Will the Fed save the economy or make things worse?

The Fed raised interest rates by 0.25% to a new Fed funds target of 5.25% last week. The market agrees that the Fed has kept its options open and another 0.25% rate hike on June 14 is a possibility. The dual realities of tight money and a severe recession are real.

It is important to look at the Fed’s reasoning behind its moves and what impact that has on future Fed decisions and the economy.

The rate hike of 0.25% was close to market expectations but there was a lot in Fed chief Powell’s comments that suggested the Fed is not done with rate hikes. As of now, we expect at least one more rate hike of 0.25% on June 14. Powell made a number of comments to confirm that another rate hike is on the table because he mentioned that the Fed is strongly committed to their 2% target on inflation. He added that the labour market remains very tight and that labour demand is substantially in excess of labour supply. Powell even noted that unemployment is lower than when the Fed started their rate hikes in March 2022. Powell believes that low unemployment is correlated with higher inflation. Powell explicitly confirmed that the Fed was not on pause and future decisions would depend on future data.

Powell made it clear that the 2% inflation goal is the ultimate target and the only endgame of this rate hiking process. As Powell also remarked that inflation has been up and down in recent months and that it would take 3 months of data or more before the Fed could be satisfied that a terminal rate had been reached, a terminal rate and pause would be pushed past the July 26 FOMC meeting.

The Fed is trying to walk the thin line between an ongoing banking crisis and looming recession on the one hand, and continuing inflation on the other. The banking crisis and recession argue for a pause. The continuing inflation argues for more rate hikes. We do not seem to have hit the elusive terminal rate yet. But more Fed tightening will actually cause a recession.

The banking crisis will continue with or without rate cuts. The recession will get worse with or without rate hikes. It seems that the Fed might not be able to save the day and can only make it worse, as they do not lead the markets, they actually follow them. We have already seen the consequences of this kind of action when the Fed ignored the signs of inflation and lagged here. Even stronger moves are needed with tougher consequences piled on the people, to get things on course again.

Sven Franssen