A year after the first rate hike, the Fed is at a crossroads

The Federal Reserve is a year behind its rate hike path and in some ways it is both closer and further from its targets when it first set sail.

Exactly one year ago, on March 16, 2022, the Federal Open Market Committee enacted the first of what would be eight interest rate increases. The goal: stem a stubborn wave of inflation that central bank officials have spent most of the year calling “transient”.

Over the following year, inflation as measured by the consumer price index declined somewhat, from an annual rate of 8.5% then to 6% today. today and trending downward. While this is progress, it still leaves the Fed well below its 2% target.

And it raises questions about what lies ahead and its ramifications as policymakers continue to grapple with a persistently high cost of living and a shocking banking crisis.

“The Fed will recognize that it was late in the game, that inflation has been more persistent than it had expected, so it probably should have tightened earlier,” said Gus Faucher, chief economist. at PNC Financial Services Group. “That being said, considering the Fed has tightened as aggressively as it has, the economy is still very good.”

There is an argument for this point about growth. While 2022 was a lackluster year for the U.S. economy, 2023 starts, at least, on solid footing with a strong labor market. But the past few days have shown that the Fed has another problem besides inflation.

All of this monetary policy tightening – 4.5 percentage points of rate hikes and $573 billion in quantitative tightening – has been linked to significant turmoil currently impacting the banking sector, especially smaller institutions. .

Unless the contagion is quickly checked, the banking question could eclipse the fight against inflation.

“The chapters are only beginning to be written” on the ramifications of last year’s policy changes, said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “There’s a lot of collateral damage when you don’t just raise rates after a long period at zero, but the speed at which you do it creates a bull in a china shop.”

“The bull was able to skate, without knocking anything over, until recently,” he added. “But now it’s starting to turn things around.”

Rising rates hammered banks holding otherwise safe products like Treasuries, mortgage-backed securities and municipal bonds.

Since prices fall when rates rise, Fed hikes have reduced the market value of these fixed income securities. In the case of Silicon Valley Bank, it was forced to sell billions in stakes at a substantial loss, contributing to a crisis of confidence that has now spread elsewhere.

That leaves the Fed and Chairman Jerome Powell with a crucial decision to make in six days, when the rate-setting FOMC releases its post-meeting statement. Is the Fed following through on its oft-stated intention to keep raising rates until it is satisfied that inflation is back to acceptable levels, or is it taking a step back to assess the current financial situation? before moving forward?

“If you’re waiting for inflation to come back to 2% and that’s what caused you to raise rates, you’re making a mistake,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “If you’re at the Fed, you want to buy options. The easiest way to buy options is to take a break next week, stop QT, and wait to see how things go.”

Market prices have swirled wildly in recent days on what to expect from the Fed.

On Thursday afternoon, traders were again expecting a rate hike of 0.25 percentage points, pricing an 80.5% chance of a move that would take the fed funds rate to a range of 4, 75% to 5%, according to data from the CME group.

With the banking industry tumult, LaVorgna thinks that would be a bad idea at a time when confidence is waning.

Since the rate hikes began, depositors have withdrawn $464 billion from banks, according to Fed data. This is a decline of 2.6% after a massive increase at the start of the Covid pandemic, but could accelerate as the strength of community banks is called into question.

“They corrected one policy mistake with another,” said LaVorgna, who served as chief economist for 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, which is not good. I wish the Fed had a more honest assessment of what they got themselves. deceived. But you usually don’t understand that. from the government.”

Indeed, there will be food for thought when analysts and historians look at the recent history of monetary policy.

Inflation warning signals began in the spring of 2021, but the Fed remained convinced that the increase was “transitional” until it was forced to act. Since July 2022, the yield curve has also been sending signals, warning of slowing growth, with short-term yields outpacing the longer duration, a situation that has also caused serious problems for banks.

Still, if regulators can resolve the current liquidity issues and the economy can avoid a deep recession this year, the Fed’s missteps will have done minimal damage.

“With the experience of the past year, there are legitimate criticisms from Powell and the Fed,” PNC’s Faucher said. “Overall, they reacted appropriately, and the economy is in a good position given the current situation in 2020.”