Fed decides to raise rates again as inflation continues. Now what?
Susan Tompor, Detroit Free Press
9 min read
A year after the first rate hike and 12 days after big bank failures hit the headlines, the Federal Reserve on Wednesday raised short-term interest rates once again.
Those who want to borrow to buy a car or get a business loan are looking at double-fisted trouble — higher interest rates and, very likely, much tighter credit availability. You'll pay more for a loan and you could have a harder time getting one. Great.
The quarter-point hike in March now puts the target for the short-term, federal funds rate at a range of 4.75% to 5%.
The banking turmoil — actually fueled inadvertently in part by the Fed's aggressive push toward higher rates to cool inflation — only makes matters more complicated for the Fed, consumers and the economy. It clearly gives many reason to pause, if not the Fed.
The Fed gave a nod to financial fears in its statement: "The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain."
The Fed said the central bank "remains highly attentive to inflation risks."
Inflation is ongoing
When will inflation drop from 6% or slightly higher? Consumers who have been handing over more money to cover higher prices for food, rent and other goods clearly could use some relief. But even after a year of Fed rate hikes, apparently, the Fed needed to do more.
Inflation peaked year-over-year at 9.1% last June — the largest increase in 40 years. It has since fallen to an annual rate of 6% in February, based on the latest data. We saw a 6.4% bump in January.
A Federal Reserve Office Building is pictured on March 21, 2023 in Washington, D.C. The Federal Open Market Committee met Tuesday and Wednesday to decide on a possible interest rate hike in the middle of ongoing banking turmoil after the of failures of Silicon Valley Bank, Signature Bank and Silvergate.
The Fed's still far from its goal of a 2% inflation target to maintain stable prices.
"The Fed would have preferred to cool off the economy without causing a banking crisis, but monetary policy is a blunt tool, and the Fed can't always choose how higher rates will get traction," said Gabriel Ehrlich, director of the University of Michigan's Research Seminar in Quantitative Economics.
Yet, he said, the trouble spots in the banking system show that the Fed's efforts to raise rates and tighten monetary policy are starting to affect the real economy.
The U-M forecasting team continues to expect a mild recession later this year or early next year. Inflation can be expected to fall slowly, Ehrlich said, toward the Fed's 2% target but remain above that level through next year.
The banking turmoil is likely to trigger what Ehrlich dubs a "contractionary credit impulse," leading to reduced lending to businesses and consumers.
While that will help cool inflation and the economy, it isn't exactly the road the Fed or anyone else would want to take to get there.
Consumers seeing higher rates since March 2022
Wednesday's action represents the ninth rate hike since the Federal Reserve started raising rates on March 16, 2022, to drive up the cost of borrowing and cool down spending to address the worst inflation that consumers experienced in decades.
Fed Chair Jerome Powell indicated Wednesday in a news media briefing that the Fed would raise rates higher in the future, if needed. But he tempered those comments by indicating that tighter credit conditions could dampen growth, too, similar to what you'd see from a boost in rates. He noted that the effort to cool inflation doesn't have to all come from rate hikes; some pullback in inflation could come from tighter credit conditions.
Powell noted that the Fed is now anticipating tight credit conditions, following the fast run on Silicon Valley Bank and the sudden turmoil. "The question we were all (were) asking ourselves over that first weekend was 'How did this happen?' " Powell said. He noted that problems at the banks that failed were outliers in the industry.
The Fed's short-term rate hikes influence many interest rates people pay when they take out loans.
Some interest rates — including notably mortgage and car loan rates — aren't tied directly to the short-term federal funds rate that the Fed sets but the Fed action can have an impact nonetheless.
Traders work on the floor of the New York Stock Exchange during morning trading on March 22, 2023, in New York City. Stocks opened slightly low ahead of Federal Reserve Chair Jerome Powell’s next decision on whether to continue increasing interest rates to tame inflation after the conclusion of the Federal Reserve’s two-day policy meeting.
In the past year, the five-year new car loan rate jumped to an average 6.49% as of data released Wednesday, up from 4% a year ago, according to Bankrate.com. Those with lower credit scores pay much more.
Car shoppers have seen a significant jump in rates in the past year. In a year, Edmunds analysts noted, the average interest rate for used vehicle loans went from 7.8% in February 2022 to 11.3% in February.
Credit card rates — which are influenced more directly by Fed action — on average hit 20.05% based on the latest data released Wednesday, up from an average 16.34% a year ago, according to Bankrate.com.
