U.S. Federal Reserve Chairman Jerome Powell answers a question from David Rubenstein (not pictured) during an on-stage discussion at the Economic Club of Washington meeting at the Renaissance Hotel in Washington, D.C., U.S., February 7, 2023. REUTERS/Amanda Andrade-Rhoades
Amanda Andrade-Rhoades | Reuters
The Federal Reserve is a year down the road from raising its rates, and it will be both closer and further away from its targets as it hits its first path.
Exactly one year ago, on March 16, 2022, the Federal Open Market Committee adopted the first of eight interest rate hikes. The goal: to contain a stubborn wave of inflation that central bank officials have dismissed as “transitory” for most of the year.
Since then, inflation, as measured by the consumer price index, has fallen from 8.5% per year at the time to 6% now and has been on a downward trend. While this is progress, it still leaves the Fed short of its 2% target.
It raises questions about what the future holds and what the consequences will be, as policymakers continue to grapple with a persistently high cost of living and a staggering banking crisis.
Gus Faucher, chief economist at PNC Financial Services Group, said: “The Fed recognizes that they were late to the game, that inflation has been more persistent than they expected. So they should have tightened sooner.” “That said, given that the Fed has tightened as aggressively as they have, the economy is still doing pretty well.”
There is a growing argument for this. While 2022 was a bad year for the US economy, 2023 is at least starting on solid footing with a strong labor market. But recent days have shown that the Fed has another problem besides inflation.
All of the monetary policy tightening — a 4.5 percentage point rate hike and a $573 billion quantitative tightening balance sheet slump — has now been driven by significant volatility in the banking industry, particularly affecting smaller institutions.
If the contagion is not stopped soon, the banking problem may overshadow the fight against inflation.
“Collateral damage” from tariff increases.
Peter Bookwar, chief investment officer at Bleakley Advisory Group, said the “chapters are just beginning to be written” on the consequences of last year’s policies. “When you not only raise rates to zero after a long period of time, but the speed at which you do it creates a bull run in the china shop, there’s a lot of collateral damage.”
“Until recently, the bull was sliding without knocking over anything,” he added. “But now it’s starting to bring everything down.”
The higher rates hit banks that hold other safe-haven products such as Treasurys, mortgage-backed securities and municipal bonds.
Because prices fall when rates rise, the Fed’s hike has reduced the market value of these fixed income holdings. In the case of the Silicon Valley bank, it was forced to sell billions in holdings at a significant loss, contributing to a crisis of confidence now spreading elsewhere.
That leaves the Fed and Chairman Jerome Powell with a critical decision to make in six days, when the FOMC releases its post-meeting statement that sets rates. Will the Fed follow through on its oft-stated intention to continue raising rates until headline inflation falls to acceptable levels, or will it step back to assess current financial conditions before moving forward?
Tariff increase is expected
“If you’re waiting for inflation to get back to 2% and that’s a reason for you to raise rates, you’re wrong,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “If you’re in the Fed, you want to buy additional opportunity. The easiest way to buy additional opportunity is to hold off on the next week, stop the QT and just wait and see how things play out.”
In recent days, the market price has risen sharply on what to expect from the Fed.
On Thursday afternoon, traders returned to expectations of a 0.25 percentage point hike, with an 80.5% chance of a move that would take the federal funds rate to a range of 4.75%-5%, according to data from CME Group.
With the banking industry in turmoil, LaVorna believes that would be a bad idea when confidence is on the wane.
Depositors have withdrawn $464 billion from banks since the rate hike began, according to the Fed. That’s a 2.6% drop after a massive surge in the early days of the Covid pandemic, but it could accelerate as the credibility of community banks is questioned.
“They corrected one policy mistake with another,” said LaVorgna, who was chief economist at the National Economic Council under former President Donald Trump. “I don’t know if it was political, but they’ve gone from one extreme to the other, none of which are good. I wish the Fed would be more honest about what they’ve done wrong. But you don’t usually get that from the government.”
Indeed, pundits and historians have a lot to chew on when they look back at the recent history of monetary policy.
Warning signals about inflation began in the spring of 2021, but the Fed believed that growth was “transitional” until it was forced to act. Since July 2022, the yield curve has also been sending signals, warning of a slowdown in growth as short-term yields exceed long-term ones, a situation that has also created acute problems for banks.
However, if regulators can resolve current liquidity problems and the economy avoids a sharp downturn this year, the Fed’s missteps will do little harm.
“With the experience of the past year, there are legitimate criticisms of Powell and the Fed,” PNC’s Faucher said. “Overall, they responded appropriately and the economy is in a good place given where we are at this time in 2020.”