Inflation, Interest Rates, and What's to Come

Jerome Powell, and the Fed, met the consensus expectation for their March meeting and decided to raise interest rates by 25 bps to continue combating inflation. This was hardly a foregone conclusion, though. Before the meetings, Powell sounded more hawkish, raising the possibility that the Fed would increase rates by 50 bps. Turmoil in the banking sector also raised the possibility that Powell would pause rate hikes altogether for this cycle. I want to discuss why Powell backed off a bit from his hawkishness, why some analysts, including those at Goldman Sachs, thought he might not raise rates at all, and what we can expect for the rest of 2023 and beyond based on this information.  

First let’s consider the turmoil in the banking sector. As I mentioned in my post about Silicon Valley Bank, one of the potential, even somewhat likely, impacts of the Fed increasing interest rates is recession, because it’s very difficult for the Fed to use interest rate hikes with much precision vis a vis their economic impacts. In this case, the hikes have come faster than any other Fed interest rate action in history, which adds another layer of uncertainty to exactly how and when rate hikes may go too far. The red line in the chart below shows the 2022 rate hikes as compared to other historical periods of rate hikes in the Fed’s history.

Well the banking industry was the first one to get hit hard by the Fed’s rate action, and we’ve seen two bank failures, Silicon Valley Bank and Signature Bank, as well as the forced acquisition of Credit Suisse when a major depositor left the bank. First Republic Bank is also on the ropes, and while it received a deposit injection from a number of the so-called “too-big-to-fail” banks, that may not be enough to stave off their collapse. These failures alone might have given the Fed pause on another hike, because there’s a strong argument that the size and velocity of Fed rate hikes was a serious contributor to the SVB failure and potentially to future bank failures. However the real reason the Fed would have been hesitant to be as aggressive as they initially indicated they might be with rate hikes is actually a second order effect of these failures.

SVB, and to some extent Signature Bank and Credit Suisse, all took on certain risks that made their situations and their downfall somewhat unique among the rest of the actors in the banking sector. This means there’s a strong argument that their failures aren’t harbingers for a larger systemic failure. However, the failure of these banks spooked some depositors, and, more importantly, made other banks very scared that their depositors would also be spooked by the stories about SVB and the banking situation. When banks are worried about liquidity (and mass deposit withdrawal, aka a bank run, is a major loss of liquidity), they begin pulling away from the interbank lending market, which is an important part of the banking landscape. Effectively, this is how banks with a lot of cash on hand lend to banks that need more cash. You can think of this as the critical infrastructure that keeps the credit markets moving. Banks that are scared that their deposits will suddenly go out the door want to hold on to as much liquidity (read: cash) as possible, which means they are no longer willing to lend to other banks, which freezes the interbank market. During the global financial crisis, the interbank lending markets seized up in early August 2007, which was the proverbial straw that broke the camel’s back and forced unprecedented Fed action to address the credit crisis. So the Fed likely looked at the SVB situation, and were rightfully worried that the contagion would spread to other banks and seize the interbank markets again. Raising rates aggressively would put additional pressure on those interbank markets, so the Fed may have been hesitant to take any action at all, nevermind aggressive action, after these recent events in the banking sector. Coincidentally, this is also why Yellen and the Biden administration took action to insure all of SVBs deposits, it was not about saving that specific institution, it was about bolstering confidence in the other banks and avoiding a credit freeze.

But Powell and the Fed are still very worried about inflation, and they decided that despite this banking turmoil, they still needed to raise rates in order to combat inflation. I’ll look at a few notes from Powell’s remarks at his March press conference that can give us a better view of what the Fed is thinking when it comes to inflation. Powell cites subdued growth at the beginning of his remarks, which indicates that rate hikes are having their intended effect of slowing down economic activity, however Powell indicates that Personal Consumption Expenditure (PCE) inflation, while moderating, is still too high. Powell says the three month average job growth of 351 thousand jobs is high and that the current unemployment rate of 3.6% is very low. This indicates the Fed, while recognizing that wages are not rising as fast as they were last year, is still worried about a wage-price spiral maintaining upward pressure on prices. Powell directly cites a forecasted unemployment rate of 4.5% as an indication that wage pressures will ease in the future, but, reading between the lines, this indicates to me that the Fed’s main focus for inflation is employment data, and they will not stop taking action on inflation until they see a meaningful upward change in unemployment. This means that until there’s a serious slowdown in hiring activity, and potential layoff cycles, we can expect continued interest rate hikes that impact the way we finance our businesses and our personal expenditures.

