After more than 15 months of rate hikes, the Fed decided Wednesday to hold the Federal Funds rate at a range of 5% to 5.25%. But the reprieve for borrowers may only last a month.
Financial markets were anticipating that the Federal Open Market Committee (FOMC) would decide not to raise interest rates at its June meeting, so the decision wasn't a surprise, said BOK Financial® Chief Investment Officer Brian Henderson.
But the committee's next meeting, July 25-26, may tell a different story, he said.
"There's not any one thing that will trigger the Fed one way or the other," Henderson said of the July meeting. Instead, the Fed will be looking at three areas—financial conditions, macroeconomic trends and financial stability—to determine whether to extend the pause for longer or hike rates again.
Here's the latest on those factors:
1. Financial conditions
Although some parts of the economy, such as manufacturing, have been slowing, that doesn't mean the pressure is off the Fed since other economic indicators are showing growth and fueling inflation.
One telltale mark that the Fed will be watching is lending conditions, Henderson said. "The Fed has already said they expect bank lending standards to tighten, which could be worth one or two 25-basis-point rate hikes. They're going to want to see if lending standards have tightened more than expected." In other words, the harder it becomes for individuals and businesses to get loans, the less the Fed has to raise rates because the tighter lending standards will be slowing the economy (just as the rate hikes are meant to do).
However, so far, loan growth has continued, and the area with the largest loan volume is residential real estate, Henderson said. He attributed the growth to the short-term drop in mortgage rates in February and March, as the mortgage loans acquired then are probably just showing up in the books now.
Another surprise has been the rise in equity markets, which also indicates economic growth. The S&P 500 officially entered bull market territory on June 8, up 20% from its October 2022 lows. Although the Fed doesn't target stock prices, they are focused on what the rise does to wealth levels—and, in turn, consumer and business spending, Henderson said. "As an individual, if my 401(k) is increasing in value at a pretty rapid rate, it makes me more willing to spend. It also gives corporations an increasing asset base to borrow against," he explained.
Meanwhile, another factor that has increased the pressure on the Fed is the recent debt ceiling deal, noted Steve Wyett, BOK Financial chief investment strategist. If the deal had reduced government spending, that lower spending would have helped slow the economy, which in turn would have helped bring down inflation. Instead, the deal still allows government spending to increase—just not as much as what was originally projected.
“Congress is really putting a lot of pressure on the Federal Reserve to use monetary policy to try and slow the economy, and that's an imprecise science that creates a lot of collateral damage when they do it.”- Steve Wyett, BOK Financial chief investment strategist
2. Macroeconomic trends
One of the major trends that the Fed has been watching is of course inflation. The Fed repeatedly has communicated its commitment to reaching a 2% target rate of inflation—but that doesn't mean it has to drop to 2% this year, Henderson said. "They just want to have the right Fed Funds rate that makes them feel they are on course to reach that 2% goal in a reasonable period of time. They don't have 10 years, but they might like to get there in two to three years."
The problem: if we take the inflation data that has come in for the first four months of this year and average it out for the remaining months to get a "run rate," headline inflation will be at 4.2% at year-end, Henderson said. "If that number comes out for 2023, they will be disappointed."
The tight job market has been one factor keeping inflation elevated, so the Fed is keeping a close eye on it. As Henderson said, "It doesn't look like the job market is getting tighter, but it's not loosening up as much as expected."
Just how much is it loosening? There have been mixed indicators, which complicates answering that question. For instance, in May, nonfarm payrolls increased more than anticipated, which would indicate economic growth, but the unemployment rate also increased, which would indicate economic slowdown.
3. Financial stability
Finally, the Fed will be looking at the stability of the financial system to help determine its decision in July. The failure of three banks in March raised concern that the Fed's rate hikes have been putting strain on some banks' liquidity.
However, the situation now seems to have calmed, based on bank deposit data. "It looks like deposits for small banks as well as large banks have stabilized," Henderson said. "Money market funds are still seeing inflows, but overall deposits are back to where they were in late February, system-wide."
The bottom line
Despite the Fed's decision to skip raising rates in June, we probably haven't seen the end of rate increases, Henderson said.
"Barring unforeseen financial stress and geopolitical issues, it's high odds that we've got at least another rate hike."
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