Steven Ricchiuto, Chief Economist at Mizuho Americas, sat down with Eric Rosengren, Former President and CEO of the Federal Reserve Bank of Boston, to discuss the U.S. macroeconomic outlook, what factors go into interest rate policymaking and what steps the Fed may take to achieve its targeted inflation rate.
Hear what Mr. Rosengren had to say about his economic projections for the coming months and the effect of the recent rate hikes on the wider economy.
Former Boston Fed President tells Mizuho Finance Leaders Forum Fed is Bound to their Dual Mandate: 2% Inflation and Balanced Employment Rate
The Federal Reserve’s dual mandate of controlling inflation and promoting a healthy labor market is the “Constitution of the Central Bank” and until inflation reaches 2%, it will continue a multipronged approach to reach that target, Eric Rosengren, Former President and CEO of the Federal Reserve Bank of Boston, and finance professor at the Sloan Business School at MIT told Mizuho Americas Chief Economist, Steven Ricchiuto during a Q&A discussion at Mizuho’s Inaugural Finance Leaders Forum in New York.
The European Central bank most recently raised interest rates by 25 basis points, “so they’re at their terminal rate, or at least that's where they think they are at this juncture,” Ricchiuto said.
Then he asked Rosengren: “Do you think the Fed is at or near its terminal rate?” (The terminal rate is generally defined as the top end of the interest rate range where stable prices and full employment are achieved).
“I do,” Rosengren said. “And let me explain why. Inflation's come down quite a bit. As everybody is well aware, it's still nowhere close to where the Fed wants, but there's been very significant progress. The Fed’s focused on its dual mandate. On the inflation side it’s been missing very significantly.”
The dual mandate in action
The Fed focuses on core personal consumption expenditures when considering the rate of inflation, “even though the total is what we're supposed to focus on but because energy prices are so volatile, we tend to focus on core,” he said.
Energy prices have remained volatile because of tight global supplies.
“Core’s at 4.2%, the target’s 2%. So we still have a way to go, but we've come down pretty quickly,” Rosengren said.
A large component of that is housing costs, which everyone thought would come down faster than they have, Rosengren said. People are reasonably confident that rent prices will come down over the next six months, he said, but “getting the last mile of the last 1 to 2% down on inflation is going to be more problematic.”
The price of goods also went up the most due to the pandemic but they’ve since come down. The Fed would like to see the unemployment rate go up a little more to make sure the labor market doesn’t have the same tightness that it’s had in the last six months, he said.
The U.S. economy grew at a roughly 2% rate in the first two quarters of the year, Rosengren pointed out. “It looks like it's going to grow faster than 2% for the third quarter,” he said. “If that does happen, then I think the Fed would consider raising rates additionally.”
Forecasters expect a lower 1-2% growth rate and if that happens, the unemployment rate would rise.
The United Auto Workers strike and a pending budget deadlock or government shutdown in Washington, D.C., are also factors that could change the way the Fed looks at raising rates, Rosengren added.
“The baseline forecast would be that we don’t really need to do more tightening,” he said. “That being said, I don’t think the Fed’s going to ease anytime soon.”
The Fed considers every piece of data at its disposal in deciding whether or not to raise interest rates, and being “data dependent” is not just a buzzword, Rosengren said.
“When they say they're data dependent, it really does mean that there have been enough surprises that they're not that confident that they can say unequivocally, we're not going to raise rates again, and they're not going to say unequivocally we're going to start easing because there's too much uncertainty in the economy to make those kind of definitive statements,” he said.
The origin of the 2% target inflation rate
The 2% inflation rate set out by the Fed is not an arbitrary target, Rosengren added.
“The first framework document was done under Ben Bernanke, and that's when the 2% percent inflation target was actually set,” he said.
Prior to 2000, economic modeling put a lot of weight on what was happening in the 1970’s, he said. “What economists started to notice was even when we had pretty big shocks to the economy, inflation was staying very close to 2%. And so the models started to have a feature in them that if inflation expectations stayed at 2%, you could do very little to deviate from that 2% inflation rate. So what that meant was you had a lot more latitude to focus on the full employment part of the mandate.”
Now it’s a number that’s hard to change.
“I think the committee is very tied to the 2% target, not because it thinks 2% is exactly the right number, but because they're worried about the consequences of starting to move it,” he said. “And if the Fed's not committed to hitting your target, now, all of a sudden it becomes somewhat unbounded as to how you react. So once they picked a target and they didn't pick a range, they picked a number, it becomes very hard to move that number.”
He added that most economists think that number was set “a little bit too low” evidenced by the fact that interest rates have hit zero percent twice in 20 years. “That wasn't an outcome that was anticipated. If you actually looked at the models, people said it was very, very unlikely we'd get to zero,” he said.
To Raise or Not to Raise: That is the Question
The Fed takes all of the banks’ and governors’ views into account and sets out to see which “rate path” they are on for the Summary of Economic Projections (SEP), which are collected from each member four times a year to coincide with the Federal Open Market Committee's (FOMC's) meetings.
Each reserve bank and each governor is asked to fill out three or four economic variables, so GDP, unemployment, inflation measures and provide an interest rate that's consistent with that, Rosengren added.
They are not trying to forecast “where the economy will be,” Rosengren said. “You're forecasting where you think the economy should be. When you look at the DOT plot, the first thing to notice is there's a fair amount of variance around it. Different members have very different views about what appropriate monetary policy is going to be.”
The market assumes that the Fed chair is considering the median “and as a result, they think that's a pretty good forecast of where the chair wants interest rates to go,” he said.
Even the Fed chair is constrained by his own conjecture and by what the appropriate monetary policy is to get to 2% inflation and full employment in a two-to-three-year period, Rosengren added.
The total number of post-pandemic Fed rate hikes saw borrowing costs shoot up from near zero in early 2020 to a more than 20-year high of 5.5% in July when the Fed boosted the interest rate by another quarter basis point trying to calm post-pandemic inflation.
On the downside, the quick uptick in interest rates over such a short period of time caused problems with some regional banks, which was an issue of management.
In 2018, legislation was passed that eased regulations on regional banks, raising the total asset limit for these institutions to be considered systemically important from $50 billion to $250 billion. “The result was regional banks didn't get stress tests,” Rosengren said. They didn't get the same level of supervision. And as a result, those banks ended up growing very, very rapidly.”
In terms of overall bank regulation, Rosengren added, “I would say thinking about how to do supervision right might be more important than to just keep raising capital requirements.”