Federal Reserve Chair Jerome Powell responds to a question from David Rubenstein (not pictured) during a discussion on stage at a meeting of the Economic Club of Washington at the Renaissance Hotel in Washington, DC, the United States, February 7, 2023. REUTERS /Amanda Andrade-Rhoades
Amanda Andrade-rhoades | Reuters
The Federal Reserve is a year on its rate-hike path and in some ways is both closer and farther from its targets when it first set sail.
Exactly one year ago, on March 16, 2022, the Federal Open Market Committee approved the first of a total of eight interest rate hikes. The goal: stemming a stubborn wave of inflation that central bank officials spent most of a year dismissing as “temporary.”
Since then, inflation, as measured by the consumer price index, has eased somewhat, from an annual rate of 8.5% then to 6% now, and the trend is falling. While that’s progress, it still leaves the Fed well short of its 2% target.
And it raises questions about what lies ahead and what the impact will be as policymakers continue to grapple with persistently high living costs and a shocking banking crisis.
“The Fed will admit it came in too late, that inflation was more stubborn than it expected. So it probably should have tightened sooner,” said Gus Faucher, chief economist at PNC Financial Services Group. “Considering that the Fed has tightened as aggressively as they have, the economy is still very good.”
There is an argument for this point about growth. While 2022 was a lackluster year for the US economy, 2023 at least starts on solid footing with a strong job market. But the last few days have shown that the Fed has another problem to deal with besides inflation.
All of these policy tightenings – a 4.5 percentage point hike in interest rates and a $573 billion quantitative balance sheet tightening – have been accompanied by significant dislocations that are now sweeping through the banking industry, hitting smaller institutions in particular.
If the contagion is not contained soon, the banking problem could overshadow the inflation struggle.
“Collateral damage” from rate hikes
“The chapters are just beginning to be written” on the impact of last year’s policies, said Peter Boockvar, chief investment officer of Bleakley Advisory Group. “There’s a lot of collateral damage when you don’t just hike rates to zero after a long time, but the speed at which you do that creates a bull in a china shop.”
“The bull could walk around and not knock anything over until recently,” he added. “But now it’s starting to shake things up.”
Rising interest rates have hit banks holding otherwise safe products such as government bonds, mortgage-backed securities and municipal bonds.
Because prices fall when interest rates rise, the Fed’s rate hikes have reduced the market value of these fixed income holdings. In the case of Silicon Valley Bank, it was forced to sell billions in holdings at significant losses, contributing to a crisis of confidence that has now spread to others.
That leaves the Fed and Chair Jerome Powell with a key decision to make in six days when the rate-setting FOMC releases its post-meeting statement. Will the Fed continue its often-stated intention to keep raising rates until it is satisfied that inflation is falling to acceptable levels, or will it step back to assess current financial conditions before proceeding?
Rate hike expected
“If you’re waiting for inflation to get back to 2% and that’s why you raised rates, you’re doing it wrong,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “When you’re at the Fed, you want to buy optionality. The easiest way to buy optionality is to just pause next week, stop QT and just see how things play out.”
Market prices have been lashing out violently over the past few days over what to expect from the Fed.
As of Thursday afternoon, traders had reverted to expecting a 0.25 percentage point rate hike and had priced in an 80.5% chance of a move taking the federal funds rate to a 4.75% range, according to CME Group data would bring 5%.
With the banking industry in turmoil, LaVorgna thinks it’s a bad idea at a time when confidence is waning.
Since rate hikes began, depositors have withdrawn $464 billion from banks, according to Fed data. That’s a 2.6% drop after a massive surge in the early days of the Covid pandemic, but it could accelerate if the health of community banks is questioned.
“They corrected one policy error 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 went from one extreme to the other, neither of which is good. I wish the Fed had a more honest assessment of what they did wrong. But you don’t usually understand that from the government.”
Indeed, there will be much to chew on as analysts and historians look back at the recent history of monetary policy.
Inflation warning signs began in spring 2021, but the Fed maintained its belief that the hike was “temporary” until forced to act. Since July 2022, the yield curve has also been sending signals warning of a slowdown in growth as shorter-term yields exceed longer duration, a situation that has also posed acute problems for banks.
However, if regulators can resolve the current liquidity problems and the economy can avoid a severe recession this year, the Fed’s missteps will have done minimal damage.
“Given the experience of the past year, there are valid criticisms of Powell and the Fed,” PNC’s Faucher said. “Overall they have responded appropriately and the economy is in a good place given where we were at this point in 2020.”
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