On Wednesday, the Federal Reserve raised interest rates by 0.25%. The Federal Reserve’s benchmark interest rate is now the highest in 22 years . A majority of market participants believe that the Federal Reserve is now finished raising interest rates. Traders place just a 35% probability on another rate hike in 2023.
I suspect that market participants are wrong.
The Federal Reserve’s inflation rate target is 2%. Core inflation, as measured by the personal consumption expenditure price index, the Federal Reserve’s preferred measure, is running above 4%. The Federal Reserve remains committed to its 2% target, which is appropriate in order to keep inflation expectations anchored and to maintain the credibility of the interest rate policy of the Federal Reserve. An over 4% inflation rate is substantially higher than the 2% target.
It is unlikely core inflation will fall to 2% without more tightening. The labor market is tight. The unemployment rate is 3.6% , very low by historical standards. In effect, the economy is operating at full employment. And because the labor market is tight, wage inflation remains elevated. According to the Federal Reserve Bank of Atlanta, wage inflation is running at around 5.6% .
HOW BAD WOULD A UPS STRIKE BE FOR THE ECONOMY?
With trend productivity growth of around 1.5%, wage inflation must fall to 3.5% in order to be consistent with a 2% inflation rate. Respected economic experts such as professor Jason Furman and Richard Fisher, former governor of the Federal Reserve Bank of Dallas, both say that the economy is benefiting from the growth tailwinds of fiscal and financial stimulus.
On fiscal stimulus, between the Infrastructure Investment and Jobs Act and the Inflation Reduction Act, Congress invested $1.25 trillion across the transportation, energy, water resources, and broadband sectors for the next five to 10 years. Much of that money has yet to be disbursed. That money will continue to propel an already strong employment market. On financial stimulus, equity markets are up almost 20% year to date. United States households are enjoying record wealth . Some portion of that accumulated wealth will be spent.
To compound the problem of continuing excessive stimulus, recent labor agreements have been inflationary . Pilots unions are achieving wage gains of 40% over a four-year period. The proposed labor agreement between the Teamsters Union and United Parcel Service increases wages by a total of $30 billion . The United Auto Workers union is negotiating with the Big Three auto manufacturers. The current contract expires on Sept. 14. The UAW wants a wage contract similar to that entered into between the UAW and Deere, which included a first-year wage increase of 10%, clearly inflationary.
All of this underlines why it is highly likely the Federal Reserve will continue to raise interest rates in order to achieve its 2% target. But as the Federal Reserve continues to raise interest rates, recession risk rises proportionally.
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James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on finance and the economy, politics, sociology, and criminal justice.
