The Federal Reserve delivered another 25-basis-point interest rate hike last week.
It was the tenth hike over the last 14 months. One of the most rapid interest-rate hiking cycles in modern history… In just over a year, the Fed increased interest rates from nearly zero to the 5.00%–5.25% range.
And while the Fed’s policy remains restrictive to combat inflation, the latest report delivered softer language, which the market interpreted as proof that there will be no more hikes this year.
Whether the market is right or not, a lot of investors are now anticipating interest rate cuts. But it may be too early for that…
In his remarks, Jay Powell admitted that inflation is still a problem and it’s not the best time for loosening monetary conditions.
At the same time, the CME Group FedWatch Tool, which tracks the probability of the Fed’s rate moves, outlined at least two rate cuts for this year.
There is clearly a contradiction in expectations between investors and the Fed.
Investors should not be complacent. It’s true that the Fed has done enough during the current hiking cycle… but it’s dangerous to assume that it’s “done.”
Investors should keep in mind that between interest rate hikes and cuts, the Fed has a third option: do nothing. In other words, it can keep rates unchanged until inflation slows down.
These are the top indicators worth watching to understand the current economic conditions:
- Inflation. Annual US inflation slowed down to 5% in March, down from 6% recorded in February. Yet it’s still way over the Fed 2% target. A meaningful reduction to about 3% may be a good signal for the Fed. For the full year 2023, inflation is now expected to drop to 4.5% from 8% recorded in 2022. The market expects it to drop to 2.3% next year.
- Unemployment rate. So far, this indicator has shown the resilience of the US economy. In March, the unemployment rate was 3.5%. It’s a strong reading. However, unemployment is often a lagging indicator which usually increases during the recession (or after). For instance, during the Great Financial Crisis of 2008, it only started to increase during the crisis and reached its peak of 10% in late 2009.
- Volatility in the banking sector. As we wrote recently, banks suffer the most from the rapidly rising interest rates. Year-to-date, three collapsed banks (Signature Bank, Silicon Valley Bank, and First Republic) sent the US banking system into a tailspin. Wall Street Journal estimated these three banks caused a $532 billion loss in total assets. Adjusted for inflation, this is the same amount of capital banks lost during 2008.
Both investors and the Fed are watching these three. If inflation slows down (and gets closer to 2%), the labor market doesn’t heat up further, and the banking sector continues showing strain in the face of high interest rates, the Fed may cut.
If some of these indicators are off, or a black swan event occurs (such as an unexpected acceleration of consumer prices), the Fed won’t likely cut rates in the near term.
The next Fed meeting is scheduled for June 13th-14th, and it will provide more clarity on the central bank policy for the remainder of the year.
Thank you for your loyal readership,
The Financial Star team