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The Federal Reserve's Rate Hike Pause: Implications and Future Outlook
The Federal Reserve recently announced a pause in its interest rate hikes for the first time in 15 months, after increasing rates since March 2022. The most recent hike brought the target rate to 5.25%. Inflation is currently at 4.0%, with core inflation (excluding food and energy) at 5.3%, significantly above the Fed's target rate for headline inflation of 2%. The Fed's primary objective is to maintain stable prices and maximum employment while promoting moderate long-term interest rates
Reasons for the Pause
This decision was influenced by several factors, including concerns about global economic growth, trade tensions between the United States and China, and the potential impact of higher interest rates on financial markets. It was also influenced by a string of strong economic reports since the last meeting in May, despite the Fed's oft-repeated pledge to be data-dependent. Economic indicators such as Core CPI, which accelerated for the second month in a row, have been running persistently at two-and-a-half-times the Fed's target range. Additionally, the banking crisis from March has been moved to the back burner.
The FOMC's decision to hold the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy. The Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity, and the outlook for economic activity and inflation. By pausing a rate hike, the Fed signals that it believes the current interest rate level is appropriate for achieving these goals.
Despite the pause, Fed officials have indicated that two more rate hikes are likely this year. This has led to confusion among investors, as the decision to pause seems to contradict the Fed's hawkish stance on future rate hikes. Some analysts believe that the Fed may be talking a bigger game than it expects to play, while others suggest that Fed officials could be hoping that their tough talk will lead to meaningful tightening in financial conditions, which will in turn act as a brake on economic growth and inflation.
Federal Reserve's Semi-Annual Report
The Federal Reserve has released its updated Summary of Economic Projections, which includes the infamous dot plot. The median projection for the federal funds rate at the end of 2023 has risen by two rate hikes to 5.625%, indicating a very hawkish stance. Notably, no member projected a rate cut, with 16 members projecting one or more rate hikes by year-end. The median projections for GDP growth have also increased to 1.0% from 0.4%. Officials have revised their view of economic growth and the labor market for 2023 and are now looking for a rise in unemployment to 4.5% next year. The jobless rate stood at 3.7% in May. Report Linked Here.
Evidence suggests that recent banking-sector stress and related concerns about deposit outflows and funding costs contributed to tightening and expected tightening in lending standards and terms at some banks beyond what these banks would have reported absent the banking-sector stress. Credit tightening may be larger for sectors that depend more heavily on bank credit, such as commercial real estate and small businesses.
The CPI report showed that it is unhelpful to look at broad headline numbers without digging into the underlying drivers. Shelter inflation was the biggest contributor to the month's increase in CPI, with US rent inflation decelerating slightly and hotels seeing a significant jump in prices. Inflation in used cars and trucks did not slow at all, rising 4.4% in May alone, and car insurance was up 2% for the month and 17% over the year. The cost of groceries crept up slightly, but egg prices slid 13% for the month and pork costs were down 0.8% from the prior month.
The mixed data is likely to confirm pre-release biases in the outlook among investors. The debate over whether the US economy is headed for a hard landing or not continues, with some pointing to the decline in energy prices and continued pressure on both shelter and core service prices as reasons to expect a recession.
Wells Fargo's Sarah House and Michael Pugliese expect a more noticeable deceleration in core prices in the coming months, with shelter inflation appearing to have peaked and used auto prices not sustainable. They believe that excluding used autos, core goods inflation has shown signs of easing amid normalizing supply chains and moderating demand.
Inflation Target Debate
The Federal Reserve has maintained a 2% inflation rate since 2009, which was formally adopted in 2012. This target has been ingrained in retirement plans, annuities, contracts, and financial instruments for nearly a quarter century. However, there are concerns that the Fed may abandon this target to avoid a recession before an election year.
Higher inflation allows big-spending politicians to monetize longer-term national debt by repaying it with devalued dollars. This works particularly well for states and cities in blue states, like New York, that tend to have high per-capita debt, much of it long term. The Council on Foreign Relations, the embodiment of the American establishment, has suggested that the 2% target rate should perhaps be abandoned, but not in the current cycle of inflation.
Implications for Financial Markets
The Fed's rate hike pause has had a significant impact on various financial markets. In the bond market, yields on U.S. Treasury notes have soared since March 2022, with the yield on the policy-sensitive 2-year U.S. Treasury note settling at 4.72% and the yield on the benchmark 10-year Treasury jumping to 3.768%. This reflects traders' expectations of a slightly higher chance of a quarter-of-a-percentage-point rate hike in September following a similar move in July.
In the currency market, the U.S. dollar has experienced both strength and weakness in response to the Fed's rate hike pause. The ICE U.S. Dollar Index, which tracks the greenback against six other currencies, has risen 3.3% since March 15, 2022, but it has fallen 10.3% from its 2022 high of 114.11 in late September. This suggests that investors are uncertain about the future direction of U.S. monetary policy and its implications for the value of the dollar.
Cryptocurrencies, such as bitcoin and ether, have also been affected by the Fed's rate hike pause. Bitcoin tumbled 33.2% to trade at $26,328 on Friday afternoon from $39,416 on March 15, 2022. This significant drop highlights the impact of rising interest rates on cryptocurrencies and their sensitivity to changes in monetary policy.
The Risks of Overdoing Rate Hikes
As the end point of the tightening campaign has been steadily pushed out and revised higher, the risks of overdoing rate hikes have risen. Monetary policy works through lags, and there is a risk of figuring out later on that too much was done.
One risk factor is the potential exhaustion of excess savings accumulated by households during the pandemic recession. Research by the San Francisco Fed indicates excess savings could be exhausted this summer, leading to a decline in real incomes and reduced consumer spending.
Another risk factor is the resumption of student loan repayments at the end of August, which could drain around $5 billion per month from consumers' budgets. This could happen at the same time when excess savings run out, potentially causing a drag on the economy.
The Fed's decision to pause a rate hike can also have implications for employment levels. Generally if the Fed raises interest rates, businesses are less likely to borrow and invest, potentially leading to job losses and higher unemployment rates. If the Fed current rate hike cycle has gone to far, then higher unemployment rates are on the horizon.
For more analysis on these topics, check out these articles:
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