After a litany of rate hikes in 2022—four by as high as 0.75%—the Federal Open Market Committee (FOMC) announced on Feb. 1 that it is raising the Federal Funds rate yet again—but this time by a milder 0.25%.
These increases—which also raise the cost of borrowing for consumers and businesses—are part of the Federal Reserve's continued efforts to combat inflation.
And the latest figures show that this tactic is generally working: relative to a year earlier, the Fed's preferred inflation measure was up 5% in December. That's still above the Fed's 2% target but lower than the figure's 7% peak in June 2022.
However, for Americans dealing with higher interest rates on credit cards and other variable rate loans alongside persistently elevated prices of some foods and services, the latest rate change announcement may leave them wondering how many more hikes are expected this year—and the chances of a recession.
BOK Financial® Chief Investment Officer Brian Henderson answers these questions and more:
What are some signs that the Fed can slow the pace of its rate increases without risking inflation rising again?
Henderson: First, we have to consider why the Fed has raised rates so rapidly since March 2022. Up until that point, the Fed had been keeping rates low during the pandemic to stimulate the economy. But when the Fed saw inflation rising and getting away from them, they had to hurry up and get rates from extremely low and accommodative to at least neutral, which meant raising them in big increments. Additionally, the Fed has been letting its balance sheet roll off—in what's known as quantitative tightening—so they did a lot in a relatively short period of time.
Now interest rates are closer to neutral and debatably even slightly restrictive, which would mean that rates are holding back the economy. Meanwhile, inflation has been on a clear downward path and, more significantly, expectations of future inflation are consistent with the Fed's goal of 2%. I think the Fed has to be pleased with the trends that they are seeing. However, they also recognize that current inflation levels are way too high, so they know they can't cut rates anytime soon.
How many more rate change announcements are financial markets expecting?
Henderson: In addition to this February announcement, markets are expecting one more rate change announcement, while the Fed itself seems to be anticipating two more. The surprising thing is that the bond market has priced in two rate cuts for the fourth quarter of this year and another 150 basis points (1.5%) in cuts in 2024. The bond market is anticipating these cuts for two reasons: (1) the belief that inflation will drop to 2% by the end of this year, and (2) recession concerns.
Historically speaking, it's not uncommon for the Fed to have to reverse course and start cutting rates six months after its last rate hike. However, some experts doubt that inflation will get to 2% so quickly because the U.S. labor market is so tight and geopolitical issues are keeping energy prices high.
How concerning is it to the Fed that, although headline inflation is dropping, some goods and services prices continue to rise?
Henderson: The Fed is most concerned about the services side of the economy. Rent is a large part of that. But the good news is that, although existing tenants are facing "catch-up" rent hikes, the rate of price increases is slowing for new tenants coming into homes. However, outside of rent, the prices of services such as medical, transportation, restaurants and travel are still too high because labor is in such short supply.
Are there any signs that the labor market is cooling and that wages will come down, which would lower the cost of services?
Henderson: The 4th quarter 2022 Employment Cost Index rose 1% (approximately 4% annualized) which was the slowest pace in a year. However, job openings increased from 10.4 million in November to 11 million in December. The bottom line is that the job market is very tight. We're not making a lot of progress toward it cooling.
What are the chances of a hard landing, or recession?
Henderson: The odds are still 50-50. On the upside, U.S. GDP was positive in the fourth quarter, so the economy has been holding on very well. The stock market has made a pretty good recovery. China has moved toward a faster reopening after its zero-COVID policies. China reopening fully is positive for economic growth around the world—to some extent, the United States, as the demand for goods will help our exports—but definitely for Europe and some emerging market countries in Asia.
Another factor in support of a softer landing is that long-term interest rates have been trending downward, which is helping to make borrowing money for a house a little cheaper.
However, on the downside, there's the tight labor market and consequentially the high cost of services. And the manufacturing side of the economy is in a slump because of the lack of demand for goods. Retail sales actually fell slightly in November and December because the holiday selling season wasn't as good as many had hoped for.
In sum, inflation has come down, but the Fed can't rest on its laurels. We still have a long way to go.