Can slower growth tame inflation? The Fed’s pause signals a necessary balance

The Federal Reserve’s May 3 meeting could be remembered as a turning point. The Fed raised its interest rate target for the 10th consecutive meeting, this time by 0.25% to 5.25%. However, Fed Chair Jerome Powell signaled that it would likely pause rate hikes after this meeting. 

Does this mean the Fed is done hiking for the rest of this year? And could their next move be a rate cut? 

Here are our thoughts on what comes next. 

The Fed is probably done hiking

The Fed always intended to pause rate hikes before inflation reached its 2% target. This is because rate hikes work their way into the economy over time. If the Fed hikes rates today, it will probably take about six months before the impact is fully felt in the real economy. 

It’s kind of like raising the thermostat in your house. The house doesn’t get warmer instantly because you bumped up the heat - it takes a while. And if you continuously turned the temperature up until it felt warm in the house, you’d invariably raise it too much.

Source: Federal Reserve

This pause in rate hikes does not mean the Fed is satisfied with the current level of inflation. Indeed, during Powell’s post-meeting press conference, he was careful not to say that the Fed was done hiking rates saying that “we are prepared to do more” if inflation does not continue falling.” In other words, inflation remains too high. While the Fed thinks there has been enough economic slowing to quell inflation, they won’t hesitate to revive rate hikes if necessary.

That said, it would be surprising if the Fed had to hike again. A wide variety of indicators suggest the economy is slowing, at least to some extent. For example, just this week, the Institute of Supply Management survey suggested that the manufacturing segment of the economy is in outright contraction. 

The most recent employment report showed the slowest job gains in over two years. Job openings have also fallen substantially. According to the Labor Department, job openings have declined almost 15% in the last three months and over 20% over the previous year. Meanwhile, the rate of layoffs remains relatively low but is increasing substantially. Layoffs are up 20% this year and at the highest level since December 2020.

Source: Bureau of Labor Statistics

Powell has said in prior press conferences that he believed a period of slower growth and some cooling of the jobs market was necessary to bring down inflation. While he said that the “labor market remains tight,” Powell also said that there are “some signs” that labor is heading to a “better balance.” Now that those things appear to be happening, the Fed can be more comfortable pausing rate hikes. 

Stress in the banking system complicates the outlook

It’s a tricky time for the Fed. Their March meeting occurred in the immediate aftermath of Silicon Valley Bank’s collapse. This meeting is coming on the heels of First Republic suffering a similar fate. Other banks are under varying degrees of stress, too. Eight other banks within the S&P 500 have seen their share price fall at least 30% so far this year.

We think banks will focus on getting safer in the wake of the recent bank failures and pressure on stock prices. This likely means that they will be cutting back the pace of lending, which has significant economic consequences. It will crimp businesses’ ability to fund expanding activity and hiring. In part, this is how monetary policy is supposed to work. By slowing bank lending, the Fed should get the downward inflationary pressure it desires.

However, the specific way it is happening carries some risks. Because of the acute banking stress we’ve seen recently, banks may be curtailing lending much more quickly than in a normal cycle. If so, it will be difficult for the Fed to see just how much slowing is occurring by looking at typical economic indicators.

Powell acknowledged this risk: “Credit conditions had already been tightening, but that has been exacerbated by the March banking turmoil. This will likely have an impact on the economy.” This does beg the question of why the Fed went ahead and hiked this meeting. 

All of the arguments for pausing after this meeting would also be valid opinions for pausing right now. When asked about this during the press conference, Powell’s answer seemed to suggest the Fed wanted to follow through with its past guidance of hiking to around 5.25%.

Although there were no formal dissents to today’s rate hike decision, we’d bet there was plenty of debate within the Fed. While it is true that in recent months Fed officials had talked about 5.25% being a possible end point several times, that was before we had two major banks fail. It is notable, if not surprising that the Fed doesn’t consider these events enough to change course from their prior guidance. If nothing else, this proves how committed the Fed is to fighting inflation.

Is the Fed’s next move a rate cut?

Before today’s meeting, futures markets suggested that the Fed could cut rates as soon as September. When asked about this, Powell expressed skepticism. 

“We on the committee have a view that inflation is going to come down no so quickly… if that is right it would not be appropriate to cut rates.”

Source: CME as of 5:30 am ET May 3, 2023

Powell had emphasized that one of the Fed’s big mistakes in the 1970s was cutting rates prematurely before the “job was done” in reducing inflation. For this reason, Powell does not want markets to think the Fed will flinch at the first sign of economic weakness. 

That said, if the economy does keep slowing, so will inflation. We know that weakness in home prices and apartment rental rates has yet to carry through into inflation figures. When this starts happening, measured inflation could fall materially. Once this happens, the Fed will shift its focus to economic growth. We don’t know how quickly the Fed might consider rate cuts since that depends on how fast the economy and inflation are falling. There are too many variables there to make any kind of prediction.

However, we would say that it is very likely that the Fed has hiked for the last time this cycle, and therefore their next move is probably a rate cut. This was the reasoning behind our recent change in our tax-deferred bond portfolios: we bought ETFs that increased our exposure to bonds maturing between three and seven years. Historically this has been the best-performing segment of the bond market while the Fed is cutting. So, while the timing of rate cuts is uncertain, we feel the risk-reward is very favorable.