Economists at the Federal Reserve Bank of Chicago have put forth a compelling argument, suggesting that the series of interest rate increases implemented since March 2022 are steering inflation toward a 2% target while safeguarding the economy against a recession.
Their research indicates that further tightening might not be necessary at this juncture.
This scenario of curbing inflation without endangering economic growth could potentially trigger increased risk-taking in global financial markets, including the realm of cryptocurrencies.
In their analysis presented in the September edition of the Chicago Fed Letter, economists Stefania D’Amico and Thomas King utilize a vector autoregression (VAR) model. According to their findings, the 500 basis points of rate hikes introduced since March 2022 have significantly impacted economic output. They argue that additional rate increases may not be warranted to rein in prices. It’s worth noting that last year’s crypto market crash was partially attributed to this tightening cycle.
Tightening Monetary Policy: A Delicate Balancing Act
The economists explain, “We estimate that although the majority of the effects on output and inflation have already occurred, the policy tightening that has already been implemented will exert further restraint in the quarters ahead, amounting to downward pressure of about 3 percentage points on the level of real gross domestic product (GDP) and 2.5 percentage points on the Consumer Price Index (CPI) level. The abatement of inflation occurs without a recession, as real GDP growth remains in positive territory throughout the projection.”
According to their model, the headline consumer price index is likely to dip below 2.3% by mid-2024, which, according to the economists, aligns with a 2% inflation rate as measured by the personal consumption expenditure (PCE) price index—a level the Federal Reserve deems consistent with its mandate for maximum employment and price stability. Importantly, D’Amico and King’s model does not indicate forthcoming rate cuts or liquidity easing measures.
This scenario of decreasing inflation coupled with a resilient economy potentially sets the stage for a “Goldilocks” scenario, ideal for risk-taking in global financial markets. Concerns have loomed since the Fed commenced rate hikes that tightening could disrupt the global economy and potentially trigger another financial crisis.
A ‘Goldilocks’ Scenario: Balancing Inflation and Economic Growth
The economists’ forecast comes at a time when there are concerns that headline consumer price index (CPI) may rebound. Despite having dropped from 9% to 3% over the past year, there are worries that a resurgence in oil and food prices, along with indications of stabilization in prices across manufacturing and service sectors, could prompt the Fed to maintain elevated interest rates for a longer duration.
While some investment banks predict an end to the tightening cycle, they also anticipate that rates will likely remain elevated for an extended period compared to previous expectations.
However, the Fed has been cautious in signaling the conclusion of the rate-hiking cycle. According to the VAR model, the Fed’s consistent and explicit forward guidance has played a crucial role in making expectations a potent factor in accelerating the impact of rate increases on inflation and the broader economy.
The researchers emphasize, “A strong expectations channel also means a more powerful monetary policy, so the estimated effects not only occur faster, but also are bigger than typically estimated. This implies that the effects that are yet to come may still be big enough to bring inflation near target reasonably quickly.”
In summary, these insights from the Chicago Fed suggest a delicate balance in monetary policy may be emerging, offering potential stability and growth in the financial markets while effectively managing inflationary pressures.