By Nick Timiraos
Federal Reserve officials' concerns about stubbornly high inflation could lead them to signal that they are prepared to lift interest rates again this year even if they hold them steady on Wednesday.
The Labor Department reported Tuesday that overall inflation slowed in May but underlying price pressures remained firm. The figures are likely to keep the Fed on track to forego a rate rise this week following 10 consecutive increases.
The consumer-price index rose 0.1% from April, lowering the 12-month change to 4%, from 4.9% in April. So-called core consumer prices, which excludes volatile food and energy categories, climbed 0.4% in May and by 5.3% from a year earlier, down from 5.5% in April.
Policy makers' new quarterly economic projections, due to be released after their meeting on Wednesday, provide them one way to underscore that they are likely to raise rates more if the economy and inflation don't soon show signs of slowing. Fed Chair Jerome Powell will further explain officials' thinking at a news conference Wednesday.
Their March projections showed most officials anticipated they would raise their benchmark federal-funds rate to its current level, between 5% and 5.25%, and hold it there through year's end so long as growth and inflation slowed. A significant minority thought the rate would need to rise higher, to around 5.5%.
Officials made those projections on March 22 amid heightened uncertainty from the failure of two midsize banks -- Silicon Valley Bank on March 10 and Signature Bank on March 12. A third ailing lender, First Republic Bank, failed a few weeks later.
Until March, Fed officials had lifted every quarter their estimates of how high they would have to raise rates. But in March, more officials concluded the potential for banks to tighten credit might have the same economic effect as a Fed rate increase. Most held steady their projection of the "peak" rate.
Since then, some Fed policy makers have said they are anxious the economy hasn't responded to rapid rate rises over the past year and want to keep nudging rates higher to ensure growth slows soon.
Others are more concerned that the Fed's past increases haven't been fully transmitted through the economy. The bank failures this spring served as an early example of how a lending pullback could unfold with little notice, especially because financial markets grew accustomed to historically low borrowing costs over the past decade.
The crosscurrents of economic resilience and the lagged effects of past rate increases underscore how, with short-term rates now at a 16-year high, nearly any rate strategy at this point carries more peril than earlier in the rate-increase process.
"It's easier to make mistakes because it's harder to figure out what's happening to the economy in real-time," said former Fed governor Jeremy Stein. "The risk that you make a monetary policy mistake has gone up."
After raising interest rates rapidly from very low levels last year, officials slowed their increases this year. They have raised the fed-funds rate by a quarter percentage point at each of three meetings so far this year, most recently in May.
Policy makers are expected to hold rates steady at their meeting this week, but investors in interest-rate futures markets anticipate another increase is likely at the Fed's subsequent gathering in July.
Signaling a rate "skip" -- the combination of holding rates steady in June while signaling a high likelihood of a rate rise in July -- could be tricky to explain to the public. "If you were absolutely sure you were going to go ahead with an increase at the following meeting, then you should just go now," said William English, a former senior Fed economist who is a professor at Yale School of Management.
Forgoing an increase this week would allow officials to further slow their rate rises to assess the effects of their previous hikes and any fallout from banking industry stress.
When mapping out how much further and faster to raise rates, "it calls for a different, somewhat more complicated kind of analysis -- surely more complicated than being dependent on the last inflation reading and the last job report," said former Fed governor Daniel Tarullo.
One challenge for officials is that economic activity has continued to outperform expectations. Low inventories of homes for sale, for example, have boosted sales of new homes and home prices in recent months.
But there hasn't been much time for Fed policy makers to assess to what degree, if any, banks' rising funding costs are reducing lending. The economic effects of banking and other financial stresses are harder to model than traditional interest-rate increases.
"We're well over 5% interest rates, effectively, once you add in the tightening that came from the banking side. You've got loans becoming much scarcer. That should be slowing the economy down," said Stephen Cecchetti, an economist at Brandeis University.
Those who think the Fed should keep raising rates are more worried about high inflation becoming entrenched in public psychology. "I remain concerned about how slowly inflation is making its way back to 2%," said Narayana Kocherlakota, who was president of the Minneapolis Fed from 2009 to 2015.
The experience with high inflation in the 1970s shows that once the public expects higher prices, the Fed has to force unemployment higher to bring down inflation. If the public thinks the Fed isn't willing to raise rates to reduce inflation that is more than double the central bank's 2% target because of concerns about the banking system, that could lead inflation expectations to rise, said Kocherlakota.
Kocherlakota faulted the Fed for "continuing to sell the story that interest rates will not have to go significantly higher."
"Will the Fed have to go to 7%? I hope not," said Kocherlakota, an economist at the University of Rochester. "Is there a possibility they're going to have to go to 7%? Absolutely."
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