Written by Howard Schneider

WASHINGTON (Reuters) – The U.S. Federal Reserve’s new forecasts, released later this month, along with an expected half-point rate hike, may show that the central bank’s target interest rate is heading toward levels last seen on the eve of the 2007 financial crisis. It will also reveal policymakers’ best guess about the implications of a flexible labor market so far.

A stronger-than-expected US employment report for November showed businesses added 263,000 workers, with hourly wages rising at an annualized rate of 5.1% and the size of the workforce itself shrinking – all signs of a labor market that is both tight and accelerating. The Fed hopes it will start to cool off.

Combined with only a modest drop in inflation so far, new projections from the Fed’s 19 policymakers are likely to show rates continuing to rise and to remain high through 2023, contradicting current market expectations for a rate cut by the end of next year.

“The Fed has told us that it will take a prolonged period of restrictive policy to raise unemployment and lower wage growth, and today’s data provides further evidence of that effect,” Jefferies economist Thomas Simmons wrote. “This does not take the Fed off course for a widely expected rate hike of 50 (bps) at the next meeting…and gives us greater confidence in our projection that the final rate will exceed 5% next year.”

The last time interest rates were above 5% was from June 2006 to July 2007, at the start of the 2007-to-2009 financial crisis and recession, when the federal funds rate peaked at around 5.25%.

The updated forecast released after the FOMC meeting on December 13-14 will be a fresh opportunity for officials to show how they expect their “hold and hold” strategy to play out in relation to the final policy rate level. Growth, inflation and unemployment have advanced in particular.

The meeting will culminate in a volatile year that has seen the central bank respond to the fastest spread of inflation since the 1980s with the fastest increase in interest rates since then to offset it. The backlash has sent shock waves through the financial system that at one point wiped nearly $12 trillion off the value of the US stock market and recently pushed mortgage rates to 7% for a population accustomed to cheap money.

Stock markets recently rallied and rallied sharply this week when Fed Chair Jerome Powell said, in what was likely his last public statement before the meeting, that the Fed was prepared to slow down from a series of four consecutive rate hikes by three-quarters of a point in its favour. than expected increase by half a point.

It would have been an inappropriate outcome for the Fed chief who wants to keep financial conditions tight and keep public expectations firmly focused on the inflation battle.

But Powell has also been vocal about the trade-off. Even if the central bank starts moving at half a point or a quarter point in the coming months, the interest rate is heading higher toward an unspecified “appropriately constrained” stopping point, and officials intend to leave it there “for some time.”

Fed officials from San Francisco Fed President Mary Daley to Bank of St. Louis President James Bullard, who are often on opposite sides of recent policy debates, have discussed interest rates that could rise above 5% next year.

Bloating ‘too loud’

In a lengthy talk at the Brookings Institution this week, Powell outlined what could be a long transition for the United States to a world of slowly declining inflation, high interest rates, and a potentially chronic shortage of workers.

To slow the pace of price increases, he said, it was clear that energy had to be drained from a labor market where the demand for workers remains far greater than the number of people willing to take jobs — an imbalance in US demographics and immigration policy, magnified by the pandemic.

Embedded in the new economic outlook summary will be estimates of the extent of losses Fed officials feel will be paid in terms of rising unemployment and slowing growth as its policies begin to take their toll.

Powell said he still sees a “reasonable” path to a “soft” landing, with only modest job losses.

But the adjustment is not coming quickly yet.

Data released Thursday showed the Fed’s preferred measure of inflation was 6% in October, down from September’s 6.3% rate, the lowest this year but still three times the Fed’s target of 2%.

Employment data released on Friday showed little evidence of change there, too.

The economy has been adding an average of 392,000 jobs per month this year. Although the pace eased to 277,000 from August through November, this is still higher than the 183,000 monthly additions in the decade prior to the pandemic.

Expectations are far from reality

The Fed’s forecasts during the year raced to catch up with reality. As of last December, officials expected the interest rate to end in 2022 at just 0.9%, with the preferred measure of inflation falling to 2.6%. The highest expectation for individual federal funds was just 1.1%.

This was less than fourfold: with the expected half-point increase at the next meeting, the general policy rate would end up in a range of 4.25% to 4.5%.

Powell this week acknowledged the difficulty of predicting in an environment still reeling from the pandemic and its aftereffects.

But there is also little choice as the central bank ends its reckless push to raise interest rates “in front” with a larger rate hike and begins, as Powell described it, to “feel” the way to a stopping point.

As of September, the Fed narrative still includes a benign outcome of continued growth, a steady progression in inflation, and a rise in the unemployment rate less than a percentage point, to 4.4% at the end of next year from the current 3.7% — what some have referred to as “inflation.” Taher” comes at a small cost to the real economy.

It saw the federal funds rate finish 2023 at 4.6%.

It should be “somewhat higher,” Powell said, and the November jobs data may push it another notch. Upcoming projections will show that the final destination may be on the way to supply, and give a better assessment of whether the labor market is able to outpace it.

Jason Furman, former White House Council of Economic Advisers chairman, wrote on Twitter that the average earnings data from November, along with revisions for prior months, “consist with about 5% inflation.” “I was letting myself have more hope for a soft landing, but that has pretty much dashed that hope.”