Pausing interest rate hikes would be the Fed’s ‘worst mistake,’

Based on a number of encouraging signals, the U.S. economy may finally be getting a respite from inflation.

Last week’s consumer price index showed that October prices had increased 7.7% from a year earlier, lower than analysts’ expectations and the slowest annual increase this year. And on Tuesday, the October producer price index—an inflation metric from the perspective of sellers that tracks how much producers pay for goods—came in at 8% higher than a year before, well below forecasts and the smallest increase since July.

Stocks rallied in the past week on optimism the Federal Reserve, backed up by the two reports, would ease up on the fast-paced interest rate hikes it started in March to slow the economy and reduce prices.

Many investors and economists fear the Fed is overcorrecting and could trigger a recession, leading many to urge the central bank to slow the pace of its rate hikes.

But despite the skepticism, billionaire investor Ken Griffin, founder and CEO of Citadel, a major hedge fund that manages over $50 billion in assets, said that pausing rate hikes completely could have an even worse effect on the economy.

“It’s not yet time for us to change course on our monetary policy,” Griffin said during an interview on Tuesday at the Bloomberg New Economy Forum in Singapore.

“We haven’t gotten the job done. And to take the foot off the brake right now and not finish the job is the absolute worst mistake the Fed could possibly make,” he said.

Peak inflation

Responding to the past week’s positive inflation reports, high-profile economists including the University of Michigan’s Justin Wolfers and Nobel Prize winner Paul Krugman have said that inflation may have already peaked and is now trending downward, citing lagging indicators that have yet to be factored into inflation reports, such as falling rental costs.

Griffin agreed with that sentiment during his interview with Bloomberg. “We think we’ve seen peak inflation,” he said. Like Wolfers and Krugman, Griffin said evidence shows that rental costs are declining in several major metro areas, and while rents will likely “continue to show inflationary pressure for the next few months,” their peak has already passed.

The likelihood that inflation is starting to decline has stirred hopes that the Fed will soon ease up on rate hikes. At a Fed meeting earlier this month where the year’s sixth interest rate hike was approved, officials signaled that they may switch to smaller hikes in the future. 

Even some Fed officials have called for slowing the pace of interest rate hikes. Fed Vice Chair Lael Brainard told Bloombergon Monday that it would “probably be appropriate soon to move to a slower pace of rate increases,” while emphasizing that there was still “additional work to do.” And last week, Charles Evans, outgoing president of the Federal Reserve Bank of Chicago told Bloomberg there would be “benefits to adjusting the pace as soon as we can.”

But slowing the rate increases does not mean stopping them altogether, both officials said. Doing otherwise could backfire on all the work the Fed has done so far, Griffin said Tuesday.

Risk of relapse

“The biggest concern is you unanchor inflation expectations,” Griffin said. He compared halting rate hikes now to stopping a prescribed 10-day antibiotic treatment on day seven. “You relapse a few days later,” he said.

Unanchored inflation is when long-term inflation expectations become detached from reality, which could lead to the situation spiraling out of the Fed’s control. For example, inflation could accelerate again if people are mistakenly convinced that it will stay low, leading to them spend more and thereby increasing economic activity.

“If we take the foot off the brake, if we don’t finish the course of antibiotics, inflation starts to flare back up and the Fed would’ve lost credibility,” Griffin said. “If the Fed loses credibility and inflation expectations unanchor, then the amount by which we would need to raise rates to deter economic growth will be a much bigger bill to pay.”

Other economists have said the Fed should stay the course and continue raising interest rates quickly until they are convinced inflation is on a sustained downward trend, even if it means triggering a severe recession. Former Treasury Secretary Larry Summers tweeted earlier this month about a “growing chorus” of politicians and economists who are “badly misguided” for calling on the Fed to pause interest rate hikes.

The only time the Federal Reserve has prioritized avoiding a recession ahead of reducing inflation was in the “disastrous” 1966 to 1981 period, Summers wrote, adding that high and unanchored inflation would be “very hard to stop” based on historical evidence.

“It is important to recall that expectations have remained anchored BECAUSE the @federalreserve has been moving. If the Fed stops moving expectations may increase,” he wrote.

Summers has been outspokenly critical of the Fed’s decision to delay interest rate hikes when inflation began increasing last year, and in a recent interview with Fortune, put the chances of a U.S. recession at 75%, and predicted unemployment could rise as high as 6% from its current level of 3.7%.

Griffin agreed that a recession is likely to hit the U.S. “in the middle or the back half of 2023,” and expects unemployment to rise to the “mid-4% level.” But the Fed’s aggressive actions will also have a strong effect on inflation, which should decline to a “low- to mid-2% range” by the end of 2023, according to Griffin.

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