandemic level that was itself at a 50-year low.

The Fed's biggest challenge is the lack of clarity in key areas of the economy. Beyond the immediate impact on activity, the effects of the COVID-19 Omicron variant on the labor market and inflation are unknown. Omicron also has the potential to exacerbate global supply-chain issues. The Fed ideally would want a clearer read into the underlying strength of the economy as fiscal support wanes before deciding to tighten conditions.

What is Vanguard's view on when the Fed will raise rates and by how much?

Josh: We've just revised our view on when the Fed will likely need to raise rates, from the second half of 2022 to the first half, perhaps as early as March. Wage inflation data will be important to that timing. We believe the Fed will initiate at least two quarter-point rate hikes in 2022, and that additional policy tightening will likely be warranted, either through a reduction in the Fed's bond holdings or through one or two more policy rate increases.

How will inflation expectations likely play into the Fed’s interest rate decisions?

Asawari: Inflation expectations shouldn't change much in response to the latest data. If they do and continue to push higher, they'll have become unanchored, which would allow wages and prices to begin to spiral out of control. We haven't reached that point, but even before more recent concerns materialized about wage inflation—which tends to indicate more persistent inflation—we saw shorter-term and then some longer-term inflation expectations rising. We're far away from saying inflation expectations have become unanchored, but the Fed won’t want to risk that and is likely prepared to act to fend it off.

What is the Fed looking for regarding the other portion of its mandate—"maximum sustainable employment," also called "full employment"?

Adam: The Fed will want to see in the January employment data what the Omicron wave has meant for the labor market. But the traditional definition of full employment, in its rawest sense, is that everyone who wants a job has one or can easily get one. By almost every labor market metric, we're very close. There are still a couple of million unemployed people who say they want a job, and that cohort is about 600,000 larger than it was pre-COVID. That includes some who can be very selective in the job and wages they accept. We expect that cohort to contract quickly.

Given these insights, what does the Fed need to consider about the pace and duration of the forthcoming hiking cycle?

Josh: Our view is that, over the next few years, the Fed will ultimately need to raise rates to a level that restricts the economy sufficiently to contain inflation—by our estimates likely around 3%. That is roughly 100 basis points higher than where the market has been pricing.1

Our view considers our estimate of the neutral rate and inflation around the Fed's target level.2

The delicate position for the Fed is to tighten policy enough to moderate inflation pressures without doing so too aggressively and ending the business cycle prematurely. But being too easy at this point likely invites a greater risk. If the Fed were to lose control of inflation or inflation expectations, there's a range of potential outcomes that could have negative effects on the real economy, the value of assets, and people's standards of living. We expect these considerations to be part of Fed policy debates.

 

1 A basis point is one-hundredth of a percentage point.

2 The neutral rate is the rate at which policy is neither accommodative nor restrictive.

Note:

  • All investing is subject to risk, including the possible loss of the money you invest.