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Fed Rates Rise to a 16-Year High and Debate Pauses

May 1, 2023
minute read

As the Federal Reserve officials prepare for their meeting this week, they plan to raise interest rates again this year while debating whether this will be enough to pause the fastest rate-raising cycle in more than four decades.

“Loretta Mester, president of the Cleveland Federal Reserve, said on April 20 that "we are much closer to the end of the tightening journey than we were at the beginning."

Whether the Fed is any closer to that endgame will be the subject of a lot of internal debate, since officials think that communication around future policy steps can be as significant as the actual changes to rates themselves.

There is a good chance that officials will keep their options open as they fine-tune carefully calibrated signals in their post-meeting statement and in their remarks by Fed Chairman Jerome Powell after the meeting concludes on Wednesday.

The benchmark federal funds rate would be pushed to a 16-year high if another quarter-percentage-point increase were to be made. In March 2022, the Federal Reserve started to raise interest rates from close to zero.

The Federal Reserve increased interest rates by a quarter point on March 22 to a range between 4.75% and 5%. There was a sharp increase in the number of banks failing in March, at a time when officials were just beginning to grapple with the potential fallout of two midsize bank failures.

A Federal Deposit Insurance Corp. announcement early Monday that First Republic Bank would be sold to JPMorgan Chase & Co. is the latest indication that the future of the economy is overshadowed by banking stresses.

There is a likelihood that Fed officials will closely monitor how investors react to the Credit Suisse and UBS Group merger before making a decision on Wednesday, just as they did prior to raising interest rates six weeks ago when Swiss authorities merged the two investment banks.

Analysts believe that Monday's agreement may have resolved some potential banking strains further, but officials may have to rethink a planned increase if severe and unanticipated financial strains emerge before Monday's meeting.

In order to combat inflation, the Fed slows the economy by raising interest rates, which in turn leads to tighter financial conditions, such as higher borrowing costs, lower stock prices, as well as a stronger dollar, which decrease demand in the economy. 

In order to justify an end to interest rate increases, officials have been looking for signs of a slowdown and a decline in inflation to justify the decision. 

As a result of this week's developments, the Fed's calculations may change. To continue raising interest rates, the Bank of Canada may need to see signs that economic growth, hiring, and inflation are stronger than expected.

There are some signs of a cooling in the economy, such as a less pronounced increase in consumer spending and reduced factory output. There is a possibility that inflation could rise further if hiring stays steady and wages rise briskly. 

Based on the projections released after the Fed's March meeting, a majority of Fed officials believed that the central bank would need to raise rates one last time by a quarter point before stepping aside. There is a possibility that those officials may conclude that they have achieved a setting that is sufficiently restricting if they follow through this week.

Several have already indicated that they would like to see how the economy evolves in the summer before making a decision on whether or not to add further increases.

The Philadelphia Fed President Patrick Harker said in a presentation on April 11 that he doesn't see why we would just continue to go up, up, up, and then go, 'Oops,' and then go down, down, down very quickly. The Fed has long been expected to have to raise interest rates to a level that is marginally over 5%, according to him.

As of now, officials have not seen any signs that the March banking turmoil had a significant effect on economic activity by causing a decline in lending. While the Fed's senior loan-officer survey, a quarterly report on bank lending trends, will not be released publicly until after this week's meeting, those results will be available to policymakers when they meet this week when they discuss bank lending trends.

It is likely that officials who are more concerned about the impact of any tightening of credit conditions will push for a signal that the Federal Reserve will suspend its policy of raising interest rates. 

In his speech on April 11, Chicago Fed President Austan Goolsbee said that the Fed should not give up on fighting inflation, but that it also needs to accept that the combination could have an effect on some sectors or regions in a different way than it would if monetary policy were acting alone. 

The former president of the Boston Fed from 2007 to 2021, Eric Rosengren, said last week he would vote against raising rates at this meeting if he were still a policymaker. In a talk hosted by Harvard Business School, he said that he thought banking stress would have a far greater negative impact on the economy than most Fed officials believed.

Furthermore, a substantial minority of Fed officials in March told reporters they were inclined to believe that more than one rate increase would be justified this year if the economic outlook didn't deteriorate further. 

They are more concerned with the possibility that the central bank is not going to hold off on the brakes for too long, and as a result, inflation, hiring, and economic growth will defy forecasts that the economy would slow this year to a halt.

“Though I am glad to see signs of a moderating demand until these signs appear, and I am able to see inflation moving meaningfully and consistently down toward our 2% target, we will still have a lot of work to do,” said Federal Reserve governor Christopher Waller in an April speech.

Although many economists have been focusing on a possible recession over the past few months, the bigger concern for the Federal Reserve remains a booming economy that is growing too rapidly, according to Ray Farris, chief economist at Credit Suisse. "It is safe to say that they would be OK with some real economic weakness in their hearts," he said.

The upshot of this is that the Fed's policy statement, which is subject to a committee vote this week, could be one of the most important and heavily negotiated steps that its officials are taking this week. It is likely that the central bank will stick to a policy of raising rates in the near future rather than signaling a firm pause as the Bank of Canada did when it made its last rate increase in January, and at a minimum, it will keep a bias toward raising rates.

Among the analysts surveyed, there appeared to be little benefit to the Fed if either firmly ruling out the possibility of an increase in June or teeing up the possibility. Each time the Fed has held its policy meeting since the beginning of last year, it has carried an element of promising rate increases at its next gathering using language that is sometimes called forward guidance in its statements.

“You don’t always need a lot of forward guidance when you’re dealing with a situation where everything isn’t so clear,” New York Fed President John Williams told reporters in a press conference on April 20.

There is also a need to fine-tune the language of the statement as officials do not want to prematurely ease financial conditions by igniting a rally in financial markets before the announcement is complete. 

In fact, bond investors are already anticipating that the Fed will cut rates at the end of this year. There has been a marked increase in the number of central bank officials who are signaling their expectation of keeping interest rates steady to further restrain economic activity.

"The single biggest mistake investors have made since October is to take anything that's good news and overreact to it," according to Vincent Reinhart, a chief economist at Dreyfus and Mellon. Market participants will take the Fed's communications to be "too dovish, run with that, and take it too far should those communications fail."

It is believed that Fed officials will refrain from indicating a rate increase in June, according to Mr. Reinhart, who advised Fed officials on managing the endgame to rate increases in 2006. "There is nothing more inciting [for markets] to rally than a promise of one more tightening that is not delivered," he explained.

The investors will parse every word of Mr. Powell's press conference on Wednesday for clues as to the meaning of the policy statement if it turns out to be anodyne. "It is a terrible position he is in because he is standing between investors and a significant dovish rally that will undermine any restraint implemented by policymakers," Mr. Reinhart said.

Adan Harris
Managing Editor
Eric Ng
John Liu
Editorial Board
Bryan Curtis
Adan Harris
Managing Editor
Cathy Hills
Associate Editor

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