After lengthy expert debate about what the Federal Reserve's next move would be, markets got the answer on Wednesday when the FOMC announced another 25-basis point (one-quarter of a percentage point) increase.
The decision will bring the Federal Funds rate to a range of 4.75% to 5% and also raises the cost of borrowing money for consumers and businesses. Moreover, it signals the Fed's commitment to fight lingering inflation, which stood at 6% year-over-year in February. The Fed's focus area of so-called "supercore" inflation—which excludes food, energy and rent—is also around 6%.
High prices are continuing particularly in the services sector, driven by high wages and rent prices. Some cities—such as Austin, Tex.—have been experiencing double-digit annual increases in rent, while wages remain high because of the strong labor market. "The Fed needs to slow the demand for workers," said BOK Financial® Chief Investment Officer Brian Henderson. "While it's a very narrow opening to thread, ideally the Fed would be able to slow growth down enough for companies to reduce their job openings, which would take the pressure off above-average wages."
Given the persistence of inflation, the cons of stopping the rate hikes outweigh the pros at this point, Henderson continued. "Then, inflation expectations would move higher, and if reported inflation doesn't slow down and the Fed is further behind, it would have to do even more. This stop-go approach is what happened back in the '70s, which contributed to double-digit inflation and much hardship on everyone."
Still, Wednesday's announcement from the Fed came amid concerns that the hikes are putting pressure on some financial institutions' liquidity—that is, these institutions' ability to meet their obligations (such as depositors' withdrawals) without incurring significant losses.
"With the recent turmoil in the financial industry, there are legitimate questions on whether the Fed can continue to fight inflation with tighter monetary policy and at the same time provide short-term liquidity to the banking sector," Henderson explained.
Fed dual actions have precedent in the U.S. and U.K.
On March 12, the Fed announced that it was creating the Bank Term Funding Program (BTFP), which offers loans of up to one year to banks, credit unions and other eligible depository institutions that pledge U.S. Treasuries, mortgage-backed securities and other qualifying assets as collateral.
Although the BTFP is new, the idea that central banks can ultimately continue to raise rates while also responding to liquidity issues in the banking sector has some precedent in the U.S. and, more recently, in the U.K., Henderson said.
The Bank of England had been doing quantitative tightening and hiking rates to curb inflation when, in September, a dramatic rise in interest rates on long-dated UK government bonds caused debt markets to spiral, putting pension funds under severe downward pressure.
"In response, the Bank of England had to temporarily expand its balance sheet to buy government bonds before continuing to hike rates," Henderson said. "The Bank of England was successful because it was a short-term liquidity issue, not a solvency issue. I think that's what the U.S. Fed also is trying to do—separate these liquidity issues from the rest of the banking industry, which is well capitalized."
Closer to home, when the Fed first introduced quantitative easing (QE) programs in 2009, the long end of the bond market's reaction was uncertain, so they positioned QE as separate from monetary policy addressing the rest of the economy, Henderson continued. "Of course, later as the economy continued to struggle, the Fed already had rates at 0% and the markets were concerned about the Fed's ability to continue to stimulate the economy, then QE and monetary policy became conjoined."
Recession likely this year
Today, despite the series of rate hikes over the past year and recent financial industry events, positive U.S. gross domestic product numbers show a still-strong economy. However, that might change—and the Fed might even decide to cut rates before the end of the year, Henderson said.
One factor is that banks are being more cautious about lending money. This tightening of lending standards started before the most recent financial industry events, but it's happening even more now. "That's going to also have a cooling effect on economic growth," Henderson explained. "What I'm concerned about is that we're on track for recession."
If a recession does occur, the one bright side according to Henderson is: "Following every recession that we've ever had, the year-over-year inflation rate has always gone down—in every single one."