Update 647 — A Record 4th 75 bp Hike:
(How) Will The Fed Know When to Stop?
For the fourth time since March, the Federal Reserve has raised interest rates by 75 basis points — the most rapid increase in decades. After an admittedly slow start, the Fed Chair Powell says with his policy “damn the torpedoes, full speed ahead,” promising pain even at the cost of recession in the fight on inflation.
Many progressive observers and some Fed officials have signaled they want to see a slowdown in rate hikes. Some say the Fed’s policy path has been largely ineffective at taming inflation; others argue that talk of taking the Fed’s foot off the breaks is premature. We beg to differ from the latter. A strong 2022 Q3 GDP report of 2.6 percent, a big gain from Q2 which showed negative growth, in the face of these rate hikes, suggests, however, the complexity of the challenge the Fed faces.
In today’s update we cover the latest Fed rate hike and what lies ahead as the Fed considers a change of course.
The Federal Open Market Committee (FOMC) concluded its two-day meeting this week with a fourth consecutive increase in the central bank’s interest rate, an expected hike. What is to come next? The closest Federal Reserve Chair Jay Powell came, in his press conference following the FOMC announcement, to offering forward guidance regarding the end of the current level and pace of rate hikes: “It may come at the next meeting or the one after that.”
Multiple letters from Democratic members of Congress, including from;
They have called for the Federal Reserve to slow down and or even halt its current program of interest rate hikes. However, the Fed put the squeeze on borrowing costs yet again in today’s FOMC meeting, even if opening the door for a slowdown in the next meeting.
Four Heavy Doses; Patient Holding Up
It came as no shock that the Federal Reserve raised rates by 75 basis points again for the fourth consecutive FOMC meeting. Markets had overwhelmingly predicted the 75 basis point rate hike following numerous signals from the Fed that they would be sticking to the course of robust rate hikes.
The aggressive policy path represents the fastest pace of rate hikes in the central bank’s modern history, only closely rivaled by the Volcker shock of the early 1980s. Market participants have priced in a peak in interest rates in spring 2023 with just a handful of smaller rate hikes left before the Fed decides to coast or cut rates. Whether this plays out remains to be seen, but there is little doubt that we will see another rate hike in December.
Current Rate Hike Cycle vs. Previous Cycles
Orange circle marks where we currently are
Source: Macrobond, ING
The central bank’s interest rate hike strategy demonstrates its effort to reinforce to markets, households, and businesses that it is serious about tackling inflation. But markets, households, and businesses have grown weary of high interest rate hikes as overall inflation has seemed to finally crest. The good news is that inflation expectations have not de-anchored, meaning that the Fed still has credibility. Inflation can be a self-fulfilling prophecy, and longer-run inflation expectations are lower than they were in the late 1970s, which will make the Fed’s job easier relative to the Volker era.
Question of Efficacy
While the Fed’s actions have sparked recession concerns throughout the year (fanned by two consecutive quarters of GDP declines), we seem poised to avoid a recession according to a handful of data points:
- GDP: Following a weak showing for economic growth in the first half of the year, advance estimates of GDP jumped to an annual rate of 2.6 percent in the third quarter, mostly buoyed by strong trading figures and robust consumer and government spending while suppressed by the housing sector.
- Consumer Spending: A key component of GDP, consumer spending remained robust over the third quarter clocking in at 1.4 percent. While below the previous quarter’s 2 percent growth, 1.4 percent is still a healthy level for consumer spending in the wake of interest rate hikes.
- Jobs: The labor market remains strong with a three-month average of 372,000 jobs gained per month and a jobs report this Friday expected to clock in at 195,000 jobs added. The job market has slowed but still remains robust given the Fed’s policy path.
- Wages: Wage growth has slowed but continues to remain strong, quelling fears of a wage-price spiral. Average hourly earnings grew by 1.1 percent in the third quarter and employment costs rose 1.2 percent over the third quarter.
The housing sector has seen private investment dry up as mortgage rates skyrocket given they are heavily tied to interest rates. Prices have been falling as homeowners have taken units off of the market and buyers are no longer willing to take on new mortgages at these rates. The fall in prices and demand has dissuaded builders from constructing new units, draining economic activity from what was one of the hottest sectors. This has helped avoid a bubble in the sector but caused other issues to arise.
The Fed’s actions have also strengthened the dollar on the international level. The stronger dollar has cheapened imports for American consumers but has made exports more expensive. That has added to the inflation woes of Europe as the continent faces a seismic inflation hurdle driven by energy prices. Just this week, Europe clocked a new inflation high of 10.7 percent year-over-year. The surging dollar coupled with energy-driven inflation is depressing European demand for U.S. goods which will slow down trade despite the robust trade balance numbers from the Q3 GDP report, harming the economic viability of many American exporters while making imports less expensive.
In spite of the aggressive rate hike policy, inflation has not significantly receded. The September Consumer Price Index (CPI) report came in hotter than desired at 0.4 percent month-over-month and 8.2 percent year-over-year. The last few months had signaled a slight cooling so the uptick added further proof the Fed’s actions have not yet broken the back of inflation.
But there are some signs inflation is finally starting to peak according to a couple of key indicators:
- Shipping Freight Costs: The World Container Index from Shanghai to Los Angeles, a barometer for global shipping costs, has fallen from its September 2021 peak of 12,424 to 2,497, a nearly 80 percent decrease.
- Gas Prices: Gas dropped from $5.02 per gallon in June 2022 to $3.77 per gallon with more downward pressure expected to cut prices even further.
It’s hard to see how the Fed’s policies are responsible for these price drops, but the Fed is more than willing to – and debatably should – claim victory here in order to grant itself room to ease off the rate hikes and maintain its inflation-fighting credibility, even if doing such is possibly an admission about the inefficacy of its policy path. Gas prices, which are highly visible to consumers, exert a major influence on inflation expectations, which the Fed closely monitors.
Finding the Gear Shift
The Federal Reserve deciding to open debate on easing the pace of its interest rate hikes is welcome from a policy perspective to avoid the housing or labor market from rippling out to the macroeconomy. By feathering the throttle, the central bank is tacitly acknowledging it has little confidence the rate hikes are having the desired effect on bringing inflation down.
The difficulty facing the Fed was not unpredictable. When this bout of inflation erupted from supply chain issues, we voiced caution about aggressive interest rate hikes as they are a demand-side intervention that could not repair supply chains. Federal Reserve Chair Powell even admitted earlier this year that interest rate hikes could not reduce energy prices – a key contributor to inflation. And now, with energy prices easing, the Fed is finally considering lifting off the pedal before it tips the economy overboard.
The Fed should err on the side of moving to a 50 basis point rate hike or lower as soon as warranted by economic data — not only on prices but on wages and jobs. Markets seem to be inclining that way too: the CME FedWatch Tool showed the odds of a 50 basis point interest rate hike in December growing dramatically after the FOMC meeting. The Fed could use its last FOMC meeting of the year next month to provide an early holiday present of pulling off the aggressive interest rate hike path it is currently on.