by Jeffery S. Bredthauer, University of Nebraska Omaha; Arabinda Basistha, West Virginia University; Joerg Bibow, Skidmore College, and Marketa Wolfe, Skidmore College, [This article first appeared in The Conversation, republished with permission]
The Federal Reserve raised interest rates by a quarter-point on March 22, 2023, bowing to market expectations that it would temper its aggressive program of rate hikes amid a still-brewing banking crisis.
The U.S. central bank lifted rates to a range of 4.75% to 5%, its ninth-straight increase since March 2022. As late as early March 2023, it appeared that the Fed was planning to resume last year’s full-throttle rate-hiking campaign after slowing down in February. But the collapse of Silicon Valley Bank on March 10 forced the central bank to take a step back.
So what does the Fed’s announcement tell us about where monetary policymakers think the economy – and inflation – are heading? A team of economists and finance scholars have weighed in to help make sense of it all.
Rate hike shows Fed confident in banking sector
Jeffery S. Bredthauer, University of Nebraska Omaha
This muted rate hike signals that the Fed is being cautious in order to steady the financial sector, which has been struggling since the collapse of Silicon Valley Bank on March 10, 2023. But the fact that the Fed raised rates at all acknowledges that the fight against inflation will need to continue.
While still an increase, it’s more of a pause, in my view, because until the recent banking turmoil, the central bank was expected to lift rates by a half-point. Inflation has remained stubbornly elevated even though the Fed had jacked up rates 4.5 percentage points before the latest hike, and Chair Jerome Powell made it clear in congressional testimony that he was intent on subduing the rise in prices.
But the aggressive rate rises left some regional banks like Silicon Valley Bank vulnerable because they drove down the value of tens of billions in assets they held. Silicon Valley failed because it didn’t have enough assets to meet withdrawals.
While the Fed and other regulators have acted to shore up the system by backstopping depositors and smaller financial institutions, the concern now is that there may be more banks in a similar predicament. The smaller rate hike should help ease some of these concerns.
Yet, the inflation battle must go on, and the Fed recognizes that strong demand continues to prop up consumer prices, particularly in the service sector. As such, I believe the Fed news shows that it has confidence in the banking system by continuing its interest rate hikes, albeit at a slower pace than had previously been expected.
And this is important. The greatest fear would be that spooked customers might irrationally start withdrawing money from banks because they fear a financial collapse – the classic bank run. That will not happen as long as there is faith in the banking system.
Drop in inflation gave Fed breathing room to ‘pause’
Joerg Bibow and Marketa Wolfe, Skidmore College
The Fed had two courses of action available when it came to setting rates. The first would have seen it continue aggressively raising rates, ignoring financial stability concerns – perhaps even seeing the hiking campaign as a sort of bloodletting that would squeeze inflation out of the economy. The second way forward would be to take a beat and see how the ongoing fragility in the banking sector plays out first.
Fortunately – in our view – the Fed did not choose the former.
While falling short of a total pause in raising interest rates – an option some market watchers had been calling for – the latest hike represents a substantial slowdown from the Fed’s previous plans, and therefore demonstrates the Fed’s caution in the face of a nascent banking situation.
It was able to do this in large part because there are clear signs inflation has come down.
As measured by the Personal Consumption Expenditure Price Index – the Fed’s preferred measure – inflation has declined from a 40-year high of 7% in June 2022 to 5.4% in January 2023.
And the main cause of the recent surge in inflation – COVID-19 supply chain disruptions – has eased. In addition, an upward wage-price spiral has not developed.
Furthermore, the banking turmoil might have already delivered an equivalent of another interest rate hike in terms of its impact on the economy.
Although inflation remains high by historical standards, the risk it will reaccelerate seems low. Altogether, this allowed the Fed to take a breath and deal with what’s going on in the banking sector.
Put another way, the Fed decided, with so much uncertainty about the impact the recent turmoil will have on the economy, the risk of causing more damage was greater than the risk of inflation.
Interest rates may peak soon
Arabinda Basistha, West Virginia University
A big question on Fed watchers’ minds has been when will the central bank stop raising rates or when will it settle on a “terminal” rate – that is, the level that monetary policymakers believe will ensure prices are stable.
That point may be just around the corner.
In September 2022, Powell said the Fed was trying to get to “a place where real rates are positive across the yield curve.”
Real interest rates are a measure of the real, inflation-adjusted cost of borrowing, which is calculated by subtracting expected inflation rates from nominal interest rates. A yield curve shows yields for bonds of different maturities.
Back in September, part of the yield curve was negative, meaning annual inflation was higher than the interest rates. Today, more of the curve has turned positive, which means the Fed is closer to Powell’s goal.
Moreover, Powell switched from declaring that “ongoing” rate rate hikes “will” be needed to the softer “some additional” increases “may be appropriate,” which suggests it sees the light at the end of the interest rate tunnel. Powell also acknowledged that the banking sector stress can work in a way similar to an interest rate hike by reducing inflationary pressures via lower business activity.
Overall, it seems that the Fed is much closer to its policy destination with one or two moderate interest rates increases left in this year, if inflation risks evolve according to expectations. I see a pause in interest rates as early as fall when they settle at a terminal rate of around 5.5%.
Jeffery S. Bredthauer, Associate Professor Of Finance, Banking and Real Estate, University of Nebraska Omaha; Arabinda Basistha, Associate Professor of Economics, West Virginia University; Joerg Bibow, Professor of Economics, Skidmore College, and Marketa Wolfe, Associate Professor of Economics, Skidmore College
This article is republished from The Conversation under a Creative Commons license. Read the original article.