Near Term Rates Slowing While the Fed to Weigh Higher Interest Rates Next Year

Federal Reserve officials have signaled plans to raise their benchmark interest rate by 0.5 percentage point at their meeting next week.  However, elevated wage pressures could lead them to continue lifting it to higher levels than investors currently expect.

Policy makers expect price pressures to ease meaningfully next year, but brisk wage growth or higher inflation in labor-intensive service sectors of the economy could lead more of them to support raising their benchmark rate next year above the 5% currently anticipated by investors. 

Inflation and unemployment have an inverse relationship.  When inflation rises, unemployment drops.  Higher unemployment means lower inflation.  When more people are working, they have the power to spend, which leads to an increase in demand for goods and services.  And price inflation follows.  In addition, when unemployment is low, wage growth increases due to the competition in the labor market.

On Friday, the Bureau of Labor Statistics reported that the American economy added 263,000 jobs in the month of November, and the unemployment rate remained close to a historic low of 3.7%.

Markets rallied after Chairman Powell’s comments last week.  Investors interpreted them as a shift from comments he made this past summer and fall.  Lower rate expectations in the future increase the present value of equities.  However, the November labor report has brought the market back down.

Officials are likely to debate next week how much to raise rates in February, with views shaped by how they see underlying price pressures. If inflation slows but the labor market stays tight, they could be more divided over how to proceed.  Without signs of hiring slowing, they worry inflation is at risk to pick up again.  Other members see inflation being driven primarily by supply bottlenecks and an overheated housing market.

Mr. Powell said it is hard to judge how high rates need to rise to slow the economy because of post pandemic difficulties forecasting inflation, supply bottlenecks, and shifts in demand.

Mr. Powell outlined two possible strategies for proceeding. One would be to quickly raise the fed-funds rate well above the 5% level broadly anticipated in financial markets and then lower it right away if it turns out they have gone too far. Another would be to “go slower and feel your way a little bit to what we think is the right level” and then “to hold on longer at a high level and not loosen policy too early.”

Mr. Powell said he favors the second course. The labor market remains a source of concern because officials are worried that rising prices could be sustained by continued income growth and strong demand for workers.