One year after the first rate hike, the Fed stands at policy crossroads

The Federal Reserve has a year down the rate-hiking path, and in some ways it is both closer and further away from the goal when it first set sail.

Exactly one year ago, on March 16, 2022, the Federal Open Market Committee made the first of eight interest rate hikes. The goal: to arrest a stubborn wave of inflation that central bank officials have spent the better part of a year dismissing as “transitory.”

In that year, inflation as measured by the consumer price index has decreased somewhat, from an annual rate of 8.5% then to 6% now and the trend is lower. While that’s progress, it still leaves the Fed less than its 2% goal.

And it raises questions about what to do and what the consequences will be as policymakers continue to grapple with the ever-increasing cost of living and the looming banking crisis.

“The Fed will admit that they are late to the game, that inflation is more persistent than expected. So, it should be faster,” said Gus Faucher, chief economist at PNC Financial Services Group. “That being said, given the fact that the Fed has tightened as aggressively as it has, the economy is still doing very well.”

There is an argument for that point in terms of growth. While 2022 was a bad year for the US economy, 2023 is off to a solid start, to say the least, with a strong labor market. But recent days have shown that the Fed has other problems on its hands besides inflation.

All the tightening of monetary policy – 4.5 percentage points in rate increases, and the roll-off of the quantitative tightening balance of $ 573 billion – has been tied to the significant dislocation that is currently in the banking industry, especially those that attack small institutions.

If the contagion does not stop, the banking problem could overshadow the inflationary war.

“Things are now just beginning to be written” about the consequences of last year’s policy moves, said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “There’s a lot of collateral damage when you not only raise rates after a long time at zero, but the speed at which you do that creates a bull in the china shop.”

“This bull can skate, not beat anything, so far,” he said. “But now it’s starting to break things.”

Rising rates have hurt banks that hold safe products such as Treasurys, mortgage-backed securities and municipal bonds.

Because prices fall when rates rise, Fed 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 huge losses, triggering a crisis of confidence that has now spread elsewhere.

That leaves the Fed and Chairman Jerome Powell with a critical 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 raise rates until satisfactory inflation drops to an acceptable level, or is it pulling back to assess current financial conditions before moving forward?

“If you wait for inflation to return to 2% and that causes you to raise rates, you’re making a mistake,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “If you are at the Fed, you want to buy optionality. The easiest way to buy optionality is to rest next week, stop QT and just wait and see how it plays out.”

Market prices have been whipsawed violently in recent days on what to expect from the Fed.

As of Thursday evening, traders have returned to expecting a 0.25 percentage point rate hike, with an 80.5% chance of a move that would take the federal funds rate to a range of 4.75%-5%, according to CME Group data.

With the banking industry in turmoil, LaVorgna thinks it will be a bad idea when confidence is on the wane.

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

“They’re justifying one policy with another,” said LaVorgna, who served as the National Economic Council’s chief economist under former President Donald Trump. “I don’t know if it’s politics, but they’re going from one extreme to the other, nothing good. I wish the Fed had a more honest assessment of what went wrong. But you usually don’t know. from the government.”

Indeed, there will be much to chew on as analysts and historians look back on the history of recent monetary policy.

Warning signals about inflation starting in the spring of 2021, but the Fed still believes that the rise is “transitory” until it is forced to act. Since July 2022, the yield curve has also sent a signal, warning of a slowdown in growth as short-term yields exceed longer durations, a situation that also poses acute problems for banks.

However, if regulators can address current liquidity problems and the economy can avoid a sharp recession this year, the Fed’s mistakes will only cause minimal damage.

“With the experience of the past year, there are legitimate criticisms of Powell and the Fed,” PNC’s Faucher said. “Overall, they have responded appropriately, and the economy is in a good place considering where we are now in 2020.”