I think the most prudent question, now, is when can we expect interest rates to moderate, and what can we expect until they do. I’m not going to engage in any technical analysis here, but I’m going to lay out how I think about the uncertainty around interest rates, and how that might inform our thinking about the next year or two of Fed action.

This discussion is a bit of an oversimplification, but not much of one. In “normal” times, the Fed’s decisions about interest rates are fairly easy to forecast in the short term, meaning in a quarter or two, perhaps even out to a year. Barring any economic shocks, the average rate change is zero and you can book your forecast for no interest rate movement with a good amount of certainty. But in normal times, “time” is, essentially, the only critical driver of uncertainty. It takes time for world events to occur, along with their downstream economic impacts. So while forecasting a 0% rate change next quarter is a winning bet, making that same forecast for where the interest rates will be in five years is not nearly as safe of a bet. A lot can happen in five years.

In challenging economic environments, the number of factors that impact our level of uncertainty, like “time” does in our steady-state scenario, increases. The speed and magnitude of the Fed’s recent rate hikes over 2022 and into 2023 are a source of uncertainty. The current turmoil in the banking sector is a source of uncertainty. Interest rate impacts on real estate development and home prices is a source of uncertainty. And inflation itself remains a source of uncertainty. As these sources of uncertainty stack up, it becomes much more difficult to forecast interest rate moves even a quarter out, and the breadth of possible interest rate actions widens. Fortunately, the Fed forecasts their own moves.

The Federal Open Market Committee (FOMC) forecast represents each FOMC member’s opinion on what the target rate should be at the end of each year. Notably, these projections have not changed much from the end of 2022 despite SVB and other developments. In this chart, 2022’s data shows every member predicting the same rate, because it is historical and is known. Then in 2023 each dot represents each member’s opinion on where rates should be at the end of 2023, and so on. Note that the projections spread out as the years go forward, because of the impact of time on uncertainty.

For simplicity’s sake, consider the Fed’s own projections as “all else being equal” meaning that this is what the FOMC members believe should happen if no other major economic changes occur, and inflation continues the course they believe it will. This means the median predictor in the chart thinks inflation will remain high through 2023, requiring one large rate hike of about 50 bps or two smaller hikes of 25 bps before the end of the year. Then they all expect inflation to tame at varying rates, which will enable the Fed to reduce interest rates once again.

But this being an “all else being equal” projection means that the only source of uncertainty they are considering is, essentially, inflation (again, this is an oversimplification, but not much of one!). What that means is our other sources of uncertainty, the housing market, the banking sector, and the universe of “unknown unknowns” may need to be accounted for. I should note that FOMC members certainly account for these risks in their models, but the published projection is the midpoint projection from their models, and thus assumes no major economic shocks, either positive or negative. Outside of the risk of runaway inflation, all of those other risks and uncertainties represent potential reasons for the Fed to temper interest rate action. With this in mind, I would argue that the FOMC forecast should represent a high mark in our personal forecasts. If any of these downturn risks come to fruition, the Fed would likely be forced to pause interest rate hikes, or even to reduce interest rates.

Given that, by my read of the situation, Powell’s Fed is tying their actions closely to jobs numbers, I would keep a close eye on the monthly employment numbers, signs of more turmoil in the banking sector, and signs of a tightening housing market. If unemployment remains relatively unchanged and the other areas of the economy appear to be humming along, the Fed may see a need for more aggressive interest rate action. If unemployment goes up, the Fed may stay the current course, but perhaps with another 25 bps rate hike rather than a 50 bps rate hike. If unemployment rises and there is continued or worsening turmoil in banking or other industries, the Fed will likely at least pause interest rate hikes or lower rates in order to avoid exacerbating an existing problem. All of these scenarios, save possibly the first, assume that inflation is moving either in line with or decreasing faster than the Fed’s current projection. Unfortunately, this means that the most likely outcome here is a recession. The Fed is forecasting a 1% rise in unemployment in their forecast, and such a rise in unemployment coupled with the Fed’s growth projections would most likely result in a recession. Any of our other scenarios, where other sources of economic peril rear their heads, would only worsen the current path. The only path that avoids recession, in my opinion, is a sharp enough decline in inflation that takes the Fed’s focus away from employment numbers and wage pressure. It’s possible but I wouldn’t bet on it.