The Fed announced that it has raised its Federal Funds target rate to between 5% and 5.25% on Wednesday. This is the 10th consecutive rate increase since the Fed embarked on its inflation-fighting quest in March of 2022.1 The rate is now at the highest level since 2007.
The latest increase in the Fed Funds rate makes the current rate raising program the fastest since the 1980s when then Fed Chairman Paul Volcker raised rates to 19% in 1981 to quash the inflation of the late 1960s and 1970s. Though today’s rate is high compared to the historical average since the Great Recession of 2009, it remains well below the historical average of the 1980s and the latter half of the 1990s.2 Fortunately, inflation has come down from its scorching heights in the summer of 2022. Much of that decrease has been in food, fuel and durable goods. Inflation in services remains stubbornly high, though the central bank will know more about the continuing inflation fight when the Bureau of Labor Statistics releases its most recent inflation print next week.
While inflation has been coming down, it remains elevated and the labor market has yet to materially weaken with the ADP employment report on May 2 showing continued hiring in the U.S with 296,000 jobs being added in April.3 However, Chairman Jerome Powell acknowledged that the Fed’s year-long rate increase regime is having an impact and they are expecting the economy to slow.
The Fed says the policy is working and they will wait to see its further effects
The question is to what extent the current tightening is contributing to recent high-profile bank failures, like at Silicon Valley Bank and First Republic. Thus far, the Fed has been able to walk the tightrope between battling inflation and not sinking the economy into recession with the U.S. economy remaining resilient through 2022 and into Q1 of 2023.4 However, senior loan bank officers are already reporting significantly weaker demand for commercial and industrial loans from both large and small firms, which can be a precursor of an economic recession.5 These fears of an economic slowdown that could result in job losses has already sparked some controversy with some high-profile lawmakers asking the Fed to pause its rate hikes, including Senators Elizabeth Warren, Bernie Sanders and Sheldon Whitehouse, the chairman of the Senate budget committee.6
While this may indeed mark the beginning of a pause from the Fed, leaving interest rates at a restrictive level will still likely weigh on economic activity in the quarters ahead. According to Shawn Snyder, Global Investment Strategist for J.P. Morgan Wealth Management, “Even if this is the last rate hike from the Fed, that does not necessarily imply that financial conditions will ease. If banks raise their credit standards in response to the latest bout of counterparty risk amongst the regional banks, it could serve as a substitute for additional rate hikes.”
The key question moving forward is whether inflation will fall fast enough to keep the Fed on the sidelines for a sustained period of time. Powell said, “Our future policy actions will depend on how events unfold in determining the extent to which additional policy firming may be appropriate to return inflation to two percent over time… A decision on a pause was not made today.”7 Though another rate increase this year is possible if inflation remains sticky or if the labor market unexpectedly heats up. Powell reiterated, “We’re no longer saying that we anticipate” rate increases. Further, Snyder notes that, “While the Fed left the door open to additional rate hikes should they be needed, the market seems to think the door has been shut. In fact, the market is pricing in a series of rate cuts beginning this fall. It would not be surprising to see market volatility later this year if the Fed holds rates steady while a recession takes hold.”
References
Board of Governors of the Federal Reserve System, “Selected Interest Rates.” (May 2023)
Federal Reserve Bank of St. Louis, “Federal Funds Effective Rate.” (May 2023)
Reuters, “U.S. private payrolls beat expectations in April – ADP.” (May 2023)
New York Times, “Many Democrats are pushing the Fed to pause rate increases. Biden’s not one.” (May 2023)
Bureau of Economic Analysis, “Gross Domestic Product.” (May 2023)
Federal Reserve Bank of Dallas, “Loan demand continues to fall sharply.” (February 2023)
Board of Governors of the Federal Reserve System, “Federal Reserve issues FOMC statement.” (May 2023)
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