Banking crisis concerning
A week ago, many wondered whether the Fed would need to calm Wall Street by taking another rate hike off the table after the March 10 collapse of Sillicon Valley Bank put a glaring spotlight on ongoing weaknesses in parts of the banking system.
Higher interest rates, after all, put more pressure on banks that face a mismatch of the assets and liabilities on their balance sheets. Key assets, such as long-term U.S. Treasuries and mortgage-backed securities, make up a sizable part of the balance sheets at many banks and lost value as interest rates skyrocketed in the past year. Driving rates even higher further erodes balance sheets, which has been an issue for troubled banks.
A pedestrian walks past the Federal Reserve Headquarters on March 21, 2023, in Washington, D.C. The Federal Open Market Committee met Tuesday and Wednesday to decide on a possible interest rate hike in the middle of ongoing banking turmoil.
"The Federal Reserve is in a tight spot," said Steven Miller, director for the Center for Economic Analysis at MSU.
The instability in the banking sector, he said, gave the Fed some reason to consider pausing in March. But ongoing inflation remains a significant economic risk.
By once again raising rates, Miller said, the Fed appears to be taking the stance that the banking sector upheaval will be contained. If rates remained unchanged, he said, the Fed would have signaled a high degree of concern for the banking sector.
Wednesday's rate hike also sends a message that the Fed isn't giving up easily on the inflation fight.
"This is a long-run gambit that the Fed is undertaking," Miller said. "Controlling inflation requires a very deliberate and visible commitment to controlling prices."
To successfully fight inflation, the Federal Reserve must offer a consistent message that it is serious about reducing inflation.
Consumers and business leaders must be convinced that inflation is going to cool down. A year of inflation, though, has many expecting that prices will continue to increase steadily.
"This expectation," Miller said, "generates inertia for future price increases as workers demand wage hikes to keep pace with inflation."
In addition, he said, business owners set future prices on the assumption that their costs will continue to rise.
"The Federal Reserve must temper these expectations if they are to reduce the long-term trend of inflation," Miller said.
Anne Nichols, managing director for Fern Capital in Dearborn Heights, said the Fed should have paused, given the uncertainty surrounding some banks.
The Fed, she said, should offer strong language on what it will do in case inflation continues to surge.
The "bank failures are showing the ‘breaks’ in the system that can happen when the Fed tightens quickly," Nichols said.
The economy, Nichols said, is starting to slow as tech company layoffs spread to other areas. "February saw a decline in housing prices," she added. "The market may be doing some of the Fed’s work to slow the economy and prices."
Following Silicon Valley Bank's failure, we saw the March 12 failure of New York-based Signature Bank. The FDIC sold most of the bank to Flagstar Bank, now a subsidiary of New York Community Bank. The 40 branches of Signature Bank became Flagstar Bank branches Monday.
The two bank failures on the FDIC list are the first failures since October 2020. Silicon Valley Bank's failure is the second largest in U.S. history after Washington Mutual's woes in September 2008. Signature Bank is the third largest bank failure in U.S. history.
David Sowerby, managing director and portfolio manager for Ancora Advisors in Bloomfield Hills, said the Fed had good reason to stick to its low inflation objectives and raise rates Wednesday.
"The Federal Reserve created the inflation problem with excessive money growth, and they are the ones who will need to remedy it," Sowerby said.
He said the Fed's remedy includes restrictive money growth, higher interest rates and eventually slow economic growth, even the likelihood of a recession.
Inflation, Sowerby said, should get more under control in the months ahead. The data shows a slowdown in money supply growth, he said, and indicates that the inflation of 3% could be reached by the end of 2023 or early 2024.
Inflation, he said, was fueled by rapid growth in the money supply from the Federal Reserve and too much fiscal stimulus spending in 2021 and 2022.
A measure of money supply — including cash, personal savings and market accounts that consumers easily can access — grew rapidly during the pandemic as the Federal Reserve focused on policies to shore up the economy and Washington rolled out government stimulus programs. But the Fed's aggressive push to tighten monetary conditions in the past year has caused a slowdown in money supply growth to drive down inflation.
A group of economic indicators suggest that a bumpy road is ahead for the economy, Sowerby said, putting the odds at better than a 50% chance of recession in next 12 months.
MSU's Miller said history shows it requires a recession to disrupt inflation.
"In the 1980s, the Federal Reserve orchestrated a severe recession to do just that," Miller said.
Now, he said, "a light recession and the banking sector instability may slow the growth of prices, but consumers and producers have to be convinced that inflation has ended for inflation to end. See the Catch-22?"
