Howard Schneider and Ann Saphir

(Reuters] – U.S. Federal Reserve officials are aligned on plans to speed up interest rate increases this year. However, they remain divided over the crucial decision about where to stop the economy from spiraling into recession.

This debate is just beginning, but it will be more important this summer, as policymakers assess how fast their initial rate hikes cause households to reduce spending, and whether that slows inflation at levels never seen since 1980s.

The Fed is at risk due to the recent increase in long-term rates. This has left it unable to help improve inflation prospects. It must choose between a faster rate hike that could push the economy forwards or a slower pace which will allow an inflationary mindset to prevail.

“Ultimately it’s making a decision…’this is a path that seems consistent (with controlling inflation)’…Or judging that it’s not the case,” Chicago Fed President Charles Evans said last week, outlining the struggles Fed officials anticipate in determining how high rates may need to rise to bring inflation back in line with the central bank’s 2% target.

“It’s a devilishly hard question,” Evans said.

The Fed’s ability to answer the question correctly is crucial for the current economic boom. But not everybody believes that they can.

Lawrence Summers, former Treasury Secretary, has often argued for the Fed to take too long to react to price increases. He recently stated that this inflation, last at 6.4% according to the Fed preferred measure, combined with low unemployment, makes it likely there will be a recession within 2 years.

GRAPHIC – “Broad-based”, or not? What is “Broad-based?”? – https://graphics.reuters.com/USA-FED/INFLATION/klpykzrowpg/chart.png

The ‘EXTREMELY IMPORTANT DEBATE’

The Fed’s next policy step will be taken during the May 3-4 meeting when officials expect to raise the target rate by half of a percentage point.

Even the most dovish policymakers, including Evans, now agree that rate hikes in increments beyond the familiar quarter-point-per-meeting are needed, given the strength of inflation. They have also come together around an overall rise in the federal funds rates to at least 2.5% per year, which is at least 2% above the close-zero rate set for fighting the sharp but temporary recession caused the coronavirus epidemic pandemic.

The majority of tightening has been accepted by consumers, financial markets and businesses.

It may not be enough. Analysts point out that high levels of inflation may create their own momentum and increase the rate of effective price rise control.

Robert Dent, Nomura Research economist, said that the rate at which interest rates rises meaningfully affects the economy could be higher because of inflation. “That’s partly why they are more comfortable with going higher and faster.” It’s an important topic that is sure to get more attention from the Fed over the next six-months.

In March’s last meeting, policymakers estimated that the rate range they would recommend for 2023 at 3.1% to 2.1%. That gap is a reflection of risks surrounding the Ukraine war and the pandemic. It also points out uncertainty about consumers’ and businesses’ reactions to increased borrowing costs.

In part, equity markets are experiencing volatility recently, Bank of America (NYSE) economists argued. This is because of the wide berth surrounding possible Fed policy options, which includes options contracts that indicate the central bank’s potential policy rate of 2% to 4.5% in the coming two years.

GRAPHIC: A fast trip to neutral – https://graphics.reuters.com/USA-ECONOMY/POWELL/zdvxogolapx/chart.png

FIND ‘NEUTRAL’

Fed officials debate monetary policy using a concept called the “neutral” (or “natural”) rate of interest. This is a crucial figure in determining whether they are encouraging or discouragering economic activity.

It is the long-term rate that balances the economy on a variety of fronts, while keeping full employment and inflation at their target. The Fed considers it to be the rate at which output grows at a pace consistent with the underlying productivity and demographic trends.

GRAPHIC: ICE (NYSE:) inflation expectations index ICE inflation expectations index – https://graphics.reuters.com/USA-FED/INFLATION/akvezxjwrpr/chart.png

Fed officials believe the neutral rate at 2.4%, and they have pledged to do so “expeditiously”, as part of one of the largest monetary policy adjustments ever performed by the U.S. central banking.

If the Fed’s outlook changes in the following weeks or months, or if consumers change their spending habits or businesses start setting wages or prices differently from what they expected because their expectations have changed or their preferences have changed, policymakers might need to become more aggressive.

While “neutral”, as a short-term term, may have been more volatile because of inflation dynamics, which could make it harder for the Fed to catch up. James Bullard from St. Louis Fed believes they’re already behind the curve and will need to raise rates sooner than expected.

GRAPHIC: What’s the deal with a bumpy landing? – https://graphics.reuters.com/USA-ECONOMY/RECESSIONTEMPLATE/egpbkoolgvq/chart.png

The ‘WALL of Worry’

Fed officials are keen to maintain the momentum of recovery and prevent any significant increase in unemployment, especially from 3.6% currently. This is arguably the most robust job market since 1950s.

However, they must take some of the economic extremes out of the equation, whether it’s the 35% increase in median property prices due to the pandemic or the rise in wages that Fed Chair Jerome Powell refers to as “unsustainably high.”

GRAPHIC: Fed policy trails inflation by historic margin Fed policy trails inflation by historic margin – https://graphics.reuters.com/USA-FED/gdpzynrmnvw/chart.png

This week’s inflation data will indicate whether there has been any improvement, while the next week’s April employment report will give an update on wage growth.

Some evidence suggests that the housing market is cooling, as mortgage rates for home are now higher than usual at 5%, up from 3% in 2013.

However, the Fed’s policy decisions are not yet clear. A number of economists raised recent estimates about how much Fed officials will have to do. They can look forward to the meeting next week for some guidance.

According to Jefferies economists, the employment market is strong with wage growth. However, unemployment could fall below 3 percent this year. Aneta Marcowska and Thomas Simons both wrote that so far consumers seem to be immune to an “Omicron, Ukraine invasion, a spike gas prices, and sharply lower interest rates.”

This could lead to Fed raising rates by more than 4%. A level that has not been seen since the 2007-2009 financial crisis, and that will likely increase recession risk.

The Fed must be more aggressive because “The U.S. Economy is climbing the wallof worry” they said. Inflation has been increasing and there’s an increase in strength.