Federal reserve chairman Jerome Powell while speaking at a fed conference in Washington hinted that fed may pause hiking rates in next June meeting. If it happens it will be a pause in benchmark interest rates after 10 straight rate hike, fed started raising rates 14 month back to fight soaring inflation. This rate pause signaling cleared some air on the Fed’s likely next move after numerous statements by fed officials this week created dilemma about the situation.
Speaking at the event he said, “Having come this far, we can afford to look at the data and the evolving outlook and make careful assessments” he was referring to Fed’s 10 straight rate hike which have elevated its key short-term rate from near zero a year ago to about 5.1%, its highest level in 16 years. It is to be known that fed raised rate by another quarter point in it’s last policy meeting bringing rates to 5.1-5.25% range.
Markets were optimistic as in a statement after its last policy meeting, the Fed removed a sentence from its previous statement that had said “some additional” rate hikes might be needed. It replaced the word with language that said it will now weigh a range of factors in “determining the extent” to which future hikes might be needed.
Rate pause probabilities
Market was optimistic that fed will pause in next policy meeting taking cues from what chairman Powell suggested in May meeting press conference but strong job data and few cacophonic comments from fed officials created a sense of dilemma among investors. Later on Friday, while speaking in a Fed conference in Washington Powell said the central bank’s benchmark rate, which affects many consumer and business loans, is now high enough to restrain borrowing, spending and economic growth. Fed officials hope that slower growth will cool inflation over time, clearing air a bit.
As fed suggested they will be data dependent for further policy decisions let us have a look at important data released in past weeks, Retail spending rebounded in April after two months of declines, suggesting that consumers spends are still high despite cautious environment. Jobless claims declined more than expected for the week ended May 13, staying below historical averages.
Coming back to rate pause possibility, expectations of another hike was at a high on Thursday as traders were seeing 35% chance late Thursday but as Jerome Powell made these comments in an fed event on mid-morning Friday traders pared down their expectations to about a 20% chance that the central bank will raise rates next month, as of today suggests CME fed watch tool.
Factors that may effect Federal Reserve decision
Fed’s rate pause decision will be dependent on these events and how they unfold.
The Debt ceiling issue though both President Biden and congress leaders are willing to resolve the issue in time but talks are not making progress. Where congressional leaders want assurance that gov will reduce it’s spending and will not raise taxes President don’t want any strings attached in this deal and that making market nervous too. Fed must be keeping close watch on the situation as any delay or default may de-stabilize markets/economy. Last time when it happened in 2011 S&P500 fell more than 20% due to rating downgrade. This time reports are suggesting market can fall as much as 45% if default happens.
Rate hike impacts on economy, as Powell suggested recently that 10 straight rate hikes warrant assessing the evolving outlook and making careful decisions, fed should take time to assess the consequences of its actions and avoid tightening credit so much as to trigger a recession. The Fed’s interest rate hikes flow through the economy with a lag. So, it will take some months for the full effect of its aggressive tightening cycle to show up in the economy.
Financial conditions of regional banks are still not very stable, past week treasury secretary Jenet Yellen suggested that few more banks may need assistance or merger with larger banks in order to rescue them. Powell on Friday conference noted that turmoil in the banking sector, after three large banks collapsed in the past two months, will likely cause banks to reduce the pace of lending, which could weaken the economy.
“As a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals,” he said. “Of course, the extent of that is highly uncertain.” This suggests federal reserves will watch the situation closely before arriving at a decision.
To take more cue lets look at another fed officials comment, recently in an interview to a channel Minneapolis fed Neel Kashkari cautioned against reading to much from June rate pause, he is of view that rate pause in June doesn’t mean that fed is done with tightening cycle.
While speaking to a channel he said, “Right now it’s a close call either way, versus raising another time in June or skipping”, “Some of my colleagues have talked about skipping. Important to me is not signaling that we’re done. If we did, if we were to skip in June, that does not mean we’re done with our tightening cycle. It means to me we’re getting more information.”
Some key data points set to release before June meet are, the April Personal Consumption Expenditures price index (Fed’s preferred inflation metric), May jobs report, the May Consumer Price Index and May Producer Price Index.
If these data points show considerable weakening in the labor market or continued decline in inflation, that may help for a pause scenario, but signs of a robust economy with little to no signs of slowing down could mean the Fed has more room to tighten.
Will cuts follow rate pause later in the year?
Highly unlikely suggests experts, though a segment of market thinks fed will start cutting rate later in the year as inflation will come down fast going ahead. But experts suggest inflation is still above 2% federal reserve annual target. Inflation was 4.2% in March, compared with a year earlier, though it is down from 7% last June, it is a significant reduction but still fed is eager to bring inflation below 2% range.
Rate cut decision will also be data dependent, if economy slows down significantly due to decline in economic activity, further bank failures, default etc, fed will be forced to intervene but if economic activity continues as usual with a mild change and if labor market remains strong fed may keep the rates steady.
Large bank failures will force banks to reduce the pace of lending thus weakening the economy suggested Powell on Friday conference but not all Fed officials share Powell’s concern that the upheaval in banking will harm the economy. Some Fed officials have suggested that the failure of Silicon Valley Bank and two others might have little impact.
Raphael Bostic, president of the Federal Reserve Bank of Atlanta, and Austan Goolsbee, head of the Chicago Fed, said this week that they haven’t seen lenders in their districts pull back on lending just because of the bank failures.
“I don’t know that we have a crisis right now in financial markets,” Bostic said. “We have a small number of institutions that had risk management strategies that work less well than you would like.”
Goolsbee, who spoke on a panel with Bostic, said that banks in his region have tightened credit because of the Fed’s rate hikes and not necessarily because of the bank failures, but they haven’t gone further because of the bank failures.
Scenario of rate pause vs rate cuts
Markets are resilient this year after brutal 2022 in the hope that fed will conclude its aggressive tightening program soon but few are optimistic enough that apart from rate pause fed will cut rates later this year. Until inflation is sticky economy is hot, unemployment rate at lowest level, housing market is still resilient as low inventory and high demand are still keeping price turbulent, fed won’t cut rates in haste and it’s good for US economy as they will lose more credibility if things go southward.
Even if the Fed were to cut rates down soon, an immediate bull run isn’t happening suggests historical data. Data shows that stocks tend to perform tepidly following a rate pause, pivot to cuts compared to only pause, The S&P 500 has historically climbed 16.9% on average in the 12 months following the last hike of a Fed rate cycle and fallen 1% in the 12 months after the central bank first cut rates, suggests Credit Suisse which released a note on May 9.
“Assuming that the May 3 rate increase was the last of this cycle, stocks should perform quite well through the remainder of the year. However, if the Fed were to ease later in the year the upside would be far more limited,” the analysts suggested going by the historical data.
Premature rate cuts can have adverse consequences, between 1972 and 1974, then Federal reserve Chair Arthur Burns hiked interest rates dramatically. Then, he cut them back down to save the drowning economy and when inflation later ripped higher again the Paul Volcker led Fed took drastic action to push interest rates up again to control it bringing effective Fed funds rates to 22% at its peak in July 1981. This aggressive rate hike behavior by federal reserve was responsible for back to back recession and historic 10% unemployment rate.
Acknowledging this misstep by then fed, Jerome Powell in last year’s august said they won’t cut rates until there are enough data to strongly suggest that inflation is in given 2% range.
So going for a pause and then waiting to see the effects of past hikes is more prudent option for fed and the same is better for markets too because works done in hurry often bring bad outcomes.
