Today’s FOMC meeting featured a number of hawkish components. Most notably, the Fed’s forecast for policy rates was revised substantially higher, and many officials now see policy rates in restrictive territory in both 2023 and 2024. In his press conference, Chair Powell restated his various concerns about inflation. He also reiterated that a 50-basis point hike may be appropriate sometime this year.

Today’s hawkish message from the Fed is in response to the most recent economic data. Inflation has continued to be elevated and the labor market had shown more strength than most expected. Specifically, the inflation surge that started last October has continued into 2022. Core CPI rose 1.1% in the first two months of the year, which took the 12-month gain to 6.4%. At the same time, the labor market continues to recover faster than many expected. Job growth averaged over 600,000 per month in January and February, and today’s employment is close to its pre-pandemic level.

The outlook may not justify such a hawkish policy, especially as it pertains to growth

While the recent data may justify today’s hawkish message, it is not entirely clear that the outlook does. US growth is likely to slow this year, perhaps substantially so. The factors that have recently boosted activity—including the reopening after Covid and fiscal stimulus—have mostly faded. In fact, fiscal policy has now flipped to being a headwind. The absence of the generous checks that supported incomes last year will weigh on this year’s growth. At the same time, it is much more likely that inflation will moderate than persist around current levels. A substantial portion of today’s elevated inflation can be attributed to pandemic-specific factors, including economic reopening (which impacted airline and hotel prices, among others) and problems with supply chains (which impacted car and furniture prices, among others). As the pandemic recedes, so too will those price pressures. Moderating demand will also take some pressure off prices.

Indeed, recent data signals emerging changes in the economic environment. Average hourly earnings were flat in February, while both job openings and quits have fallen somewhat. That suggests the peak of labor market tightness may be in the past. Supply-chain problems have stopped getting worse, and the recent rise in imports is consistent with some gradual healing. GDP growth is expected to decelerate materially in the first quarter, with some forecasters anticipating it will be close to zero. Finally, balance is being restored to the economy as sales are now slowing just when inventories had been rebuilt. While none of these data points is definitive nor likely to lead to a sharp turn, they do suggest a notable shift in the environment, away from one that is uniformly inflationary to one in which risks are at least balanced, and downside risks to growth may be emerging.

The challenging implications of the conflict in Ukraine

The conflict in Ukraine has likely exacerbated the challenge facing the Fed over the rest of the year. Of course, the outcome of the conflict itself is highly uncertain and a number of scenarios remain possible. That said, it is straightforward enough to observe that elevated oil prices, which could be the result of a number of possible outcomes for the conflict, could pressure inflation higher in the near term, thereby creating a potentially substantial drag on growth over subsequent quarters.

Given the concerns regarding inflation that predate the conflict, it is not surprising that investors have primarily focused on how the conflict may further push up consumer prices. It remains to be seen, however, whether the impact of higher oil prices will broaden beyond gasoline and other directly related products. One channel through which the impact could broaden is through inflation expectations. Volatile oil prices raise the prospect of volatile inflation expectations, which in turn could influence realized inflation. While undoubtedly something to watch, this channel is less direct than most think. The limited evidence on how expectations impact realized inflation suggest a rather slow process, potentially drawn out over multiple years, rather than something quick that will influence realized inflation in the months immediately following a shock.

While inflation has received most of the attention, it is possible that the risks to growth from higher oil prices may end up being an equally big challenge for the Fed. In particular, the drag caused by an energy shock may be more than a back-of-the-envelope analysis suggests. Many argue that because the US is no longer a net oil importer, higher oil prices will have roughly offsetting effects among winners and losers, lowering consumption by about the same amount that they raise production. That analysis may be misleading in today’s environment. The challenge today is that the hit to consumption may be substantial, especially as it is coming when disposable incomes were set to decline anyway. The boost to production, on the other hand, may disappoint if the shale industry continues to respond slowly to price signals. If the hit to consumption were to dominate, the net effect of higher oil prices would be clearly negative for growth, and potentially to a greater degree than the basic analysis suggests.

Growth risks will factor more prominently in Fed considerations going forward

The hawkish tone at today’s Fed meeting was in response to the recent data, which has featured a combination of high inflation and labor market strength. In some sense, the clarity in the recent economic data made today’s meeting relatively straightforward for the Fed.

The remaining meetings of the year are unlikely to be as straightforward. In particular, a slower path for growth will likely factor more prominently in the Fed’s deliberations. Indeed, moderation in growth is widely expected due to the fading of the extraordinary factors that boosted activity last year. Even prior to the conflict in Ukraine the economic data had started to shift, with recent signs suggesting that demand is slowing and the peak of labor market tightness may be behind us. The conflict in Ukraine further adds to the challenge, especially should higher oil prices lead to lower consumption and thereby exacerbate the risks to growth.

The Fed’s response to a softening growth outlook is unlikely to be immediate. After all, inflation remains above the 2% objective and the labor market appears to have some momentum. Nonetheless, growth risks will matter eventually. While these growth risks may not deter the Fed from hikes in the near term, they could inject a note of caution into the Fed’s communication over the next few months. The Fed will seek to reassure that it is not only aware of the growth risks, but also that at a minimum its actions will not unduly raise those risks. Looking a bit further out, say by the second half of the year, the growth risks are likely to be more salient, especially should the data confirm the expected slowing. At that point the Fed will need to address the issue in a more head-on fashion, potentially by adjusting its path for interest rates in response. In any case, the relative straightforwardness of today’s outcome is likely to give way to something much trickier as the growth risks start to factor more prominently going forward.